APPENDIX 14

Theory of Bargaining

Chapter 14 examined models of wage and employment determination in unionized workplaces. These models do not predict
a unique outcome. Rather, they predict a range of possible outcomes, and where the parties settle within that range depends
on the outcome of bargaining. This appendix discusses two leading theories of bargaining that can be used to predict and
explain the outcomes of union-employer bargaining.

Theory of Bargaining
Bargaining theory is concerned with predicting the outcome in any particular bargaining situation, and explaining what
factors this outcome depends on. Because of the importance of bargaining in many aspects of life, bargaining theory has
received considerable attention from social scientists. There is not yet, however, any single widely accepted theory of
bargaining. In this section we examine some important contributions, with particular emphasis on their implications in the
collective bargaining setting.

Although each bargaining situation may be unique, all share some common features: there is a set of possible outcomes, with
minimum acceptable outcomes for each party; and because agreement is voluntary, neither party will agree to an outcome
worse than its minimum acceptable outcome. Whether the parties bargain over wages alone or over wages and employment,
there is a set of feasible outcomes, with upper and lower limits representing the minimum outcomes acceptable to the union
and the firm. This type of situation is illustrated in Figure 14.A1(a). The point d = (d1, d2) shows the utility of each party if
no agreement is reached; this is referred to as the “disagreement,” or threat point. Neither party will agree to an outcome
worse than d, and each can threaten to impose this outcome on the other by failing to agree. The bargaining set S consists of
feasible outcomes in which one or both parties is better off than they would be without an agreement. This diagram illustrates
the bargaining situation in terms of the parties’ utilities, because what ultimately matters to each party is the satisfaction
obtained from an agreement. However, the parties do not bargain over utilities but, rather, over outcomes, such as wages and
employment, and in some cases the analysis is best carried out in terms of these outcomes.

(a) The bargaining problem (b) The Nash solution and the independence
of irrelevant alternatives axiom
U Union
utility
A U
U1 •
S
N A
UN • •
N
UN •
C S
U0 •
T
B Firm
U2 •
utility

d = (d 1d2) f0 f1 fN f2 F d = (d 1d2) fN F

Figure 14.A1 The Bargaining Problem and the Nash Solution

Panel (a) illustrates common features of bargaining situations. Union utility is plotted on the vertical axis and firm utility on
the horizontal axis. The point d shows the utility of each party if no agreement is reached. The bargaining set S consists
of the set of feasible outcomes in which one or both parties are better off than without an agreement.

Panel (b) illustrates the Nash solution (point N) and the “independence of irrelevant alternatives” axiom. An example of an
irrelevant alternative is the shaded area in the upper corner of S.
A14-2 APPENDIX 14: THEORY OF BARGAINING

In bargaining, there are incentives for both co-operation and conflict. The incentives for co-operation are evident from the
fact that there are various feasible outcomes that make both parties better off than if no agreement is reached. As long
as the employees’ utility is at least as great as they can obtain elsewhere and the employer’s profits at least as great as
can be earned elsewhere, both sides are better off continuing the employment relationship. Indeed, the two parties have an
incentive to co-operate at any Pareto-inferior outcome, such as the point C in Figure 14A1(a), because both can gain from
this process. The incentives for conflict arise, because once all Pareto improvements have been realized, such as at the point
A in Figure 14A1(a), actions that make one party better off result in the other becoming worse off. Further, recognition
by each party that the other will benefit from reaching an agreement may create an incentive to threaten the other with
nonagreement. For example, recognizing that the firm is better off with outcome f1 than d2, the union may threaten the firm
with nonagreement unless the firm agrees to the outcome A. Alternatively, the firm may threaten nonagreement unless the
union agrees to B. Because of these incentives for both co-operation and conflict, most bargaining situations contain an
uneasy mixture; on the one hand, recognition of the importance of reaching agreement, and on the other, attempts to mislead,
outmaneuver, or otherwise gain advantage over the other party.

Solutions to the Bargaining Problem

A number of solutions to the bargaining problem have been proposed. These can be classified into two groups: theories of
the bargaining process and theories of the bargaining outcome. The former not only predict the outcome but also model the
process by which that outcome is reached. The latter model the bargaining outcome by specifying a number of properties,
or axioms, that the outcome should obey. Leading examples of each type are outlined below. The theories described here
assume full information: each party knows the set of feasible payoffs, or outcomes; the preferences of the other side; and,
therefore, the set of feasible utility outcomes, S in Figure 14.A1. However, this does not imply that there is no uncertainty.
Although each party is aware of the outcomes available to itself and the other party, it may well be uncertain about what the
other will do. As is common in uncertain situations, the parties are assumed to maximize expected utility.

Nash’s Bargaining Theory

Following the publication by Von Neuman and Morgenstern in 1944 of the Theory of Games and Economic Behavior,
Princeton mathematician John Nash (whose life was the subject of the book and movie A Beautiful Mind) proposed a solution
to the bargaining problem that is still widely used today. Nash (1950) specified four axioms that the solution should obey:

A1. Pareto-efficiency. Only Pareto-efficient bargains will be agreed to.

A2. Symmetry. If the feasible bargaining set, S, is symmetric (i.e., if it doesn’t matter which party’s utility is measured on
which axis), the solution will give equal utility increments (relative to the disagreement outcome) to each party.
A3. Transformation invariance. The solution is not altered by linear transformations of the utility function of either party.
A4. Independence of irrelevant alternatives. Suppose that the solution to the bargaining problem has been reached for
a particular bargaining set, S; for example, the point A in Figure 14.A1(b). Then the solution will not be altered if
some outcomes other than A are unavailable (such as the shaded area in Figure 14A1(b)). That is, if A is the solution
with the bargaining set S, then A will also be the solution if the same two players face the bargaining set T (S less the
shaded area).

The first axiom can be regarded as a natural consequence of the rationality of the two bargainers and the full information
assumption. Why would they agree to an outcome such as C when both can be made better off at outcomes such as A and
N? The second axiom can be viewed as stating that the bargaining power of each side is reflected in the nature of the set
of feasible bargaining outcomes and the disagreement outcome. If the set of bargaining outcomes is symmetric, the two
parties must be equally powerful, because they both stand to gain or lose equally from agreement or nonagreement. Thus,
the solution should reflect this equality of bargaining power, and give each an equal gain from agreement.

The third axiom states that the units in which utility is measured should not matter. Utility functions simply represent an
individual’s preferential ordering of outcomes, and any pair of functions that order outcomes in the same way are equally
valid for this purpose. In expected utility theory, cardinal utility functions are needed; any linear transformation of a cardinal
utility function will preserve the ordering and, therefore, be a valid utility function. The measurement of temperature is
analogous. The Fahrenheit and Celsius scales are equally valid measures of temperature, one being a linear transformation of
the other. Because this axiom states that the actual numerical scale used to measure utility is arbitrary, its main consequence
is to rule out interpersonal comparisons of utility.
 APPENDIX 14: THEORY OF BARGAINING A14-3

The fourth axiom has probably been the most controversial. According to this axiom, if the parties chose outcome A from
all the alternatives in the set S, then the same outcome should be chosen from the set T because the only difference between
the two situations is the absence of the outcomes in the shaded area, outcomes that have already been rejected in favour of
A by the two bargainers. An analogy in the case of individual decision making is contained in the following scenario. You
go out to a restaurant for dinner, and are told by the waiter that there are three choices: chicken in mustard sauce, veal with
a chanterelle sauce, and salmon with a cucumber sauce. You decide to order the veal. The waiter subsequently informs you
that they are out of salmon. Would you want to change your order? Obviously not—you chose veal over salmon and chicken,
so should choose veal over chicken alone as well. Whether this reasoning applies in a two-person bargaining situation is a
more complex question, which is why the axiom has generated controversy.

Nash’s (1950) remarkable result was that assumptions A1 to A4 imply a unique solution to any bargaining situation; the
outcome that maximizes the product of the two parties’ utility increments from the disagreement point—that is, maximizes
(U − d1)(F − d2). The Nash solution is shown as the point N in Figure 14A1. Geometrically, the Nash outcome
maximizes the area within the set S; that is, the area dUNNfN in Figures 14A1(a) and (b) exceeds the area of any other
rectangle contained in the bargaining set.

A number of other axiomatic theories of the bargaining outcome have been proposed; Roth (1979) provides a survey of these
theories, and Roth and Malouf (1979) as well as others have tested these competing theories in experimental settings. The
Nash solution predicts the outcomes of some bargaining experiments well. However, in other situations the outcomes appear
to contradict axiom A3, and a theory that assumes the parties make interpersonal utility comparisons predicts outcomes
better does than the Nash solution.

It can be debated whether the axiomatic approach constitutes a positive or normative theory of bargaining. The approach
proceeds by stating properties that the solution ought to obey, and, therefore, may be more appropriate for the analysis of
arbitration decisions (i.e., decisions about what the outcome ought to be) than collective bargaining outcomes. For the latter
purpose, theories that explicitly model the bargaining process may be more appropriate. It should be noted, however, that
although the axiomatic theories do not specify the process by which the outcome is reached, they may be consistent with
one or several such processes. For example, in an early contribution to the theory of bargaining, Zeuthen (1930) proposed
a model of the concession behaviour of each party. The assumed concession process results in the outcome that maximizes
the product of the two utility increments, an outcome identical to the Nash solution. Recent contributions have provided
more-general theories of the bargaining process, and these are examined next.

Rubinstein’s Bargaining Theory

In an important contribution, Rubinstein (1982) obtains a solution to the bargaining problem using some concepts of
non-co-operative game theory. The type of bargaining situation analyzed in Rubinstein’s bargaining theory has the
following characteristics. The two bargainers take turns making offers. If an offer is accepted, the process ends; if the offer
is not accepted, the other party makes a counteroffer in the next period. However, delay is costly to both sides. Each period,
the total pie to be shared by the two parties gets smaller. This situation is illustrated in Figure 14A2. As before, there is a
bargaining set that shows the outcomes available to each party. In the first period, this is the set bounded by du1f1. However,
if an agreement is not reached in the first period, the set of utility outcomes available in period two shrinks to that bounded
by du2f2. Similarly, in period three the bargaining set becomes du3f3, and in period four the only feasible outcome is the
disagreement point d = (u4,f4). Thus, in this example the “pie” that the parties can share has shrunk to zero by period four. In
general, it may require delay of more than four periods in order to reach the situation where both parties gain nothing from
an agreement (if, indeed, this situation is ever reached); the assumption that this outcome is reached quickly is made simply
for ease of illustration.
A14-4 APPENDIX 14: THEORY OF BARGAINING

(a) Rubinstein’s solution to the (b) The effect of delay costs on the
bargaining problem Rubinstein outcome

U
U Union
utility
u1
u1 A u2 R
uA • uR
u3
u2 R
uR • • u4•
uB •B
u3 •

Firm
d utility
u4
f4 fA fB f3 fR f2 f1 F f4 fR f3 f2 f1 F

(c) The effect of a proportional change in

disagreement costs on the Rubinstein solution

u1

u2

R
u3 •

u4

u5
f5 f4 f3 f2 f1 F
Figure 14.A2 The Rubinstein Solution to the Bargaining Problem
Panel (a) illustrates a non-co-operative bargaining game in which the parties make alternating offers that the receiving
party may either accept or reject, and both parties incur delay costs. In round 1, the set of feasible outcomes is du1f1, but if
no agreement is reached, the parties face the reduced set du2f2 in round 2, du3f3 in period 3, and du4f4 in period 4. If the
union makes the first offer, the Rubinstein solution is point R. Panel (b) illustrates the effects of an increase in the delay
costs to the firm, holding constant the costs to the union. This change leads to an outcome R, with higher union utility and
lower firm utility. Panel (c) illustrates the effect of a change in delay costs that affects both parties by the same proportion.

In bargaining situation 1, the parties face bargaining set du1f1 in period 1, du2f2 in round 2, du3f3 in round 3, du4f4 in period
4, and du5f5 in the final round. The solution is the outcome R. In situation 2, delay costs are proportionally larger for
both parties; they face du1f1 in round 1, du3f3 in period 2, and du5f5 in period 3. The solution is again outcome R, which
illustrates the prediction that a change in delay costs that affects both parties by the same proportion will not alter the
outcome.

As before, both parties are assumed to possess full information about the bargaining situation. That is, each knows the size
of the pie available to be shared in the first period, the other party’s preferences, and the costs of delay (or disagreement) to
both sides. Thus, each can infer the nature of the bargaining set it will face in subsequent periods.

Each party is assumed to be concerned only with its own self-interest; that is, it wants to obtain the highest possible
utility from the bargain and cares only about the outcome, not how it was reached. Also, each behaves rationally (and
expects the other to do likewise) in the sense that neither will believe threats that would not be in the interest of the
threatening party to carry out. For example, suppose it is the union’s turn to make an offer in period one. The union could
 APPENDIX 14: THEORY OF BARGAINING A14-5

offer A = (uA,fA) and threaten to refuse to accept or make any future offers unless the outcome A is accepted. If the firm
believed the threat, it would accept because fA is better than f4, which is what the firm would receive if the offer A is rejected
and the union carries out the threat. However, the threat is not credible. Suppose the firm rejects the offer. In period two the
bargaining set becomes du2f2, and if the firm offers the outcome B, the union will accept because uB is better than u3, the
best outcome the union could obtain in the next period. For this reason, the firm knows that the union’s threat in period one
is not credible, and it will therefore not believe it.

We can now turn to the solution. Suppose that in the initial period it is the union’s turn to make an offer. Rubinstein’s analysis
predicts that the union will offer and the firm will accept the outcome R = (uR,fR); that is, the Rubinstein outcome is the point
R in Figure 14A2. To see why this solution is predicted to occur, we proceed by backward induction. In the second period it
will be the firm’s turn to make an offer, and in the third period it will be the union’s turn. In the fourth period, there is nothing
left to be shared between the two bargainers. Now look at the situation facing the union in period three. Both parties recognize
that the best the firm can attain next period is the outcome f4. Thus, in period three the firm will accept any offer equal to or
better than f4. The union would, therefore, offer (u3,f4) and the firm would accept. Now go back to the situation facing the firm
in period two. The firm knows that the best the union can expect next period is u3. Thus, the firm won’t offer more than u3;
that is, it will make an offer in the interval between (u3,fR) and (u4,f2). However, the firm also knows that in the next period the
union will offer and the firm will accept (u3,f4). Thus, in period two the firm will offer and the union will accept (u3,fR). Now
go back to period one and the union’s choice of offers. The same analysis leads to the conclusion that the union will offer and
the firm will accept (uR,fR). Thus, the point R = (uR,fR) is the bargaining outcome; the costs of delay and the rational behaviour
of the two parties result in an agreement that avoids incurring any disagreement costs.

Clearly, delay costs play an important role in generating agreement in the Rubinstein model. The existence of these costs,
and the fact that both parties are aware of them, gives each some power over the other. For this reason, the relative magnitude
of delay costs exerts an important influence on the negotiated outcome. This result is illustrated in Figure 14A2(b). The
bargaining set du1f1 is identical to that in Figure 14A2(a), as are the delay costs to the firm (measured by the outcomes f1, f2,
f3, and f4). However, the union’s disagreement costs are less than in Figure 14.A2(a), as indicated by the outcomes u1, u2, u3,
and u4. As a consequence, the outcome predicted by Rubinstein’s theory is more favourable to the union and less favourable
to the firm.

It is important to recognize that relative disagreement costs determine the extent to which the negotiated outcome favours
one party or the other. By holding constant the firm’s disagreement costs and lowering the union’s in the comparison between
the situation in Figure 14A2(a) and (b), the union’s relative delay costs declined. The consequence is a more favourable
outcome for the union and a less favourable outcome for the firm. However, suppose the disagreement costs fall by the same
proportion for both parties, leaving relative costs unchanged. This situation is shown in Figure 14A2(c). Two bargaining
situations are depicted in the same diagram. In the first case, the outer boundary of the bargaining set is u1f1 in the first
period, u2f2 in the second period, and so on, reaching the disagreement point (u5,f5) in the fifth period. In the second
bargaining situation, disagreement costs are proportionally higher for both parties; the boundary of the bargaining set is u1f1
in the first period, u3f3 in the second, and the disagreement point in the third period. In both cases, the firm makes the first
offer. The solution is unchanged by the proportionate increase in delay costs, illustrating the reason for emphasizing the role
of relative disagreement costs in bargaining outcomes.

As a description of the collective bargaining process, the Rubinstein model is highly simplified. For example, in most
bargaining situations, either party can make an offer in any period. Nonetheless, this theory captures important aspects of
collective bargaining, in particular the role played by the costs of delay or disagreement in bringing about a negotiated
settlement. The negotiations process itself consumes scarce resources; thus, the sooner an agreement is reached, the lower
the direct negotiations costs to each party. But the major disagreement costs are those associated with attempts of one side to
bring pressure to bear on the other to make concessions. Although there are a variety of relatively inexpensive (and possibly
also ineffective) methods for exerting pressure on the other party (e.g., work-to-rule actions, refusal to work overtime), the
primary mechanism is the strike or lockout.
A14-6 APPENDIX 14: THEORY OF BARGAINING

WORKED EXAMPLE
Solutions to Non-co-operative Bargaining Situations
To help understand the solution to the non-co-operative bargaining game proposed by Rubinstein, consider the
following examples.

Situation 1: Two players, A and B, have $50 to share. In the first bargaining round, player A can propose how
to share this sum, and player B can either accept or reject player A’s proposal. If an agreement is not reached
in the first round, there will be $12.50 to share in round 2, when player B can propose how to share this sum
and player A can either accept or reject B’s proposal. If an agreement is not reached in round 2, each player
receives nothing. To see what agreement (if any) would be reached in this bargaining situation, we apply the
same principles as outlined in the explanation of non-co-operative bargaining theory in this chapter.

Rubinstein’s bargaining theory predicts that the players will reach an agreement in the first round, and that
player A will receive $37.50 and player B will receive $12.50. The explanation involves backward induction. In
round 2, player B will offer $0 to player A and $12.50 to player B, and player A will accept this offer because
player A can’t do any better by rejecting the offer. Thus, in round 1, player A knows that she will have to offer
player B at least $12.50, as this is the maximum that player B can obtain if agreement is not reached in round 1.
Thus, player A will offer $37.50 to player A and $12.50 to player B. Player B will accept this offer, as she can’t do
any better by rejecting it. Thus, the predicted solution is $37.50 to A and $12.50 to B.

Situation 2: Two players, A and B, have $50 to share. In the first round, player A can propose how to share this
sum, and B can either accept or reject A’s proposal. If an agreement is not reached in round 1, there will be $25
to share in round 2, and player B can propose how to share, with A being able to accept or reject B’s proposal. If
an agreement is not reached in round 2, player A can propose how to share $12.50 in round 3, and B can either
accept or reject. If no agreement is reached in round 3, each player receives nothing.

Rubinstein’s theory predicts that the players will reach agreement in round 1, and that player A will receive
$37.50, and player B will receive $12.50. Reasoning is the same as in situation 1. We use backward induction,
starting with round 3 in which there is $12.50 left to be shared and it is player A’s turn to make an offer. Because
there will be nothing left if agreement is not reached in round 3, player A will offer $0 to player B and $12.50 to
player A. This implies that player B will offer $12.50 to A and $12.50 to B in round 2, which, in turn, implies that
A will offer $37.50 to A and $12.50 to B in round 1.

The strike involves the collective withdrawal of union labour in an attempt to halt or sharply curtail production. The lockout
denies union members access to their normal job and source of income. Both types of work stoppage impose costs on
the employer and the employees represented by the union (and also possibly on third parties). The firm loses profits and
the workers lose income. In addition to the costs incurred during the strike or lockout, there may be costs of a more
permanent nature. Clearly, rational bargainers (and perhaps even irrational bargainers) will, in the negotiations process, take
into account the magnitude of the costs that they and the other party will bear in the event of a strike or lockout. Rubinstein’s
theory confirms our intuition that the relative size of the costs of a work stoppage will be an important determinant of the
negotiated settlement. Further, it is not necessary for a strike or lockout to occur in order for the costs associated with a work
stoppage to influence the outcome.
 APPENDIX 14: THEORY OF BARGAINING A14-7

Summary
• Bargaining theory seeks to predict the outcome in any given bargaining situation, and to explain what factors
this outcome depends on. In any bargaining situation, there are incentives for both co-operation and conflict. The
incentives for co-operation arise because of “gains from trade”—there is a set of feasible outcomes that make both
parties better off than if no agreement is reached. The incentives for conflict arise, because, once all the mutually
advantageous trades have been made, actions that make one party better off make the other worse off.
• Two principal types of solutions to the bargaining problem have been proposed. Theories of the bargaining process
not only predict the outcome but also model the process by which that outcome is reached. Theories of the
bargaining outcome specify a number of properties or axioms that the solution should obey.
• Nash’s bargaining theory specified four axioms the bargaining solution should obey. Together, these four
properties imply a unique solution to any bargaining situation; that is, the outcome that maximizes the product
of the two parties’ utility increments from the disagreement point (the utility of each party if no agreement is
reached). Nash’s solution to the bargaining problem is widely used in theoretical and empirical work and has been
tested in laboratory experiments.
• Rubinstein’s solution to the bargaining problem uses non-co-operative bargaining theory, and assumes a process
of alternating offers that the receiving party can either accept or reject. There are costs of delay, so the size of
the pie to be shared by the two parties shrinks the longer it takes to reach agreement. Even though, under full
information the two parties would never delay reaching an agreement, the relative magnitudes of the delay costs
facing each negotiator influence the Rubinstein outcome. In collective bargaining, this implies that the relative
costs of a work stoppage (strike or lockout) influence the negotiated outcome even though a strike or lockout may
not occur.

Keywords
bargaining theory Rubinstein’s bargaining theory
delay costs threat point
Nash solution