ECON0009 Introduction to Economic Thinking

Lecture 8.22
Prof Peter Postl
peter.postl@ucl.ac.uk

Alternating O¤er Bargaining over a ‘shrinking pie’ Two players are

bargaining over how to divide one block of ice cream of size x amongst them-
selves. In Stage 1 of their dynamic strategic interaction, player 1 proposes a
split of the block of ice cream to player 2. If player 2 accepts, the proposed
split is implemented and the bargaining process ends. If player 2 rejects the
proposed split, then Stage 1 ends and we move into Stage 2 where player 2
proposes a split of the block of ice cream to player 1, and so on.
Each player’s payo¤ equals her share of the block of ice cream: if a player
gets the whole block x, then her payo¤ is x.
Suppose that the players do not discount future payo¤s. However, at the
end of each stage, one third of the block of ice cream melts away, so that the
size of the block of ice cream in Stage 2 is only two thirds of its original size.
At the start of Stage 4, nothing is left of the block of ice cream.
Set up this dynamic strategic interaction as an extensive-form game,
sketching the game tree and deriving the backwards-induction solution of
the game. Assume that players, whenever indi¤erent between accepting and
rejecting a proposed split, will accept.

Answer: The following game tree illustrates the game described in the
question.

1
 We now solve this alternating o¤er bargaining game using backwards-
induction, starting with Stage 3:

Stage 3: We (trivially) truncate the game tree by removing Stage 4 because

neither player gets to take any decisions in this stage as there is no ice
cream left to bargain over. Thus, if player 1’s proposal in Stage 3 is
rejected by player 2, we arrive at a terminal node in which both players’
payo¤ is zero.

Stage 3.ii: Player 2 will accept any proposal 21 that leaves her with
a payo¤ of zero or more: I.e. she will accept any proposal under
which her quantity of ice cream (given by 13 x 2
1 ) is at least 0.
Put di¤erently, she will accept any proposal where 21 31 x.
Stage 3.i: Player 1 anticipates player 2’s optimal strategy in Stage
3.ii and therefore proposes a split in which she claims the entire
available amount of ice cream for herself: 21 = 13 x. This leaves
player 2 with zero ice cream and a zero payo¤.

Stage 2: Truncating the game tree by removing Stage 3, note that a rejec-
tion by player 1 of player 2’s proposal will now lead to a terminal node
of the (truncated) game tree with the following payo¤s: 13 x for player
1, and 0 for player 2.

2
 Stage 2.ii: Player 1 will accept any o¤er 2 that leaves her with a
payo¤ of 31 x or more. I.e. she will accept any amount of ice cream
1
2 3
x.
Stage 2.i: Player 2 anticipates player 1’s optimal strategy in Stage 2.ii
and is therefore aware that she must concede an amount 2 31 x.
Subject to this constraint (which guarantees acceptance of her
proposal), player 2 will now choose the o¤er 2 that maximizes
her own payo¤ (given by 23 x 2 ). Obviously, as player 2’s payo¤
is strictly decreasing in the amount she concedes to player 1, it
is optimal for her to o¤er the smallest amount of ice cream that
player 1 will accept: 2 = 13 x. This leaves player 2 with a quantity
of 13 x of ice cream, and hence a payo¤ of 31 x.

Stage 1: Truncating the game tree by removing Stage 2, note that a rejec-
tion by player 2 of player 1’s proposal will now lead to a terminal node
of the (twice truncated) game tree with the following payo¤s: 13 x for
player 1, and 31 x for player 2.

Stage 1.ii: Player 2 will accept any proposal 11 that leaves her with
a payo¤ of 31 x or more. I.e. she will accept proposals where the
1 1
amount of ice cream she gets (given by x 1 ) is at least 3 x. Put
di¤erently, she will accept any proposal where 11 23 x.
Stage 1.i: Player 1 anticipates player 2’s optimal strategy in Stage 1.ii
and therefore proposes a split in which she claims the maximum
amount of ice cream for which player 2 still accepts the proposal:
1 2 1
1 = 3 x. This leaves player 2 with a quantity of 3 x of ice cream,
1
and hence a payo¤ of 3 x.

To conclude: This version of the alternating o¤er bargaining game has a

solution in which bargaining ends in Stage 1 where player 1 proposes the
split 23 x; 31 x , which is accepted immediately by player 2.