Christoph Pfeiffer

Christoph Pfeiffer
Game Theory
—Successful
Negotiation
in Purchasing
Requirements, Incentives and Award
Game Theory—Successful Negotiation
in Purchasing
Christoph Pfeiffer
Game
Theory—Successful
Negotiation
in Purchasing
Requirements, Incentives and Award
Christoph Pfeiffer
Competitio Consulting GmbH
Hamburg, Germany
ISBN 978-3-658-40867-1 ISBN 978-3-658-40868-8 (eBook)

https://doi.org/10.1007/978-3-658-40868-8
This book is a translation of the original German „Spieltheorie – Erfolgreich verhandeln im Einkauf“
by Pfeiffer, Christoph, published by Springer Fachmedien Wiesbaden GmbH in 2021. The transla-
tion was done with the help of an artificial intelligence machine translation tool. A subsequent human
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Preface and Acknowledgments
Construction projects are not the only ones that tend to run over their original
schedules. Books, too, usually require more energy and time than expected. This
book was no exception.
A book is necessarily a collaborative project. First and foremost, I would like
to thank Sarah Pfeiffer for her patience and loving support. Without her, I could
not have completed this book.
Professionally, I am most indebted to Gero von Grawert.
His well-founded and precise comments have greatly improved the content
and technical aspects of this text.
Any remaining errors are mine.
Hamburg, Germany Christoph Pfeiffer
v
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 Basic Game Theory Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 Normal Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.2 Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3 Nash Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 Randomized Strategies and Second Mover Advantage . . . . . . . . 12
2.5 Extensive Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.6 Backward Induction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.7 Evolutionary Game Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.8 Mechanism Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3 Examples of Applied Game Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.1 Price Guarantees—A Case for the Cartel Office? . . . . . . . . . . . . 31
3.2 Location Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.3 Number Selection and Level n Rationality . . . . . . . . . . . . . . . . . . 39
3.4 The Tragedy of the Commons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.5 Price Fixing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
3.6 Three Goals and a Car . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.7 From Duel to Truel and the Advantages of Weakness . . . . . . . . 53
3.8 Focal Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3.9 The Prisoner’s Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.10 The Repeated Prisoner’s Dilemma and the Evolution
of Cooperation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
3.11 You can win with stubbornness . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
vii
viii Contents
3.12 The Ultimatum Game and the Perception of Fairness . . . . . . . . . 66

3.13 The 100-Euro Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
4 Purchasing Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.1 The Basic Model of a Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.2 Central Auction Formats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.2.1 English and Japanese Auction . . . . . . . . . . . . . . . . . . . . . . . 76
4.2.2 Dutch Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.2.3 First-price Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
4.2.4 Second-price Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
4.2.5 Ausubel Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.2.6 Average Price Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
4.2.7 Multi-good Auctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.3 Further Aspects of Auction Design . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.3.1 The Winner’s Curse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.3.2 Monetization of the Advantages and Disadvantages
of an Offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4.3.3 Credibility of the Mechanism . . . . . . . . . . . . . . . . . . . . . . . 104
4.3.4 (Stochastic) Reserve Prices . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.3.5 Duration of the Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.3.6 Ambiguity in the English Auction . . . . . . . . . . . . . . . . . . . 106
4.3.7 The English-Dutch Auction . . . . . . . . . . . . . . . . . . . . . . . . . 108
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
5 Data-based Identification of Cooperation between Suppliers . . . . . . 113
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
6 Case Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
6.1 A Multi-good Auction with Partial Monopoly Markets . . . . . . . 121
6.2 Chilean School Meals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
6.3 Building a Factory in Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
7 Application and Limits of Game Theoretical
Optimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
9 Appendix—Derivation of Optimal Bid in a First Price Auction . . . . 133
Introduction
1
A Tier 1 automotive supplier increases annual profits by more than 20% with a
single sourcing project. A 15% savings is achieved in another project that was
expected to result in price increases. A school district achieves significant cost
reductions in its statewide purchasing of school lunches, while improving the
quality of the meals and increasing margins for its suppliers.
These remarkable results, described in more detail in a later chapter, are based
on a logical structure that can be applied systematically: game theory. Game the-
ory is the mathematical modeling of interactions in which the utility of one party
depends on the behavior of the other. In principle, all human interactions can be
understood as games. However, game theory does not only aim at understanding
interdependent decisions and deriving the optimal behavior of the actors involved
with the help of analytical methods. It also provides answers to the question of
how to optimally design incentives in the context of such strategic interdepen-
dencies. As a result, game theory has become the analytical foundation for many
areas of auction and negotiation theory.
Over the past few decades, purchasing has evolved from an “order taker” to
a strategically important function with a wide range of responsibilities. In many
companies, the ratio of purchasing volume to revenue exceeds 50%, making it
clear that efficient purchasing plays a significant role in achieving both short- and
long-term goals. Purchasing is no longer limited to improving the bottom line,
but is also responsible for the top line as suppliers increasingly contribute to the
overall attractiveness of the final product through their own innovations.
Purchasing objectives are derived from the business strategy. These objectives
may be to reduce costs, reduce the number of suppliers, or improve product
quality. The objectives are translated into a purchasing strategy and further broken
down into commodity group strategies. The tactical purchasing process includes
the specification of the service to be purchased, the selection of the best suppliers,
© The Author(s), under exclusive license to Springer Fachmedien Wiesbaden 1

GmbH, part of Springer Nature 2023
C. Pfeiffer, Game Theory—Successful Negotiation in Purchasing,
https://doi.org/10.1007/978-3-658-40868-8_1
2 1 Introduction
Table 1.1 The Savings-Revenue Equivalence Matrix shows what increase in sales would be
required to achieve the same EBIT effect as the respective savings
Savings [EUR million]
0.1 0.2 0.5 1 10
Margin 2% 5 10 25 50 500
5% 2 4 10 20 200
6% 1 3 7 14 143
10% 1 2 5 10 100
20% 1 1 3 5 50
and the preparation and conduct of negotiations (cf. van Weele 2018, pp. 66–
69). Suppliers can be selected either through traditional bilateral negotiations or
through a competitive bidding process in which suppliers compete on a level
playing field.
The most common application of game theory within tactical sourcing pro-
cesses is the rule-based design of negotiations with pre-qualified suppliers.
Mechanism design, a subfield of game theory, provides recommendations for
the optimal design of a negotiation with defined goals under various conditions.
Applied to procurement, game theory has become an important tool to systemati-
cally ensure efficient allocations. However, there are significant differences in the
degree of its diffusion. While some automotive OEMs or technology companies
already have their own game theory departments, game theory is often still new
territory in the SME sector, in retail, in public procurement or in procurement
under the sector regulation.
An interesting consideration is how much sales would have to increase to
match the EBIT effect of the savings achieved through sourcing. The result
depends on the average margin achieved. With a 5% margin, sales would have to
increase by EUR 2 million to match EUR 100,000 of savings (Table 1.1).
Let us begin, however, with an example that illustrates the mutual interde-
pendence of decision-making. In the short story The Final Problem (Doyle 1993,
pp. 30–48; last filmed in the BBC series Sherlock) towards the end of the plot,
an interesting situation arises (cf. von Neumann and Morgenstern 1947, pp. 176–
178): Sherlock Holmes and Dr. Watson have collected enough evidence to convict
the mathematics professor (!) and villain James Moriarty. Moriarty is aware of
this and will therefore try to kill Sherlock and Watson. The two of them flee
on a train to Dover, from where they intend to cross over to Continental Europe
by ferry. As the train leaves Victoria Station, they see Moriarty on the platform,
1 Introduction 3
Victoria Station
Sherlock
Canterbury Canterbury Dover
Sherlock: Sherlock:
Morriarty: Morriarty:
Moriarty
Sherlock: Sherlock:
Dover
Morriarty: Morriarty:
Fig. 1.1 Sherlock Holmes and Dr. Watson consider at which station to get off the train.
Sherlock’s decision is based on how Professor Moriarty is likely to behave, and Moriarty’s
behavior is based on how he expects Sherlock and Dr. Watson to behave
who unsuccessfully tries to stop the train. Apparently, Moriarty is aware of their
escape plan.
Sherlock and Watson have two options: get off at the next stop, Canterbury,
or continue on to Dover. Which decision is better for Sherlock depends on what
Moriarty decides. If Sherlock and Watson get off at the stop where Moriarty is
waiting for them, he will probably kill them. To make an optimal decision, Sher-
lock will ask himself what he would do if he were Moriarty, and Moriarty will
ask himself how he would behave in this situation if he were Sherlock (Fig. 1.1).
4 1 Introduction
Assuming another person’s point of view implies one’s own point of view,
which implies the other person’s point of view. But the problem does not end
here; it can continue indefinitely. This creates an infinite regress, that is, an infinite
sequence of successive considerations. This mental tangle can be untangled with
the help of game theory. Without going into a detailed analysis of the strategic
situation at this point, suffice it to say that Sherlock and Dr. Watson decide not
to continue to Dover, but to get off the train at Canterbury. This allows them to
avoid Professor Moriarty, who is taking the express train to Dover without any
stops.
The game-theoretic analysis and design of auctions has been one of the most
productive areas of economics in recent years (Klemperer 2018). Although the-
oretical insights have not always been confirmed, the possibility and necessity
of applying theoretical insights to economically highly relevant situations has
accelerated the growth of practically applicable knowledge.
Although most theoretical, experimental, or empirical studies of auctions focus
on forward auctions, many of the findings are also applicable to reverse auctions.
In particular, the auctioning of third-generation mobile frequencies and the
resulting revenues (e.g. EUR 50 billion in Germany) raised awareness of auctions.
The results of UMTS frequency auctions vary widely across Europe.
While Germany and the United Kingdom achieved high per capita revenues,
revenues in other countries, such as the Netherlands and Switzerland, were sig-
nificantly lower (Fig. 1.2). The auction designs used in the UMTS auctions had
certain weaknesses, which auction participants adapted to over time. The first
auctions in the United Kingdom and Germany worked well in terms of revenues,
but administrators had to accept much lower revenues in later auctions.
Purchasing auctions are less transparent to outsiders and do not attract the
same media attention as public spectrum auctions. Nevertheless, auction rules
used have a significant impact on the acquisition cost, which contradicts the
theoretical statement of the revenue equivalence theorem. This theorem states
(under restrictive assumptions) that the outcome of the auction, i.e. the price
level achieved, is independent of the auction format chosen.
A basic knowledge of auctions and game theory is therefore especially
important for buyers. But every purchase needs a seller. As (complex) buying
auctions have become more common, sellers are increasingly confronted with
this problem, so it is also worthwhile for them to study game and auction theory.
References 5
-98%
3,690
3,150
1,050
850
618
76
GER UK IT NL AU CH
Result in € / population / license
Fig. 1.2 Overview of UMTS Auction Results in Europe 2000 (cf. Grimm et al. 2002, p. 224)
References
Doyle AC (1993) The final problem, the memoirs of Sherlock Holmes, Roden C (ed). Oxford
University Press, Oxford
Grimm V, Riedel F, Wolfstetter E (2002) The third generation (UMTS) spectrum auction in
Germany. ifo Studien 48:123–143
Klemperer P (2018) Auctions: theory and practice. The Toulouse lectures in economics.
Princeton University Press, Princeton
v. Neumann J, Morgenstern O (1947) Theory of games and economic behavior. Princeton
University Press, Princeton
van Weele AJ (2018) Purchasing and supply chain management. Cengage, Andover
Basic Game Theory Concepts
2
Abstract
This chapter gives a brief overview of the basic concepts of game the-
ory. Without claiming completeness, it introduces elementary methods that
are applied in the following chapters. For a detailed, formal presentation,
I would recommend Berninghaus (2010) or—largely without mathematics—
Binmore (2007). If you have prior knowledge of game theory, or are simply
impatient, you could skip directly to Chap. 4.
Game theory was developed by John von Neumann as a way to mathematically

model and better understand the logic of strategic interaction. In 1928, von Neu-
mann introduced the foundations of game theory in his article Zur Theorie der
Gesellschaftsspiele. Through his collaboration with Oscar Morgenstern, the foun-
dation for the further development of game theory was laid in 1944 in Theory of
Games and Economic Behavior.
The analysis was still primarily limited to zero-sum games and two-player
games. In zero-sum games, the advantage of one player is the disadvantage of
the other, and there is no way to increase total utility. Games with more than
two players, on the other hand, were only possible by forming coalitions, so
that the games logically corresponded to a two-player game again. John Nash
(1950) developed the tools necessary to generalize to non-zero-sum games and
non-cooperative games with more than two players.
The Nash equilibrium has been further refined, for example, by the intro-
duction of sequential games (Reinhard Selten) or imperfect information (John
Harsanyi). Experimental studies in which subjects (usually with real money) play
theoretical models are now an integral part of game theoretic analysis.

https://doi.org/10.1007/978-3-658-40868-8_2
8 2 Basic Game Theory Concepts
In game theory, a game consists of at least two players. Each player has one or
more strategies to choose from. Depending on which combination of strategies
the players pick, there is an outcome that results in a payoff for each player.
Payoff is often equated with monetary gain, but non-monetary payoffs are just as
common.1
2.1 Normal Form
The most common representation of a game is the normal form (Fig. 2.1). The
normal form is a compact representation of all strategies and possible outcomes.
It assumes that there is a single interaction in which all players decide simul-
taneously. Another common assumption is that all players are rational. In this
sense, each player is rational if she maximizes her payoff as defined. In addition,
common knowledge of rationality is often assumed: all players know their own
rationality, the rationality of the other players, and the knowledge of the other
players about the rationality of all players.
Figure 2.1 shows a two-player game in normal form, consisting of two rows
and two columns. Player 1 can choose a row and player 2 can choose a column.
The players may also be referred to as row players or column players.
Depending on which combination of rows and columns (also called strategy
combination) is chosen, the payoffs for each player are realized in one of the
four squares. However, it is not possible to solve the game without knowing the
payoffs. No statement can be made about the expected behavior of the players
until at least the payoff relationships are known.
2.2 Dominance
Figure 2.2 shows specific payoffs. We can see that player 1 always has a better
payoff when he chooses strategy 1. Strategy 1 is therefore the dominant option
for player 1. Player 2 can infer that player 1 will not choose the dominated
alternative. The decision situation is simplified for player 2 by eliminating one
of player 1’s options.
1Deviations are also plausible because there is usually a nonlinear relationship between
monetary gain and utility. Money tends to have diminishing marginal utility. That is, each
additional unit of money returns less value as the total amount increases. Similarly, a loss is
valued more intensely in absolute terms than a gain of the same amount.
2.2 Dominance 9
Player 2
Option 1 Option 2
Option 1
Payoff player 1 Payoff player 1

Player 1
Option 2
Fig. 2.1 A general two-player game in normal form
In the remaining first row, player 2 gets a better result if he chooses the second
option. As a result, after a simple iteration (cf. Sect. 2.6), the strategy combination
where player 1 chooses option 1 and player 2 chooses option 2 emerges.
Is an equilibrium a realistic prediction if it results from a dominance derived
from multiple steps? It has been shown that only a simple iteration can be reli-
ably reproduced in experiments. Equilibria resulting analytically from multi-step
eliminations due to nested dominant alternatives are no longer reliably repro-
duced in experimental interactions (cf. Kreps 2019, p. 22). However, it can be
argued that firms tend to have better analytical capabilities than individuals and
that they use them when faced with sufficiently relevant decision problems. As a
result, interactions between firms may lead to equilibria that are derived from a
higher number of iterations.
A weakly dominant strategy always achieves a payoff that is better or equal to
a payoff gained by any other strategy. Experimental studies show that iteration in
the case of weak dominance can only be reproduced unreliably (Ibid., pp. 24–25).
Player 2
Option 1 Option 2
Option 1
P1: 3 P1: 2
P2: 0 P2: 1
Player 1
Option 2
P1: 2 P1: 0
P2: 4 P2: 0
Fig. 2.2 A two-player game with defined payoffs shown in normal form. P1 denotes player
1’s payoff, P2 denotes player 2’s payoff
2.3 Nash Equilibrium
A Nash equilibrium (NE) is a combination of strategies in which no player can

improve her payoff by unilaterally changing her strategy.2 The Nash equilib-
rium and John Nash, who gave the Nash equilibrium its name, were popularized
through the movie A Beautiful Mind. In one scene, John Nash, played by Russell
Crowe, is in a bar with friends. There is also a group of five women present,
one of whom, from the perspective of John Nash and his group, is a particularly
attractive blonde. The other four women are brunettes. John is now considering
what strategy the group should use:
If everyone competes for the blond, we block each other, and no one gets her. So, then
we all go for her friends. But they give us the cold shoulder, because no one likes to
be second choice. Again, no winner. But what if none of us goes for the blonde? We
2In a strict NE, a unilateral change in strategy results in a worse payoff for any player who
makes the change.
2.3 Nash Equilibrium 11
don’t get in each other’s way; we don’t insult the other girls. That’s the only way we
win.
Unfortunately, the strategy described in the movie is not a Nash equilibrium,

because each of the men could improve his payoff by unilaterally deviating from
the strategy proposed by John and turning to the blonde woman. Varian (2002)
notes that, atypically for game theory, the consideration of the other side was
largely neglected in the example.
A game with two true Nash equilibria is shown in the simple coordination
game in Fig. 2.3. Two players can individually decide whether to go to a movie
theater or a coffee shop. Both players are social, i.e. if they both visit the places
separately, they both get a payoff of zero.
The two asymmetric solutions do not yet represent a Nash equilibrium, since
both players can improve their payoff by unilaterally changing their strategy.
Player 1 prefers going to a coffee shop to going to a movie theater. For player 2,
it is the other way around. The strategy combinations of both players going to the
Player 2
Café Cinema
P1: 10 P1: 0
Café
P2: 6 P2: 0
Player 1
P1: 0 P1: 6
Cine
P2: 0 P2: 10
Fig. 2.3 There are two Nash equilibria in this simple coordination game
coffee shop or both players going to the movies each represent a Nash equilib-
rium. If there is an opportunity for interaction before the decision is made, there
is a good chance that a Nash equilibrium will be realized. In repeated interactions,
coordination can also occur through learning processes. One interpretation of the
Nash equilibrium is that of an agreement reached over time through adaptation.
2.4 Randomized Strategies and Second Mover

Advantage
Under certain circumstances, it is advantageous for players not to follow a deter-

ministic strategy, but to make their own decision somewhat unpredictable. This
is obviously the case in many sports. In a penalty kick from the 11-meter spot
in soccer, the ball is so fast, at least when advanced players perform the kick,
that the goalkeeper has no chance of preventing a goal if he decides which side
to jump to after the kick. Therefore, he must decide to jump to one side or stay
in the middle before or during the shot. This gives the kicker the opportunity to
make a reactive shot, as practiced by Wynton Rufer, Rodolfo Esteban Cardoso
and Hans-Jörg Butt. “This is a deliberate delay in the last steps of the approach
(as a temporal deception), which is used to provoke or wait for a reaction from
the goalkeeper to one side, in order to then shoot the penalty kick into the other
corner” (Kibele 2013).
Let’s stay with the case where the goalkeeper and the soccer player choose
an area of the soccer goal at the same time. For simplicity, let’s assume that
the areas of the soccer goal to choose from are left, center, and right. The scor-
ing probabilities are shown in Fig. 2.4. The penalty kick can be viewed as an
anti-coordination game in which the shooter tries to choose the area that the
goalkeeper does not choose. To further simplify the analysis, we assume that if
the kicker shoots into an area not chosen by the goalkeeper, a goal is certain.
But even if the goalkeeper chooses the same area as the shooter, there is a
certain probability that a goal will be scored. In the example, we assume that the
shooter has a particularly strong shot into the left corner, so there is a 60% prob-
ability of a goal, even if the goalkeeper chooses the same corner. In the middle
and right corners, the remaining probabilities are 30% and 40%, respectively.
So what area should the shooter target? With a goalkeeper who makes random
decisions, shooting to the left side would be a dominant strategy. In this case, the
scoring probability can be calculated as shown in Fig. 2.6. As the probability of
scoring is 87% when shooting to the left, this choice would always be preferred.
2.4 Randomized Strategies and Second Mover Advantage 13
Goalkeeper
Left Center Right

Right
100 % 100 % 40 %
Shooter
Center
100 % 30 % 100 %
Left
60 % 100 % 100 %
Fig. 2.4 The penalty kick game between shooter and goalkeeper. The scoring probabilities
represent the shooter’s expected payoff and the goalkeeper’s negative payoff
However, if we assume that all the probabilities are known to both play-
ers and that the goalkeeper considers his choice of strategy rationally, then the
goalkeeper could simply counter the shooter’s strategy of always aiming to the
left by jumping to the left himself. The probability of scoring would then drop
to only 60%. However, viewing the shooter deterministically and ignoring the
reasoning of the other side may not lead to an optimal result.
What is the alternative? Another possibility would be to shoot randomly. This
would already lead to a better result than the deterministic choice of strategy,
because it is more difficult for the other side to adapt to it. A deterministic strat-
egy cannot be the optimal solution for either player, as it can be easily exploited
by the other side. The pure random strategy is an improvement over the deter-
ministic strategy, but it does not seem to be optimal either, as it does not take
into account the different probabilities of scoring. The pure random strategy can
also be exploited, for example by the goalkeeper only choosing the centre. This
would reduce the score probability to 77%.
If the shooter considers the different hit probabilities, this should mean that
he shoots less to the center and more to the left. However, it still needs to be
determined what the exact probabilities should be.
How can this question be answered?
The optimal strategy of the players should not be exploitable by the other
team. Since the shooter’s advantage is always the goalkeeper’s disadvantage (and
vice versa), the goalkeeper will try to achieve the worst case for the shooter. A
non-vulnerable strategy is the maximin strategy. As the name suggests, it maxi-
mizes the minimum utility, i.e. it optimizes the worst-case scenario. This makes
the other side indifferent between the alternatives.
In Fig. 2.6 the probabilities from Fig. 2.5 are supplemented by a worst-
case column, in which the line minimum, i.e., the outcome least favorable to
the shooter’s chosen strategy, is entered. The three deterministic strategies (left,
middle, right) are extended by two random strategies for the shooter, which are
added in the two rows below. For simplicity, we restrict ourselves to deterministic
strategies for the goalkeeper. The payoffs for the randomized strategies result as
expected values, analogous to the calculation in Fig. 2.5.
This results in the following optimization problem: Which probabilities for
each shooting direction (P(L), P(M), P(R)) maximize the minimum payoff? The
following constraints apply: Each probability may take a value between 0% and
100%. In addition, the sum of the three probabilities must be 100%.
Static probability analysis
Probability goalkeeper left = 1/3
Probability goalkeeper center = 1/3 The goalkeeper behaves purely randomly (0-rational)
Probability goalkeeper right = 1/3
Hit probability shooter shoots left = 1/3 x 100% + 1/3 x 100% + 1/3 x 60%.
= 2/3 + 1/5 = 13/15 = 87 %
Hit probability shooter shoots center = 1/3 x 100% + 1/3 x 30% + 1/3 x 100%
= 2/3 + 1/10 = 23/30 = 77 %
Hit probability shooter shoots right = 1/3 x 40% + 1/3 x 100% + 1/3 x 100%.
= 4/30 + 2/3 = 24/30 = 80 %
Fig. 2.5 If we assume a purely random behavior of the goalkeeper, a shot to the left is the
optimal choice. However, if the goalkeeper anticipates this, the probability of success drops
to 60%
2.4 Randomized Strategies and Second Mover Advantage 15
Goalkeeper
Worst Case
Left Center Right Shooter
Right
Deterministic strategies
100 % 100 % 40 % 40 %
Center
100 % 30 % 100 % 30 %
Shooter
Left
60 % 100 % 100 % 60 %
Random strategies
All options
1/3-Pr
87 % 77 % 80 % 77 %
probability
Optimal
82 % 82 % 82 % 82 %
Fig. 2.6 In this zero-sum game, the only Nash equilibrium is a randomized strategy
A good approximation can be obtained by trial and error. For example, if

we decrease the probability of aiming at the center by 5 percentage points and
increase the probability of aiming at the right by 5 percentage points, the worst
case for the shooter improves to a hit probability of 80%. This value is already
3 percentage points higher than the randomly chosen value.
A more precise optimal value can be determined using a mathematical opti-
mization method, linear programming. It uses algorithms to solve an optimization
problem under constraints. This can be done in Microsoft Excel.
The following optimal values are obtained from optimization: The shooter
shoots to the left with 44.7%, to the center with 25.5%, and to the right
with 29.8% according to the maximin optimization. The worst case for the
shooter improves by another 2 percentage points to 82% compared to the first

approximation solution (Fig. 2.6).
What is interesting about this solution is that it makes the choice of strategy by
the goalkeeper irrelevant to the outcome. Regardless of the goalkeeper’s choice,
both players always have the same expected payoff. This is true even if, for
example, the goalkeeper always stays in the middle. The maximin strategy creates
immunity to any attempt by the opponent to gain an advantage.3
2.5 Extensive Form
At the beginning of the last section, we saw that some shooters have developed
a shooting technique in which they simulate the shot and delay it for a short
moment. This allows them to observe the goalkeeper’s decision before taking
their own shot. In effect, they turn a simultaneous game into a sequential one.
You can anticipate the goalkeeper’s decision and then shoot where the goalkeeper
is not. This way, almost 100% accuracy is possible, regardless of the goalkeeper’s
decision.4
A sequential game in which players make their decisions one at a time can be
represented in the extensive form (Fig. 2.7). In the sequential game, the shooter
has an advantage because he can observe the goalkeeper’s decision and then make
an optimal decision for himself. This is the second mover advantage.
In the same way, however, a first mover advantage is also possible under
different circumstances. This can be seen, for example, in the coordination game
in Sect. 2.3, where two players have the choice of going to a movie theater or a
coffee shop. Player 1, who prefers the coffee shop, can now go to the coffee shop
first, call player 2 from there and let him know what he has decided. Since player
1 has a preference for going to a coffee shop together rathan than being alone at
the cinema, he will go to the coffee shop. Each individual decision situation can
be considered a subgame. The equilibrium that emerges in this game is therefore a
subgame perfect equilibrium, which is a refinement of the Nash equilibrium. This
implies that the players behave foresightedly and anticipate the behavior of the
other player. The optimal choice for player 1 is derived by backward induction.
3 Levitt et al. (2002) statistically evaluated penalty kicks in the Italian and French soccer
leagues over a three-year period. They conclude that the interaction between the kicker and
the goalkeeper is essentially simultaneous. Furthermore, they show that both randomize their
strategies during the penalty kick, in line with the theoretical analysis.
4 To make the results of penalty kicks more open and exciting, the delay in execution could
be prohibited.
2.5 Extensive Form 17
100 % 100 % 30 % 100 % 100 %
100 %
Center
100 %
Left
Righ
Le
t
t
er
gh
ft
nt
Ri
Ce
nt Ce
er
60 % 40 %
Left Right
Center
Le
ht
ft
g
Ri
Goalkeeper
Shooter
...% hit probability
Fig. 2.7 The subgame perfect equilibrium can be determined by backward induction
In the upper decision situation for player 2, he can choose between a payoff
of 6 (café) and a payoff of 0 (cinema). In this situation, he will obviously choose
the café. In the lower decision node, player 2 can choose between a payoff of
0 (café) and a payoff of 10 (cinema). The choice would obviously be the movie
theater. This leaves only two possible outcomes, namely (café, café) or (cinema,
cinema), i.e. the two Nash equilibria of the simultaneously played game. Player
1 will choose the café because he knows that player 2 will follow him and the
café generates the higher payoff for him (Fig. 2.8).
Backward induction is only possible with complete information. As soon as
there are information asymmetries, backward induction may not be feasible. So
if player 2 does not know where player 1 is in the second phase of the game,
for example because there is no communication between them, then the game is
sequential, but strategically it is equivalent to the simultaneous game (Fig. 2.9).
Player 1
Player 2 Player 1: 10
Player 2: 6
Ci
ne
m
a Player 1: 0
Player 2: 0
Player 1: 0
Player 2: 0
Ci
ne
m
a
Ci
ne
m
a Player 1: 6
Player 2: 10
Fig. 2.8 The subgame-perfect equilibrium can be determined by backward induction under
perfect information
2.6 Backward Induction
In the centipede game5 (Fig. 2.10) players take turns for a predetermined number
of rounds, either keeping an envelope filled with a certain amount of money
for themselves or passing it on to another player. If the envelope is passed, the
amount of money in the envelope is increased by a certain amount.
Let’s make the conditions more concrete: Player 1 starts in round 1 with an
amount of EUR 0. If a player chooses to pass, the total amount increases by
EUR 100 in each subsequent round6 , so that in round 2, player 2 would be faced
with the decision of either keeping EUR 100 or passing the envelope back to
5 The centipede game goes back to Rosenthal (1980). The name of the game is derived from
the many ways to act, which make it look like a centipede.
6 In this case, it is a constant increase in the amount of money. Other interesting scenarios
might include increasing the amount itself with each round.

2.6 Backward Induction 19
Player 1
Player 2 Player 1: 10
Player 2: 6
Ci
ne
m
a
Player 1: 0
Information
asymmetry Player 2: 0
Player 1: 0
Player 2: 0
Ci
ne
m
a
Ci
ne
m Player 1: 6
a
Player 2: 10
Fig. 2.9 With information asymmetry at the second node, the sequential game is strategi-
cally equivalent to the simultaneous game
player 1 with EUR 200. The number of rounds is limited to 10. At the start
of round 10, the total amount in the envelope has increased to EUR 900. Since
player 1 starts in round 1, player 2 would be up in round 10. After round 10,
no more rounds are scheduled, so player 2 can only choose between EUR 900
(keep) and EUR 0 (pass). A self-interested, rational player will choose the keep
strategy.
However, in round 9, player 1 can decide whether to give the envelope to
player 2, and thus whether there will be a round 10 at all. Since player 2 is
expected to keep the envelope in round 10, it is also advantageous for player 1
to keep the envelope in round 9. This logic can be applied step by step back to
round 1. The analysis performed step by step from the end of a game back to the
logically derived first step is the backward induction.
20
Pass Pass Pass Pass Pass Pass Pass Pass Pass Pass
S1: 1000
S2: 0
Keep
Keep
Keep
Keep
Keep
Keep
Keep
Keep
Keep
Keep
S1: 0 S1: 0 S1: 200 S1: 0 S1: 400 S1: 0 S1: 600 S1: 0 S1: 800 S1: 0
S2: 0 S2: 100 S2: 0 S2: 300 S2: 0 S2: 500 S2: 0 S2: 700 S2: 0 S2: 900
Player 1 Player 2
2
Fig. 2.10 The centipede game with 10 rounds

Basic Game Theory Concepts
2.6 Backward Induction 21
By backward induction, player 1 can deduce that player 2 will keep the enve-
lope in round 2. So how will player 1 behave in the first round? Based on the
previous considerations, player 1 would be indifferent between the two possi-
ble actions, since in a deterministic-rational world they both imply a payoff of
zero. However, it is clear that in practice most players will not choose an empty
envelope as long as there is some chance of winning in subsequent rounds.
What is the explanation for this discrepancy between the analytical prediction
and the observed behavior? García-Pola et al. (2020, p. 2) list the following
approaches:
1. The players are boundedly rational and make mistakes with a certain probability
in the sense of a deviation from the Nash equilibrium. When making decisions,
they anticipate possible errors by themselves or others.
The Quantal Response Equilibrium (QRE) is a statistical solution concept in game

theory developed by McKelvey and Palfrey (1995). In the QRE, players’ rational
expectations are complemented by possible errors. In this way, rational strategies
are still played more often than bad strategies, but not always (Ibid. p. 22). In a
sequential game, players assume that both they and the other players will make
mistakes in later rounds, in the sense of deviating from the Nash equilibrium with
some probability.7
The empirically observed behavior of not ending the game at the first opportu-
nity in the centipede game or similar interactions can thus be interpreted in part8
as a rational anticipation of one’s own or others’ irrational behavior. The sum of
possible future errors decreases with each additional round, so the probability of
passing the envelope on also decreases.
In Fig. 2.11 the centipede game is calculated as a QRE. For the model it is
still necessary to specify the parameter lambda, which indicates the degree of
irrationality. Even with very low values, it can be seen that the results obtained
7 In extensive games, the Agent-Quantal-Response-Equilibrium (AQRE) is also used (cf.

McKelvey and Palfrey 1998). The player sees his future self as another person over whose
behavior he has no control, and who will deviate from the analytic optimum with some
probability.
8 In addition to the expectation of an error, the deviation may also be the result of a previous
error.
Probabilities envelope forwarding AQRE

Probability
Round
Player 1 Player 2
Fig. 2.11 If a certain probability of error is built into the calculation of both players, the
probability of passing the envelope is initially higher and decreases as the game progresses.
The QRE model is reproduced here with three different rationality values for both players.
The QRE was calculated using the Gambit software package (McKelvey et al. 2014)
are closer to what would be expected in reality compared to the model with full
rationality.9
If player 1 assumes in the first round that there is a certain probability of
errors (in the sense of deviations from the Nash equilibrium) in later rounds by
both her and the other side, then a certain payoff of 0 Euro is an inferior outcome
to a possible higher payoff in later rounds. Thus, handing over the envelope is
the rational choice.
2. The second approach is based on level-k reasoning. Players expect the other
player to use a certain iteration depth to analyze the game. If this is known, it
9It should be noted, however, that these values are based on a statistical model that gains its
explanatory power by being fitted to existing data, for which data from comparable situations
must be available.
2.7 Evolutionary Game Theory 23
is optimal to choose an iteration depth that is exactly one level higher than that
used by the other side.
In the logic of level-k reasoning, the optimal behavior of a player results from
the expected depth of iterations of the other side. With a fully rational opponent,
player 1 must assume that player 2 will claim the contents of the envelope in
round 2. However, if player 2 is a so-called level-0 player, this means that he
makes his decisions purely randomly. In this case, it would make more sense to
pass on the envelope in round 1. If player 2 also gives up the envelope in round
2, player 1 can choose between 200 euros for sure or 400 euros with a 50%
probability in round 3 (assuming that he would definitely keep the envelope in
round 5 if he got that far). The calculation of a player who assumes that the other
side is purely random is that of a level 1 player. A player who anticipates the
reasoning of a level 1 player is a level 2 player, and so on.
Since the level of the other side cannot be predicted exactly, statistical eval-
uations can also be used to make statements about how often a certain iteration
depth is encountered. However, these are highly context-dependent, and it should
be noted that the existence of these statistical measures can itself cause a change
in behavior. Nevertheless, k=2 and k=3 are among the most commonly observed
levels of rationality.
Note that Nash equilibria determined by multiple iterations have relatively
little predictive power in reality. The more iterations required, the weaker a state-
ment. The centipede game takes the predictive weakness of Nash equilibria to the
extreme, as it is determined by a particularly large number of iterations. Models
that also take into account the possibility of error or limited rationality generally
have better predictive power when the required reasoning involves multiple steps.
2.7 Evolutionary Game Theory
The games considered so far are aimed at rational agents who make conscious and
(largely) rational decisions according to their strategic calculus. In evolutionary
game theory, however, players have fixed, genetically determined strategies. In
this perspective, members of a population compete for scarce resources using
different fixed strategies. Successful interaction secures resources, while failure
results in fewer or no resources. Secured resources lead to population growth,
while lack of resources leads to population contraction. In this context, the payoff
can be understood as a measure of the evolutionary fitness of a strategy or a
species (Cowden 2012).
Both aggressive and defensive strategies are possible when competing for
resources. The best-known game in evolutionary game theory is the doves-hawks
game, which, in addition to its importance for understanding evolutionary pro-
cesses, also shows the role of aggression in social interactions. In this game,
hawks pursue an aggressive strategy, while doves rely on cooperation and conflict
avoidance.
If a hawk meets a dove, the hawk can claim the entire resource for itself,
because the dove will retreat as soon as it sees a hawk. If two pigeons meet, the
resource is shared equally. A hawk that is surrounded by doves always benefits
from its aggressive strategy, because it can always claim the resource that is
being fought over. The disadvantage of the aggressive strategy arises as soon as
two conflict-oriented strategies meet and a conflict starts to occur. The higher the
conflict costs and the higher the number of other aggressive players, the more
disadvantageous the conflict-oriented strategy becomes. Species that fight each
other for resources or status tend to have traits that reduce conflict costs. For
example, a lion’s mane is not only impressive, but also serves to reduce the
number of neck and throat injuries in fights between male lions. The mane is a
brilliant evolutionary development that only reduces the conflict costs of the lion
in fights with other lions, but in no way impairs its fighting power against other
species.
The doves-hawks game is shown in Fig. 2.12. The value of the resource to be
fought over is assumed to be 20 for all players. The amount of conflict cost is
represented by the variable C and is not specified so that different magnitudes of
C can be compared.
A key concept in evolutionary game theory is evolutionary stability. An evolu-
tionarily stable strategy (ESS) is a strategy or strategy component in a population
that cannot be invaded by other strategies.
Let’s imagine a population consisting entirely of pigeons. If a mutation occurs
and one or more individuals begin to adopt a hawkish strategy, they would ini-
tially have an easy time (as long as the cost of conflict is not very high) and would
spread quickly. A population consisting entirely of pigeons can therefore be eas-
ily invaded and would not represent an ESS. For a strategy not to be uninvadable,
the expected payoff of a mutation must be less than the expected payoff of the
existing strategies. The concept of ESS is closely related to the Nash equilibrium;
a strict Nash equilibrium (see Sect. 2.3) always represents an ESS.
Under what circumstances is the hawk strategy strongly dominant? A strategy
is strongly dominant if it is always advantageous to the player, regardless of the
strategy chosen by the other player. The hawk’s payoff is always higher than the
dove’s. The dove strategy results in a zero payoff if the other player is a hawk.
2.7 Evolutionary Game Theory 25
Fig. 2.12 The hawk-dove Hawk Dove

game in normal form
(Pastine and Pastine 2017).
The higher the cost of
conflict, the less
Hawk
(20 - C) / 2 20
advantageous an aggressive
strategy (20 – C) / 2 0
Dove 0 10
20 10
For the hawk strategy to become a strongly dominant strategy, it must produce
a payoff greater than zero when confronted with another hawk strategy. Solving
the inequality (20 − C)/2 > 0 results in a conflict cost, C, that is less than 20. As
long as the conflict cost is below this threshold, the hawk strategy is a strongly
dominant option, a strict Nash equilibrium, and therefore an evolutionarily stable
strategy.
The evolution of the proportions of a strategy in a finite population can be
simulated using a Moran process. The genetic fitness, which results from the
respective payoffs, determines the probability of reproduction and extinction. If
the hawk strategy is dominant at low conflict costs, the entire population will
eventually become hawks (Fig. 2.13), even though the sum of payoffs in a pop-
ulation would be higher if it consisted only of doves. At higher conflict costs,
the situation changes, but the dove strategy can never be dominant at any conflict
cost value, since the hawk strategy is always advantageous if the other player
behaves in a conflict-avoidant manner.
As conflict costs increase, the evolutionarily stable fraction of hawks
decreases. However, even with very high conflict costs, a single hawk can still
generate a high payoff if it encounters only doves. The only limit to the growth
of hawks comes from encounters with other hawks.
When conflict costs are high, a small fraction of an aggressive strategy
is the equilibrium. Consider, for example, the office tyrant who is surrounded
Low conflict costs (C<20) High conflict costs (C=40)
100 %
Doves
Doves
Share in the
Share in the
population
population
50 %
Hawks
Hawks
Time Time
Fig. 2.13 As long as the conflict cost is less than 20, the hawk strategy dominates and
spreads until the entire population consists of hawks. At higher conflict costs, the evolution-
arily stable fraction of hawks decreases
by employees who follow a conflict-avoiding strategy. The tyrant’s aggressive

strategy can only be maintained as long as there is no other tyrant nearby.
2.8 Mechanism Design
In mechanism design, rules are developed to achieve predefined goals. A set of

rules is called a mechanism. It is further assumed that participants are rational
and self-interested, and that they voluntarily participate in a mechanism. Through
the use of mechanisms, economic or business goals can be achieved without the
need for the mechanism designer to know the preferences or cost structures of
the participants.
Mechanism design is also called economic engineering because it reverses the
typical process of economic analysis (Maskin 2019). Instead of evaluating exist-
ing rules or institutions, an optimal mechanism is designed based on previously
established objectives.
A central goal for a mechanism in economic policy is allocative efficiency. If
this goal is achieved, the resulting allocation of goods maximizes the aggregate
welfare of the participants. In procurement, it is desirable to award the contract
to the firm with the lowest cost. Furthermore, participation in the mechanism
should be individually rational, i.e. a participant should expect to benefit from
participating in the mechanism.
2.8 Mechanism Design 27
Another requirement for a mechanism may be that it induces participants to be

truthful about their costs or preferences. For rational participants, the mechanism
must be such that truthfulness is in their own interest. In practice, however, the
truthfulness requirement is usually less relevant.
How can a single mechanism achieve multiple goals? An example: A mother
is faced with the challenge of dividing a cake as fairly as possible between her
two children, Emma and Tom. An obvious solution would be to divide the cake
into two equal parts down the middle. This solution assumes that the mother
has sufficient information about the children’s preferences, since the cake is not
necessarily of equal quality. In practice, dividing the cake may lead to later com-
plaints (allocative inefficiency), which the mother would like to avoid. Such a
dictatorial solution, in which an allocation is simply determined, typically fails
due to a lack of information about the preferences or costs of the participants.
Moreover, it is often not feasible in the context of a free market economy.
Another approach would be to ask for preferences and allocate the amount of
cake accordingly. But even this approach has little chance of success, because
if preferences are not linked to costs, they are not credible and are likely to be
exaggerated.
A simple mechanism that leads to optimal allocation for a homogeneous good
is the “you divide, I choose” rule. For a homogeneous good, allocating according
to this rule is a zero-sum game that can be solved with the maximin strategy (see
Sect. 2.4). When Tom divides the cake, he knows that he must cut it exactly in
the middle. Any deviation from the center would put him at a disadvantage if his
sister chooses the larger part of the cake.
The decision situation is different if the good to be divided is valued differ-
ently. Suppose one half of the cake is covered with Smarties. Tom prefers the
side with the Smarties, Emma likes both sides equally and is allowed to make
the division. How should Emma divide the cake if Tom gets to choose?
One possibility would be a vertical division into two equal parts (Fig. 2.14,
division (1)). One half would be covered with Smarties and the other half would
not. Although Emma is indifferent between the two pieces, Tom has a preference
for the Smarties side, so he would have a clear preference and potentially get a
better result than Emma with this approach.
If Emma has a good idea of Tom’s taste, she can improve her bargaining
result by moving the cut to the right (Fig. 2.14, division (2)). This would make
the piece with the Smarties a little smaller, but it would probably still be more
attractive to Tom than the piece on the left. The stronger Tom’s preference for the
Fig. 2.14 Dictatorial 0% 50 % 100 %

allocation does not
systematically lead to
optimal allocation when
individual valuations are
unclear. When Emma
allocates, she could cut the
cake vertically down the
middle (1). However, if she
knows that Tom prefers (3)
cake with Smarties, she
could cut further to the right
with some risk (2). Another
option would be to cut
horizontally down the
middle (3).
(1) (2)
Smarties, the farther to the right Emma can move the cut.10 However, the farther
to the right Emma moves the cut, the greater her penalty for misjudging Tom’s
preference. From Emma’s point of view, this approach is only recommended if
she can estimate Tom’s preferences with high accuracy.
Emma could also decide to divide the pie horizontally. With the other side’s
preferences unknown, this strategy-like any other 50–50 division-would be ratio-
nal for her, since Emma is indifferent between the two pieces. This protects her
from the other side’s strategy, since their decision can no longer affect her util-
ity. However, the equal split would have to be considered suboptimal if she knew
Tom’s preferences, since she could achieve a better outcome.
In the case of unclear preferences, the choser is generally in a better starting
position than the divider in the “you divide, I choose” mechanism. However, if
the divider has good information about the preferences of the other side, he can
turn this into an advantage in bargaining, as long as the preferences are different.
In the case of a homogeneous good to be divided, it is a zero-sum game that
functions analogously to the penalty shootout discussed earlier.
10 An extreme scenario occurs when Tom only values the Smarties area. In this case, the cut
can be moved to the right until the Smarties area of the right part is equal to the Smarties area
of the left part. This theoretical maximum is just over 40% of the radius. If the right part is
cut even smaller, Tom always chooses the left part.
References 29
A similar concept is used in the creation of parity shareholder structures to

avoid deadlocks in the event that one of the shareholders wishes to sell its shares.
In the case of a Russian roulette clause, each shareholder can offer to sell his
share at a certain price. The shareholder who receives the offer has two options:
He can either accept the offer and become the sole shareholder, or he can sell
his shares at the offered price. The shareholder who makes an offer to sell can
therefore only offer a selling price that he himself would be willing to pay. Again,
the better he knows the preferences of the other shareholder, the better he can
adjust his offer.
Another way to avoid potential stalemates in parity shareholder structures is
a Texas Shoot-out Clause. This allows each shareholder to make an offer to
purchase the shares of the other shareholder at any time. However, the shareholder
to whom the offer was made has the option to make a higher counteroffer for the
shares of the other shareholder. Counteroffers are repeated until a final offer is
made, at which point the shares are sold on a binding basis.
The advantage of these two mechanisms is that they can quickly resolve dead-
locks, which can be quite damaging to companies. Both mechanisms also ensure
that the shareholder with the higher share valuation becomes the sole shareholder
if the joint structure no longer appears advantageous to at least one shareholder.
Auctions are the most common mechanisms used in negotiations or coordi-
nation problems. In procurement, bidding mechanisms are developed with the
goal of minimizing costs. A key challenge is to make different bids comparable
prior to negotiations. In the case of a financially attractive award, participation
in the mechanism is associated with a positive expectation for suppliers and thus
satisfies the rationality criterion.
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García-Pola B, Iriberri N, Jaromír K (2020) Non-Equilibrium play in centipede games.
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Kibele A (2013) Elfmeter – zum aktuellen Forschungsstand einer bedeutsamen Standardsit-
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on his beautiful mind? New York Times 11.04.2002
Examples of Applied Game Theory
3
Abstract
After introducing elementary game theory methods in the last chapter,
this chapter presents examples that illustrate the working of game theory
principles.
3.1 Price Guarantees—A Case for the Cartel Office?
Price guarantees are common in many industries. Price guarantees vary in their
aggressiveness. The least aggressive version is a price match guarantee. If a cus-
tomer finds the same product at a lower price within a certain period of time after
the purchase, the vendor is obligated to refund the difference. More aggressive
price guarantees require the seller to beat the lower price by a certain percent-
age. Price match and price undercutting guarantees can differ in their effects (see
Fatás et al. 2011). In the following, I will focus on price match guarantees.
With a price-match guarantee, the customer is less likely to regret the pur-
chase—at least as far as the price is concerned. If the customer later finds a
better deal, the guarantee allows the customer to claim the better price.
Viewed in isolation, a low-price guarantee may appear to be a benefit to the
customer, who always receives the lowest price offered in the competitive envi-
ronment. However, this ignores the fact that a price guarantee can itself influence
the price level.
To assess the effect of price-matching guarantees on the prices charged, we
analyze different market constellations: first a market with only one seller (a
monopoly), then a market with two sellers offering exactly the same product (a
duopoly), and finally a duopoly with price-matching guarantees. It turns out that

https://doi.org/10.1007/978-3-658-40868-8_3
32 3 Examples of Applied Game Theory
in the duopoly with price-matching guarantees, sellers will charge the same prices
as in a monopoly market.
With only one supplier, the firm can in principle raise prices to the maximum
willingness to pay of its customers. However, because each customer’s willing-
ness to pay is different and unknown to the firm, the monopoly firm focuses
on its profit. Prices are raised until profit reaches its maximum point (Fig. 3.1).
As prices rise, the margin per unit sold increases, but the higher the price, the
fewer customers will tend to buy. At very low prices, the supplier initially ben-
efits from a price increase because few customers leave and the margin per unit
still increases. However, if prices are already high, the reduction in quantities
sold from further price increases is so high that the increased price can no longer
compensate and the overall effect on profit is negative. In between is an optimal
price at which the firm makes its maximum profit. In the absence of competi-
tion, the firm can simply choose its price based on this consideration, since it
does not have to fear undercutting by competitors. As shown in Fig. 3.1, the
profit-maximizing price in the absence of competition is 60.
Profit
Price
Fig. 3.1 In a monopoly market, profit-maximizing price is 60 when quantity = 100 − price
and variable costs are assumed to be 20 per unit, with no fixed costs. Marginal cost is 20, so
this price is the break-even point. If a competitor enters the market, the price falls to marginal
cost
3.1 Price Guarantees—A Case for the Cartel Office? 33
Price
Quantity
Fig. 3.2 In the model, quantity = 100 − price was set as the price sales function. In duopoly,
the price falls from 60 to 20, while the quantity sold rises to 80. Traditionally, price is plotted
on the y-axis and quantity on the x-axis, even though price is the variable quantity in this
model
When another supplier (B) enters the market in addition to the original
monopoly supplier (A),1 price competition takes place. In the model (Fig. 3.2),
all consumers buy exclusively from B at a price of 59 as long as A does not adjust
its price. Although B’s profit is less than the profit possible under monopoly, B
is expected to be satisfied with this market-dominant situation. However, supplier
A now has an incentive to undercut B. This dynamic continues until the price
of both firms equals their respective costs. At this point (the Bertrand equilib-
rium)2 there is no incentive to change price as long as the other company does
not deviate from its strategy. If one firm raises its price, it loses all its sales; if it
lowers its price further, it makes a loss. This combination of strategies therefore
represents a Nash equilibrium (cf. Sect. 2.3).
How does competition between firms change when both firms introduce a
price-matching guarantee? In Bertrand’s equilibrium, both competitors have set
1 For simplicity, it is assumed that there are no cost or product differences between the two
competitors.
2 After the French mathematician Joseph Bertrand, this strategy combination is also referred
to as the Bertrand equilibrium.

a price of 20. Without the price-matching guarantee, a price increase would not
have been profitable because it would have meant a complete loss of sales. With a
price-matching guarantee, however, a price increase does not result in the loss of
all customers. Customers can also buy with confidence at higher prices, knowing
that they would get the best price in case of doubt (see Doyle 1988). A two-sided
price match guarantee transforms hard price competition into a coordination game
in which both firms receive the same payoff resulting from the lower of the two
prices charged (Fig. 3.3).
The highest payoff in this game is achieved when both charge the monopoly
price. The changed structure of the game triples the price level to the benefit
of both suppliers and to the detriment of consumers. Empirical studies gener-
ally show a price-increasing effect of price-matching guarantees. On the other
Price Company B
Price Company A
Fig. 3.3 Price competition becomes a coordination game between firms when both sides
give a price match guarantee. The same price-demand function and costs apply as before
3.2 Location Choice 35
hand, price undercutting guarantees do not have a price raising effect if they are
sufficiently aggressive (see Fatás et al. 2011).
3.2 Location Choice
There are many variables to consider when deciding where to locate a business,
including demographics, transportation, market saturation, income, and poten-
tially the image of a particular area. Why do gas stations or supermarkets tend to
be located close together? Wouldn’t it make more sense for them to stay farther
apart to reduce competition?
Consider the simplest case of a single firm that has to decide where to locate
on a line from 0 to 100.3 There are 101 possible homogeneous customers, evenly
distributed along the line, so that each integer represents a customer. Furthermore,
each location is available and the choice of location can be changed at no cost.
Each customer buys exactly once from the nearest supplier. If only one supplier
is available, all customers buy from that supplier.
For a monopolist, the choice of location does not matter because customers
will buy from her anyway. However, if a short distance to facilitates the purchase
decision, the firm should strive to minimize the sum of the distances. In addi-
tion, a minimum distance to customers reduces vulnerability to market entry of
competitors.
So which location should be chosen? The intuitive and correct answer is that
location choice at point 50 minimizes the sum of the distances (Figs. 3.4 and 3.5).
This can also be seen by looking at the areas below the lines created by a location
decision. If a location is chosen at 0, the line exactly divides the 100 × 100
square, which corresponds to an area of 5000. If a location is chosen at 50, two
smaller triangles are created, each of which halves a 50 × 50 square. The sum of
the distances in this case is 2500, which is the minimum of the possible customer
distances.
Consider the case where two firms (X1 and X2) are in competition and decide
where to locate. We can imagine two ice cream vendors who have the same
offer and choose their location on a beach where tourists are relatively evenly
distributed.
Where should the two ice cream vendors position themselves? If company X2
is already at an extreme point, e.g. 0, this is advantageous for competitor X1,
because it only needs to be slightly closer to the center than X2 to win almost
3 The principle of minimal differentiation goes back to Hotelling (1929).

Distance
Settlement
Fig. 3.4 The respective distances for a settlement at 0, 25 and 50 are mapped along the y-
axis. The distances at a location at 75 or 100 are not mapped for the sake of clarity
Sum of distances
Settlement
Fig. 3.5 The sum of all distances is minimized with a central location
3.2 Location Choice 37
Site selection Result

(without scale)
100
Customers
0 50 100
1
: x1
: x2 x1 x2
Fig. 3.6 If a firm’s competitor occupies an extreme position, the firm has a simple choice.
All it has to do is occupy a location that is slightly more central than its competitor’s
all customers. The best location for X1 in this case would be point 1. All points
to the right of 1 are closer to X1 than to X2. Only the customer at 0 would buy
from X2, for all other customers X1 would be easier to reach (Fig. 3.6).
However, this allocation is not stable because X2 can also adjust its location
and move slightly to the right of X1, which in turn causes X2 to now win the
majority of customers. If this dynamic is repeated, a Nash equilibrium is created
in which both players are exactly in the middle (see Fig. 3.7). With this combi-
nation of strategies, neither player has an incentive to move, since any change
would be detrimental. E.g., if X1 moves back to 49, but X2 stays at 50, this
means 51 customers for X2, but only 50 for X1.4
In another scenario, both players start at opposite locations (Fig. 3.8). The
result of the opposite positioning is initially the same as the double central set-
tlement, but the former combination of strategies is not stable. Each player can
improve her situation by moving away from her own extreme position and toward
the center.
The move to the center is a phenomenon that can also be observed in Ger-
man politics.5 For example, the pro-business policies of the Social Democratic
Party under Gerhard Schröder and the more left leaning policies of the more con-
servative Christian Democratic Union under Angela Merkel can be interpreted as
a move toward the center. However, despite initial successes, the position shifts
4The number of locations from 0 to 100, including 0 and 100, is 101.

5The application of the Hotelling principle to political positioning in democratic competition
goes back to Downs (1957).

(without scale)
Nash equilibrium
Customers
50.5 50.5
0 50 100
: x1
: x2 x1 x2
Fig. 3.7 As long as the center is not occupied, each player can improve her situation by
moving to a more central location. In the Nash equilibrium, both firms have the same number
of customers. Neither firm has an incentive to deviate from its location choice

(without scale)
Customers
50.5 50.5
0 50 100
: x1
: x2 x1 x2
Fig. 3.8 If both competitors take extreme positions, the result is an equal number of cus-
tomers. However, this situation is not stable because it is possible for both sides to improve
their sales by moving closer to the other side’s position
led to other parties occupying the open positions leading to a more fractured
political spectrum.
Companies compete on many more factors than location. Customers typically
do not follow a uniform distribution based on geography or taste. Instead, they are
concentrated in specific locations (see also Sect. 3.8 on focal points). The model
shows why there is generally a trend towards centralization with regard to com-
pany locations or other differentiation criteria. However, centralization tends to
3.3 Number Selection and Level n Rationality 39
open up the opportunity for third parties to enter the market and occupy extreme
positions.
3.3 Number Selection and Level n Rationality
In a group of 50 people, each person is asked to pick a whole number between

0 and 100, including 0 and 100. The person whose chosen number is closest to
one third of the average of the chosen numbers wins.6 So if the average of the
numbers submitted is 50, the person whose number is closest to 17 wins.
Therefore, the optimal choice is a function of each player’s assumptions about
the other players’ calculations. If everyone chooses without any consideration,
then all the other 49 values submitted follow a uniform random distribution.
Players who make no calculations at all are called level 0 players. The expected
mean in this case would be 50. One third of 50 is rounded to 16.67, so 17 would
be the optimal choice. However, you must also consider your own choice, which,
with a total of 50 participants and an own value of 17, lowers the expected mean
to 16.45, making 16 the best choice. This number again must also be taken into
account when calculating the mean, which lowers it to 16.44, but does not change
the optimal value.
Assuming that all other players have a level-0 rationality, the expected average
number choice would 50. Level-1 player would thus choose an optimal value of
16. Based on this, a level-2 player would submit a third of this value, i.e. 5.
If the assumed rationality of the other participants is increased by one level
(level 2 players), 2 becomes the optimal choice. If all other participants are level 3
players, 1 becomes the optimal choice. If all other participants are level 4 players
or higher, 0 becomes the optimal choice.
Since the optimal choice results from the expectations of the other participants,
the question arises as to what level of rationality can typically be assumed. Exper-
imental studies have shown that rationality levels follow a Poisson distribution
with a mean of 1.5 (see Camerer 2003).7
6 This type of game was first created by Alain Ledoux, who published it in Jeux et Strategie in
1981. In the originally published version, the goal is to get as close as possible to two thirds
of the average of all submitted numbers. Numbers between 1 and 1,000,000,000 could be
chosen.
7 The Poisson distribution is named after the French mathematician and physicist Siméon
Denis Poisson (1781–1840) and is used for discrete events that are spatially or temporally
limited.
1/3 including own

number
Expectation regarding Expected distribution Expected mean value Own optimum value
other participants of other participants
0 : No expectation
1: Choose purely randomly 50 16

0 50 100
2: Think that others select 17 5

purely randomly 0 50 100
3: Think that others 5 2

think that others choose purely
randomly choose 0 50 100
Fig. 3.9 The higher the number of iterations, the lower the expected value and the optimal
value. Starting at level 5 (not shown here), 0 is the optimal answer.
The expected mean can be calculated based on the Poisson distribution in

Fig. 3.10 and the considerations in Fig. 3.9. The result for the expected mean is
18.06. According to this calculation, 6 is the best choice. Of course, this is no
guarantee of winning the game, but at least a well-considered choice under given
conditions. The expected rationality level of the participants has to be considered
individually. For example, participants who have been trained in game theory
are likely to have a higher average level, which reduces the optimal number of
entries. Typically, however, 0 is not the optimal choice even for an advanced
group of participants.
3.4 The Tragedy of the Commons
The model of the tragedy of the commons8 describes how and why a (sometimes
destructive) overuse of public goods can occur. There are many examples of this
in reality, such as overfishing of the oceans, cities with never-ending traffic jams,
or internet connections slowed down by WiFi routers using the same frequency
bands.
8 In the Middle Ages, there were certain freely accessible grassland areas that were referred
to as commons and used by all resident farmers for their livestock.
3.4 The Tragedy of the Commons 41
Fig. 3.10 In the Poisson distribution and in the game, only integers are allowed. While the
mean of the distribution is by definition 1.5 due to the right skew, the median is 1
Let’s say a piece of land is being used by a goat farmer who is trying to
maximize his total milk production.9 The more land a goat has, the more milk
it can produce. However, the additional milk produced decreases as the area
increases (Fig. 3.11).10
As can be seen in Fig. 3.12, the maximum total output is 10 liters of milk.
This can be achieved when there are 10 goats on the pasture.11
But how do the incentives change if the pasture is used by multiple goat
farmers at the same time, each of whom can individually optimize their output
and decide how many goats to graze on the pasture? In Fig. 3.13 the individual
9 The example is from Binmore (2007), pp. 27–28.

10 This is the typical phenomenon of decreasing marginal productivity when expanding a sin-
gle factor. To maintain the same increase, production factors typically have to be varied in the
same proportion so that one input does not become a bottleneck.
11 If a goat has one tenth of the total available area, it will produce exactly one liter of milk.
If a goat had 20% of the total available area, the individual yield would increase to 1.65, but
the total yield would decrease to just over 8. Reducing the ratio per goat, i.e. increasing the
number of goats, also worsens the overall result. If this pasture had an owner, he would use
it with 10 goats altogether.
42
Output goat
3
Share of land
Fig. 3.11 The more land a single goat has to itself, the more milk it can produce. However, the additional production continues to decrease.
n
The milk production (M) of a goat is described by M = e1− 10 , where n is the total number of goats
3.4 The Tragedy of the Commons 43
Total production
Goats
Fig. 3.12 Total production is maximized when a total of 10 goats are allowed to grazed
production curves are shown as a function of the number of other users. The
higher the number of other farmers using the area, the flatter the curve becomes.
However, the individual maximum point is always 10 goats, regardless of the
number of other users. Already with 3 goat farmers, 30 goats are using the area,
which leads to a significant overuse and a reduction of the goat milk production
by about 4 liters compared to the use by only one farmer. This would mean a
production of only 1.3 liters per farmer. If the 3 farmers agreed to graze a total
of only 10 goats, the production per farmer would more than double to 3.3 liters.
However, in the absence of better mechanisms, excessive goat numbers remain
the individually dominant alternative (Figs. 3.13 and 3.14).
The tragedy of the commons can occur whenever a resource is shared by
several individuals, but the costs of that resource are not borne individually.
More sustainable outcomes can be achieved by changing the structure of
the game so that collective and individual interests are aligned. In the goat
herders’ example, this might mean assigning ownership of the pasture to indi-
vidual farmers. This would lead to more responsible resource management and
more sustainable production decisions.
Production / Farmer
Goats
Fig. 3.13 For each individual farmer, the maximum individual production is always 10
goats. However, the more other farmers use the area, the lower the individual production will
be
Total production
Goats
Fig. 3.14 With 3 farmers, the total number of goats is 30 if each farmer maximizes his indi-
vidual output. The total output is significantly lower than with fewer goats. Source: Binmore
(2007) p. 28
3.5 Price Fixing 45
3.5 Price Fixing
Instead of competing fiercely, companies can also move toward cooperative

pricing.
Price fixing between companies can take several forms. In addition to the fact
that price fixing is usually illegal, each company has the potential to improve its
position by deviating from the agreement.
For price fixing to be sustainable, there must usually be repeated interaction
between the firms and the participants must be able to observe the other side’s
compliance with the agreement. The more transparent the cost and price structure
of the companies, the easier it is to implement price fixing.
A well-known case of tacit collusion between T-Mobile and Mannesmann AG
during a sales auction is the auction of GSM licenses in Germany in 1999. This
auction was designed as a simultaneous ascending auction (see Klemperer 2000).
The general expectation prior to the auction was that it would be a lengthy process
over several days in which a total of four bidders would compete intensely for
frequency bands. The frequencies were divided into 10 bands, and the minimum
bid per band was DM 1 million.
To the surprise of many, the auction ended after only two rounds. Mannesmann
opened the auction with a bid of DM 40 million for frequency bands 6–9, DM
56 million for band 10, and DM 36.36 million for bands 1–5 (see Fig. 3.15).
#Frequency
1 2 3 4 5 6 7 8 9 10
36,36 36,36 36,36 36,36 36,36 40,00 40,00 40,00 40,00 56,00
Round 1 M M M M M M M M M M
40,01 40,01 40,01 40,01 40,01 40,00 40,00 40,00 40,00 56,00
Round 2 T T T T T M M M M M
M: Mannesmann
T: T-Mobil
The auction design Proposal accepts

allowed for
a "you divide,
I choose" Mannesmann M T
dynamic to occur T-Mobil
1-5 6-10
Fig. 3.15 In the German 2G frequency band auction, Mannesmann AG (M) and Telekom
AG (T) divided the packages between themselves using open collusion
DM 36.36 million plus 10% is rounded to DM 40 million. In conjunction with

the high bids for bands 6–10, this could be interpreted as an offer to T-Mobile to
divide the frequencies equally between these two participants. The relatively high
starting bid was also intended to drive the two smaller bidders (Viag Interkom
and E-Plus) out of the process. In the next round, T-Mobile accepted the offer
with an increased bid of DM 40.01 million for bands 1–5 and no bid for bands
6–10.
The other bidders, Viag Interkom and E-Plus, did not submit any relevant
bids after this aggressive start, so this was also the final result of the auction
(Fig. 3.15, see Grimm et al. 2003).12 The comparatively low result without inten-
sive competition was not in the interest of the Federal Network Agency, which
was responsible for the auction. However, since there was no evidence of direct
communication between T-Mobile and Mannesmann, the behavior of the bidders
could not be classified as illegal.
As this example shows, agreements can also arise indirectly from the place-
ment and size of bids in auctions. As mentioned earlier, cooperation between
participants in a mechanism is facilitated if the participants can observe each
other’s behavior. One way to prevent cooperation is to have hidden auction ele-
ments where the other side’s behavior cannot be observed. In addition, packages
should be bundeled in a way that avoids an obvious advantageous choice for all
participants. At Competitio we have developed a methodology to assess the com-
petitive intensity of bundling options. The share split used in this example would
have received a low score due to its symmetry and its facilitation of cooperation
between bidders.
Another challenge is recurring price agreements between competitors in the
form of cartels. For example, competitors may agree on a rotation system where
the winner of the bidding process is determined in advance. Alternatively, they
may set certain price levels or geographically divide a market among competitors.
From a regulatory perspective, an important question is how to motivate cartel
members to disclose the existence of illegal agreements. As long as each cartel
member can assume that the others will remain silent, they have no incentive
to admit the existence of the agreement, even if there is a severe penalty for
non-disclosure.
In the past, leniency programs have proven effective in breaking up cartels.
This means that the first company to disclose illegal activities in which it was
12According to a report in the German newspaper Frankfurter Allgemeine Zeitung, there

was a last-minute bid from the telecommunications company E-Plus, but it had no effect (see
Grimm et al. 2003).
3.5 Price Fixing 47
involved is often granted immunity from prosecution. It has been shown that the
threat of a severe penalty is usually only effective in combination with a leniency
program (cf. Miller 2009).
Leniency programs for cartels have successfully spread around the world after
Italy and the United States took the lead in the early 1990s. An effective leniency
program changes the game between companies. A coordination game becomes a
prisoner’s dilemma (cf. Sect. 3.9), in which disclosure is the dominant strategy.
An ineffective leniency program offers too little to the player who cooperates
with the authorities, so the optimal strategy is always the same as the one cho-
sen by the other side (Fig. 3.16). However, with an effective leniency program,
disclosure becomes the dominant strategy, regardless of the decision of the other
cartel members.
Once a company has come clean, it can no longer be trusted with regard to
other price-fixing agreements. As a result, several cartels are often disclosed at
the same time, as was the case with Henkel Ibérica SA after the introduction of
the Spanish leniency program in 2008. Henkel was the first company to disclose a
cartel involving Unilever and Procter & Gamble, among others. Over a period of
three years, price agreements for laundry detergents were made in eight countries
of the European Union. Because Henkel was the first company to disclose the
agreements, it escaped punishment. Procter & Gamble and Unilever received
Ineffective leniency Effective leniency

Coordination game Prisoner's dilemma
Company 2 Company 2
Do not Do not
Disclose Disclose
disclose disclose
U1: -7 U1: -8 U1: -5 U1: -8

Disclose
Disclose
Company 1
U2: -7 U2: -6 U2: -5 U2: -2

Company 1
disclose
disclose
Do not
Do not
U1: -6 U1: -3 U1: -2 U1: -3
U2: -8 U2: -3 U2: -8 U2: -3
Fig. 3.16 Effective leniency creates a prisoner’s dilemma for the companies involved. In
this context, disclosure is always the better alternative, independent of the choice of the other
player
reduced fines for their prompt disclosure and cooperation, but had to pay a total
of EUR 315 million in fines (cf. European Commission 2011).
3.6 Three Goals and a Car
The following problem is known as the goat problem and has been discussed
extensively. An entire book has been devoted to this topic (see Von Randow
2004), and marriages and friendships have reportedly broken up over the discus-
sion. The goat problem is largely a problem of conditional probabilities, but on
closer inspection it also contains a game-theoretic component.
Consider the following situation: You are a contestant on a quiz show and
there are three closed doors. You know that behind one door there is a new
sports car and behind two doors there is a goat, but you have no idea behind
which door is which. You have to pick one door and you will get what is behind
that door. If a goat appears, it belongs to you, if a car appears, you become the
owner of a new sports car. The monetary value of the sports car is many times
greater than that of a goat. Therefore, even if you prefer goats to cars, you should
be interested in winning the car because you could buy a goat with the proceeds
and still have a considerable amount of money left over.
The probability of picking the right door is one in three because you have no
information about the location of the car. So you pick a door, let’s say door 2. The
host asks you if you are absolutely sure. You say yes, and the host opens another
door (door 1). Behind door 1 there is a goat. You are offered to reconsider and
either choose door 3 or stay at door 2. How do you decide?
The best possible choice should maximize your probability of winning, and
depends on various assumptions about the information available to the host and
the host’s behavior. With the information provided so far, the question of the right
choice cannot be answered conclusively. The case distinctions that arise from the
assumptions are shown in Fig. 3.17.
The first question to answer is the information available to the host: Does the
host know what is behind which door? If the answer is no, then the host has
acted purely by chance, and the behavior cannot generate any information value
(Fig. 3.18, Case 1). In this case, it would be irrelevant whether you changed
or stayed with your original choice. The probability of winning is 50% in both
cases. However, it seems unlikely that the game show host has no information
about the location of the prizes.
If the host knows which door the car is behind and which doors the goats are
behind, there are basically three more cases to distinguish (Fig. 3.19):
3.6 Three Goals and a Car 49
Yes Case 2: Change

advantageous
Yes H. always
chooses a goal Yes Case 3: Same
with a goat probability in case of
change
H knows behind H. chooses
which gate the No
purely at
car is located random
No Case 1: Same No Case 4: Further
probability in case of consideration required
change
Fig. 3.17 The probabilities determined depend on the assumptions made about the informa-
tion available to the host and the host’s behavior
Probability
Wdh
Change Stay
Fig. 3.18 Assuming that the host always opens a gate behind which a goat is located, in
simulation the strategy “change” converges towards 2/3 win probability, while the strategy
“stay” converges towards 1/3
• Case 2: The host will only open one of the remaining doors if there is a goat
behind it.
• Case 3: The host randomly opens any one of the remaining doors, possibly
the door behind which the car is located.
Probability
Wdh
Change Stay
Fig. 3.19 If the host simply opens any door, but there is a goat behind it, the probability of
winning converges to 50% for both strategies
• Case 4: The host knows which door the car is behind and makes his decision
based on game theory.
Case 2: If the host always opens a door with a goat after the first choice and then
offers to switch to the remaining door, it is advantageous to switch doors. There
is a one-third chance that the car will be chosen first, and a two-thirds chance
that the goat will be chosen first. If the car is chosen first, then after opening a
door with a goat, only the goat is left, and switching does not result in winning
the car. However, in the other cases where a goat was chosen first, switching
always wins the car, since the only other possibility of choosing a goat has been
eliminated by the host according to the rules. Since the probability of picking a
goat first is two-thirds, switching under the given circumstances leads to winning
the car two-thirds of the time. The strategy of not switching leads to winning the
car one third of the time, namely when the door with the car was chosen first.
Case 3: If the host knows which prizes are behind which doors, but randomly
chooses which door to open, then opening a door by the host does not reveal any
3.6 Three Goals and a Car 51
First choice Moderator Switch

Distribution Evaluation
candidate opens strategy
1 3 2
Change
G G C advantageous
1 3
1 2 3
2 G G
G C G
Change
C or 3 1
disadvantageous
G G
3 1 2
Change
G G C advantageous
Fig. 3.20 Under the given premises, changing leads to winning the sports car in 2 out of 3
cases. This makes changing twice as successful as the strategy of not changing
decision-relevant information. This makes the strategy of changing just as likely

to lead to a win as the strategy of not changing (Fig. 3.20).
Case 4: Why shoud the host act in predictable and repetitive way? The rec-
ommendations are based on a limited view of the host’s role, one that thrives
on being unpredictable and entertaining. Why should the host open a second
door each time? This show would not necessarily be interesting to the audience
(Fig. 3.21).
Assuming that the host actually knows the prize distribution behind the doors,
but is not bound by rigid rules, the first question from a game theory perspective
is what the host’s objective is. Suppose the host has two primary goals: One
is to create an interesting show, and the other is to keep production costs low.
These two goals can be weighted differently. By opening an extra door, the host
increases the entertainment value of the show, but he may also increase the cost
if the prize is paid by the host rather than sponsored.
A host who is exclusively cost-oriented would only offer the option to switch
if the player chose the car in the first step. Otherwise, opening another door would
worsen his expected utility. Accordingly, a candidate who expects a cost-oriented
moderator with flexibility and complete information about the price distribution
should not change the door.
Candidate
Host
C PC
Chance en
op
t
no C PC
Do Cha
nge
Goat
Stay C PC
) Ca
/3 r
(2
at
Go C PC
C PC
Ca en
r
(1 op
/3 n ot
) o
D
Go C PC
at nge
Cha
Stay C PC
Fig. 3.21 The interaction between host and contestant as a simple extensive game. “C”
denotes the contestant’s payoff, “U” the entertainment value, and “PC” the production cost,
assuming that the cost of the prize is borne by the host. The payoff values are indicated by
the symbols “+” in the case of a favorable outcome for the player, or “-” in the case of an
unfavorable outcome from the player’s point of view.
For a host with a stronger entertainment orientation, the opening of a door

loses its signal effect. The tension of the show is created primarily by creating
difficult decision situations and emotional events for the contestants.
It should also be noted that the player may be subject to loss aversion and
other cognitive biases that make switching to another door less likely. Again, this
could be anticipated by the host. The goat problem goes beyond calculating a
conditional probability and is an interesting example of the multifaceted nature
of modeling a seemingly simple problem.
3.7 From Duel to Truel and the Advantages of Weakness 53
3.7 From Duel to Truel and the Advantages of Weakness
When two shooters face each other in a duel, a better hit probability clearly
increases the probability of winning. But how does it work in a truel, i.e. a
shooting competition between three people?
In this example, three shooters (A, B, and C) compete with different hit rates.
Shooter C always hits, Shooter B hits with a probability of 75%, and Shooter A
hits with a probability of 25%.
The following rules apply: The worst shooter (A) starts, then the second worst
shooter can shoot, and the best shooter is last. The match is won when only one
competitor is left. Furthermore, you have to shoot; it is not allowed to save ammu-
nition for the next round (see Kilgour and Brams 1997 for further rule variants
and a general mathematical consideration). Each player knows the accuracy of
all other players, and everyone has exactly one bullet.
What should A do, who is allowed to take the first shot?
If he does want not shoot himself, he has three options: He can shoot at C,
at B, or into the air. How should he behave, and what are the implied survival
probabilities of the three options?
An intuitive answer might be that A should shoot C because it gives him a
chance to take out the best shooter. If A hits, shooter B is next in line. He has a
75% chance of hitting A, so A has only a 25% chance of surviving if he hits C.
If he misses, which will happen 75% of the time due to his lack of accuracy,
B will aim at C in the next round because A is out of ammuntion and C is more
dangerous anyway given his high hit rate. If B hits, which is 75% of the time, A
and B survive. If B misses, C still has a chance. He can no longer win the game
because there are still two opponents left.
Without additional assumptions, it is therefore not clear how C will behave.
Assuming that C always shoots in this case, with a 50% probability of shooting
at B and a 50% probability of shooting at A, the survival probability for A is
71.9% for the strategy of aiming at the best shooter firsts (Fig. 3.22).
Another possible strategy for A is to aim at the medium shooter (B). But if A
hits B, C is next in line. C always hits and has only one opponent, A. These are
not good prospects for A, which is why this strategy performs worse overall than
the first one. If A does not hit, the rest of the game is similar to the first strategy.
This strategy gives A a 65.6% chance of surviving (Fig. 3.23).
The last remaining option for A is to shoot into the air. Under the assumptions
made, this is actually the best option. In the two previous considerations, the
strategy of aiming at one of the opponents was disadvantageous if the shot was a
hit, since A is then the only remaining opponent and will be hit by a good shooter
54
1st strategy: A aims at the best shooter, C

Steps Probabilities Pr that A dies Pr that A survives
A C Pr(A aims at C and hits) = 25%

B A Pr(B aims at A and hits) = 75%
B wins 25% x 75% = 18.75%
B X A Pr(B aims at C and misses) = 25%

25% x 25% = 6.25%
A and B survive
A X C Pr(A aims at C and misses) = 75%
B C Pr(B aims at C and hits) = 75%

A and B survive + 75% x 75%
= 56.25%
B X C Pr(B aims at C and misses) = 25%
C B Pr(C aims at B and hits) = 50% + 75% x 25% x 50%

C and A survive = 9.38%
3
C A Pr(C aims at A and hits) = 50% + 75% x 25% x 50%

= 9.38%
C and B survive
28.12% 71.88%
: shoots and hits : Player A
X : shoots and misses : Player B

Pr: Probability : Player C
: Case distinction level 1
Fig. 3.22 The strategy that A aims at the best shooter (C) implies a survival probability of 71.9% for A
2nd strategy: A aims at the second best shooter, B
Steps Probabilities Pr that A dies Pr that A survives
A B Pr(A aims at B and hits) = 25% 25% x 100% = 25%

C A Pr(C aims at A and hits) = 100%
C wins
Pr(A aims at B and misses) = 75% 75% x 75% = 56.2%
A X B
Pr(B aims at C and hits) = 75%
B C
A and B survive
B X C Pr(B aims at C and misses) = 25% 75% x 25% x 50%
= 9.4%
C B Pr(C aims at B and hits) = 50%
C and A survive
C A + 75% x 25% x 50%
C and B survive Pr(C aims at B and hits) = 50% = 9,4%
34.4% 65.6%
3.7 From Duel to Truel and the Advantages of Weakness

Pr : Probability
: Player C
Fig. 3.23 The strategy of aiming at the second-best shooter leads to a survival probability of 65.6% for shooter A
55
in the next round with a probability of 75 or 100%. Not aiming at either opponent
has the advantage that B will focus on C next, since A is no longer a threat. Even
if B does not hit, there is still a 50% chance of survival (see Figs. 3.24 and 3.25).
Despite poor shooting accuracy, player A can actually achieve a good survival
probability in the duel. Since A is not perceived as a dangerous opponent, B and
C focus on fighting each other. A is well advised to stay out of the fight.
3.8 Focal Points
In coordination games, players can achieve high payoffs by coordinating their

behavior. However, coordinated behavior is also often observed in situations
where prior communication is not possible. How is this possible?
Thomas Schelling was the first to mention focal points (Schelling 1960, p. 57)
in The Strategy of Conflict, published in 1961:
People can often concert their intentions or expectations with others if each knows
that the other is trying to do the same. Most situations—perhaps every situation for
people who are practiced at this kind of game—provide some clue for coordinating
behavior, some focal point for each person’s expectation of what the other expects
him to expect to be expected to do.
Focal points are used to describe the many conventions by which we live: for
example, which side of the road to drive on, how to say hello, or what time to
expect a phone call. Redefining a convention-based focus is fraught with friction.
Adapting to a new culture, for example after changing jobs or emigrating, can be
seen as an adaptation of focal points.
On the other hand, focal points can emerge without any cultural or other
commonalities. Figure 3.26 shows 16 different forms and shades. If you and
another player each had to choose a field and each received EUR 200 for a
correct decision, but there was no way to communicate, which field would you
choose?
In a non-representative survey, 8 out of 9 respondents chose field 2b.13 The
graphic in 2b stands out because this shape only occurs once in the image. This
makes it the focal point.
Focal points also play an important role in negotiations with conflicting inter-
ests. For example, it has been shown that the negotiated final price is more
often divisible by 50 than would be expected statistically (see Pope et al. 2015).
13 One participant of the survey chose field 4d.

3rd strategie: A shoots into the air
3rd strategy: shoot into the air

WK that A
3.8 Focal Points
Steps Probabilities WK that A dies survives
A X
B C Pr(B aims at C and hits) = 75%
A and B survive 75%
B X C Pr(B aims at C and misses) = 25%

C B Pr(C aims at B and hits) = 50% + 25% x 50%
C and A survive = 12.5%
C A Pr(C aims at A and hits) = 50%
C and B survive 25% x 50% = 12.5%
12.5% 87.5%
Pr : Probability : Player C
Fig. 3.24 The third strategy, A shoots into the air, results in a survival probability of 87.5% for A
57
Survival Probabilities
Player A Player B Player C
A targets C A targets B A shoots into the air
Fig. 3.25 Despite poor shooting accuracy, player A can actually achieve a good survival
probability in the truel. Since A is not perceived as a dangerous opponent, B and C concen-
trate on fighting each other. A is well advised to stay out of the fight, as a successful shot
would turn the duel back into a duel where weakness is a pure disadvantage
Fig. 3.26 Which square a b c d

would be the best choice for
two players whose goal is
to choose the same square 1
without prior
communication?
2
4
3.9 The Prisoner’s Dilemma 59
The 50–50 division of the frequency bands between T-Mobil and Mannesmann
achieved through open collusion in the example of the frequency band auction
carried out in 1999 (see Sect. 3.5) can also be seen as a focal point that facilitated
agreement. To reduce the likelihood of cooperation between suppliers, possible
focal points should be avoided when developing a procurement mechanism.
3.9 The Prisoner’s Dilemma
The Prisoner’s Dilemma is the most famous example of applied game theory.
This is due to its transferability to a wide variety of contexts, and perhaps also to
its memorable story. The Prisoner’s Dilemma provides an answer to two central
questions:
1. How can cooperation between players be prevented?

2. How can cooperation between players arise under adverse conditions?
Both questions are relevant from a negotiation and procurement perspective. An

important goal in designing procurement mechanisms is to prevent unwanted
cooperation among suppliers. The prisoner’s dilemma shows how changing the
structure of a game can lead to the desired behavior of the players.
On the other hand, the question is under which circumstances cooperation
between suppliers is feasible even if there is a strong incentive not to cooperate.
This question is primarily considered in the context of the repeated prisoner’s
dilemma.
Jim and Frank rob a bank and get a substantial amount of money, but get
caught. They were able to get the money to safety before being arrested. At the
police station, Jim and Frank are interrogated in separate cells. Both gangsters
can now either remain silent or confess. There is not enough evidence for a long
prison sentence. If they both remain silent, they will only get one year in jail. As
soon as one of them “sings”, both will be sentenced to seven years in prison. In
this structure of the game, it is better for both players to remain silent (Fig. 3.27,
left). Silence is a weakly dominant strategy under these circumstances, and the
police’s interrogation techniques will not lead to any results.
However, the state has the power to pass laws and change the structure of the
game so that it becomes individually optimal for both players to confess. Under
leniency, the player who confesses can expect to be released as long as the other
player does not confess. In this case, the non-confessing player would go to jail
for seven years. If both remain silent, the sentence remains one year. If they both
without leniency with leniency
Frank Frank
Deny Confess Deny Confess
Jim: -1 Jim: -7 Jim: -1 Jim: -7
Deny
Deny
Frank: -1 Frank: -7 Frank: -1 Frank: 0
Jim
Jim
Confess
Jim: -5
Confess
Jim: -7 Jim: -7 Jim: 0
Frank: -7 Frank: -7 Frank: -5

Frank: -7
Fig. 3.27 The introduction of leniency changes the payoff structure of the two games, mak-
ing confession the dominant strategy
confess, they can expect a sentence of five years, which is a slight reduction from
the seven years. Confessing thus becomes the dominant alternative. The strategy
of confessing produces a better payoff than any other action, regardless of how the
other player behaves. Under the changed conditions, both players are expected to
confess. A key element of the prisoner’s dilemma is that the individually optimal
behavior does not lead to the best overall outcome.
Let’s go back to the questions asked at the beginning of this section. The first
question was: Can cooperation between players be prevented by changing the
structure of the game so that non-cooperation becomes the dominant behavior for
both players? The second question was: How can cooperation and the collective
optimal outcome still be achieved?
In the context of organized crime, on the one hand, the prison sentence could
be made more bearable for members of the criminal organization (e.g., by paying
a pension to the family during the prison stay), and on the other hand, the threat of
punishment makes confession less attractive. Incentives for cooperative or non-
cooperative behavior may also result from a repetition of the interaction (see
Sect. 3.10).
Credibility is a prerequisite for incentives to have the desired effect. One prob-
lem in investigations is the inability of the police to make binding promises.
Under the separation of powers, the decision to imprison is made by a judge
3.10 The Repeated Prisoner’s Dilemma and the Evolution of Cooperation 61
and negotiated after a confession. A guaranteed pardon could further increase the
effectiveness of a confession mechanism (see Miller 2009).
It is useful to take a closer look at the effect and purpose of statements that
are intended to cause a particular behavior. These can be classified by:
1. the consequences for the recipient (positive or negative),

2. the implementation costs for the sender (positive or zero),
3. their intention (motivating or deterrent)
4. and their credibility (see Dixit and Nalebuff 2008).
A statement that implies a positive consequence for the recipient of the mes-
sage, but with a cost to implement, is a promise. If the consequence to the
recipient of the message is positive and free of charge to the sender, it is an assur-
ance. An announcement with negative consequences for the recipient and cost to
implement is a threat. Negative consequences with zero or better implementation
costs are a warning. A distinction can also be made between motivational and
deterrent messages.
Threats and promises are less credible because of the costs associated with
their implementation. The higher the cost of implementation, the more difficult
it is to establish credibility. Therefore, in negotiations, the implementation costs
of statements are often presented as low. Also, negative character traits such as
malice can unfortunately be a strategic advantage if they make the implementation
of a threat appear less costly for the sender and thus more credible (Fig. 3.28).
3.10 The Repeated Prisoner’s Dilemma and the Evolution

of Cooperation
How do incentives and behaviors change when the same players play the pris-
oner’s dilemma over and over again? In a repeated interaction, there is an
opportunity to respond to the other side’s behavior. For example, if the other
side cooperates, you can respond by cooperating in the next round.14
To evaluate different strategies in the repeated prisoner’s dilemma, Robert
Axelrod initiated a tournament between algorithms in 1978 (cf. Axelrod 1980).
A total of 14 different strategies competed against each other. Each strategy com-
peted once against another strategy, once against itself, and once against a random
14This strategy follows the Christian recommendation: “If someone strikes you on the left
cheek, turn to him the other also” (Matthew 5:39).
Credibility (tendency)
Consequences for the recipient Higher Low
Negative
Warning Threat
Positive
Assurance Promise
Zero Positive
Implementation costs for the sender
Fig. 3.28 A claim that is free to implement generally has more credibility than a claim that
is costly to implement. The announcement of an expensive implementation can be credi-
ble if not implementing it would result in higher costs than implementing it. This could be
achieved, for example, by building up a high reputation. Failure to implement an announce-
ment would have such a high cost in terms of reputational damage that the statement is
credible
strategy. Each paring was repeated 200 times, and the payoffs were summed over
all the interactions. At the end of the tournament, the strategy with the highest
total score was declared the winner.
The Prisoner’s Dilemma is now considered in a more general form. The action
options are no longer Silence and Confession, but Cooperation and Defection.
Silence corresponds to Cooperation, and Confession corresponds to Defection.
The payoffs used in the Axelrod tournament are shown in Fig. 3.29.
Before the tournament, it was assumed that exploitative algorithms would
outperform benevolent strategies. An exploitative algorithm primarily tries to
maximize its own profit. A benevolent strategy, on the other hand, tries to
maximize the total utility.
3.10 The Repeated Prisoner’s Dilemma and the Evolution of Cooperation 63
Fig. 3.29 Payoff values Player 1

used in the Axelrod
tournament (cf. Axelrod Cooperate Defect
1980)
Cooperate
Player 1: 3 Player 1: 5
Player 2
Defect
Contrary to the expectation that exploitative algorithms would dominate, the

tournament results showed a different picture: Although the exploitative strategies
performed better than or equal to their opponents in each individual tournament
section, they were unable to reap the benefits from cooperation. As a result, a
fundamentally benevolent strategy performed best.
The best performing strategy was Tit for Tat (TFT). This strategy first coop-
erates and then mimics the other side’s behavior. In the tournament, successful
strategies had the following characteristics:
• They were not “jealous,” i.e., they focused on their overall score rather than
their relative performance in a direct comparison of a single interaction.
• Successful algorithms were trusting, meaning they usually started with
cooperation.
• But their positive intentions were not unlimited. Successful strategies were
provocative but not vindicative. They sanctioned noncooperation, but returned
to cooperative behavior when the other side changed its behavior.
• Another characteristic of successful strategies was their simplicity. Some
strategies tried to recognize random strategies. Like a random strategy with
the same probability for both options, defecting is the optimal strategy. Too
much sophistication semmed to increase the risk of misclassification, which
lead to a reduced total payoff.
Table 3.1 A single incorrect signal (italicized and bold) in round 3 leads to permanently
unfavorable results in two Tit for Tat strategies:
Round/Strategy 1 2 3 4 5 6 7 8
TFT C C D C D C D C
TFT C C C D C D C D
Table 3.2 An erroneous signal (italicized and bold) in round 3 leads to negative results, but
these can be quickly overcome
Round/Strategy 1 2 3 4 5 6 7 8
WSLS C C D D C C C C
WSLS C C C D C C C C
Although TFT won the first two Axelrod tournaments, it was later shown that this
strategy is vulnerable when there is a possibility of mistakes being made.Errors
can occur either in the execution or in the interpretation of an action (cf. Imhof
et al. 2007). A single incorrectly executed or misinterpreted action can lead to
repeated unfavorable results in two TFT strategies (Table 3.1).
A strategy that works better in a noisy environment is Win-Stay Lose-Shift
(WSLS). This strategy also begins with good intentions. If the other side cooper-
ates, the result is interpreted as a win and the strategy is not changed. If the other
side defects, the result is interpreted as a loss and the procedure is changed in the
next round.15 This allows WSLS to quickly return to a cooperative equilibrium.
After the erroneous non-cooperative signal in round three, there is indeed a
round of mutual non-cooperation, but by round five both players have returned to
the equilibrium of mutual cooperation (Table 3.2). Against a strategy that always
cooperates, WSLS benefits from random own variation (cf. Imhof et al. 2007).
The tournament can also be seen as an evolutionary dynamic. In this way, the
successful strategies multiply, while the unsuccessful ones disappear. This damp-
ens the evolution of exploitative strategies, since their victims can no longer be
exploited after they disappear. The effects of cooperation gains can be amplified
in this environment, as the opportunities for cooperation increase through the
growth of those strategies that have successfully cooperated with each other.
15 The definition of win or loss can of course be formulated differently.

3.11 You can win with stubbornness 65
3.11 You can win with stubbornness
In the movie Rebel Without a Cause, Buzz challenges his rival Jim to a duel in
which they both drive their cars toward a cliff. The one who brakes or gets out
first loses; the one who drives off the cliff is likely to pay with his life (cf. Dixit
et al. 2020).
In a slightly modified form of this duel, the two cars race towards each other.
The one who stays on course wins. One-sided evasion results in defeat. If both
sides swerve, it is a draw. If neither side swerves, there will be an accident and
possible death. The outcomes of this duel are shown in Fig. 3.30 as a one-period
game.
What should duelists do? First, they should rethink their payoff structure and
come to the conclusion that they are not willing to take a very high risk for a small
advantage. Also, the expected value calculation can only lead to the conclusion
that it is not advantageous to participate in this game unless the probability of an
accident can be largely eliminated.
Buzz
Swerve Remain
on course
Swerve
Buzz: 5 Buzz: 10
Jim: 5 Jim: 0
Jim
Stay on
Buzz: 0
course
Buzz: -100
Jim: 10 Jim: -100
Fig. 3.30 In the structure of the game of chicken, it is advantageous to stay the course if the
other side swerves. However, if both sides stay on course, the payoff is the lowest possible
If participation in the game is unavoidable, for example for reasons of reputa-

tion, the only way to avoid an accident is for at least one of the parties to swerve.
If one side comes to believe that the other will always stay the course, the only
way to avoid disaster is to swerve.
Both sides will therefore try to convince the other side that they will never
deviate. The more convincingly one’s own stubbornness is presented (insanity
may be the most convincing argument), the more likely it is that the other side
will deviate. A physical promise not to deviate is also conceivable. The steering
wheel could be removed or the hands tied behind the back. The key is that the
commitment is perceived as credible by the other side.
If this is the case, the only way to avoid a disaster for the other side is
to change course. An exception might be a highly valued reputation, so that
an accident with possible death is preferable to a loss of reputation. However,
such a reputation would make it difficult to find an opponent.
In the movie, Buzz’s jacket gets caught in the door opener of his car,
preventing him from getting out in time before he drives off the cliff.
3.12 The Ultimatum Game and the Perception of Fairness
In the ultimatum game, a player can split a certain amount of money between
himself and another player. However, there is a catch: if player 2 does not agree
to the split, neither player receives a payout.
What split should player 1 choose? A fully self-interested player 1 would
choose the best possible split for him, which player 2 would simply accept. A
rational player 2 will accept any split that gives him an amount greater than EUR
0. So the best proposal from player 1’s point of view would be a split of EUR
99 for him and EUR 1 for player 2 (Fig. 3.31).
In reality, it has been shown that most players will not accept a split that they
perceive as unfair, even if it puts them at an economic disadvantage. Only at a
split of 30% or more does the second player typically accept the offer (see Rand
et al. 2013).
The apparently widespread emotional aversion to unfair divisions can be a bar-
gaining advantage. It also explains why the economically optimal 99-1 division
is no longer a realistic option for player 1. Typically, therefore, split proposals in
the ultimatum game range from 30 to 50% (Ibid.).
The dictator game is a variation of the ultimatum game in which player 1
is free to decide how to divide the fixed amount. However, even under these
3.13 The 100-Euro Auction 67
Player 1
Player 2 Player 1: ++
Player 2: ++
s
e pt
A cc
r Re
fe jec
of ts
ir Player 1: 0
Fa
Player 2: 0
Player 1: +++
Player 2: +
Un ts
fa
ir c ep
of
fer Ac
Re
jec
ts Player 1: 0
Player 2: 0
Fig. 3.31 The ultimatum game in a simplified sequential form
conditions, the average payoff for player 2 is 41% (see Oberholzer-Gee and
Eichenberger 2008).
Fairness is an important factor for both sides in a negotiation. In most negoti-
ations people will have to make some kind of compromise, but an understandable
process can ensure that the interaction is perceived as fair, even when the result
is not perceived as ideal.
3.13 The 100-Euro Auction
Imagine you are attending a seminar on applied game theory and your host is
auctioning off a EUR 100 note with a minimum bid of EUR 10 (see Sect. 4.2.1).
The price increases until only one person is willing to pay that final price. Each
new bid must be at least EUR 10 higher than the previous bid. All bids must be
in whole cents (Fig. 3.32).
But there is catch: Not only does the auction winner have to pay the bid price,
but so does the second highest bidder. Now, you can place your first bid. Which
price will you choose?
For the sake of simplicity, let us assume that there are only two players in
the auction: you as Player A and Player B. It may seem tempting to bid as low
as possible, since this would increase your profit as the difference between the
purchase price and the value. If you bid EUR 10, your profit would be EUR 90 if
noone else bids.
Unfortunately, player B can now bid EUR 20 and hope for a profit of EUR
80. This would result in a loss of EUR 10 for you, since you would still have to
pay the EUR 10 bid. You would then be faced with the decision to either accept
a loss of EUR 10 or bid at least EUR 30 and hope for a profit of EUR 70.
Bid/Payoff
Round
Bid player 1 Bid player 2 Payoff player 1
Payoff player 2 Payoff auctioneer
Fig. 3.32 The bidding war promises a high payoff/loss ratio at the beginning, but it dete-
riorates with each round. The auctioneer’s payoff increases about twice as fast as the two
bidding curves
3.13 The 100-Euro Auction 69
A bidding war can occur if neither of the two players wants to accept a loss
and maintains the hope of a profit with each bid. However, with each round the
possible profit decreases and the expected loss increases (see Fig. 3.32). The
initially attractive payoff/loss ratio deteriorates with each round. If the bidding
pattern is maintained, the bid increases to EUR 100 in round 10. In subsequent
rounds, the only concern is minimizing the loss. Winning the auction would
be a Pyrrhic victory, since the price is higher than the value of the item being
auctioned.
The strategy of bidding low at the beginning does not seem promising. What
are the other options? A cooperative solution between the bidders could resolve
the dilemma. If you agree with the other bidder to place only the minimum bid of
EUR 10 and split the resulting profit equally between you at EUR 45 each, this
would be beneficial to both bidders. However, this solution would be detrimental
to the auctioneer, so agreements between bidders are not allowed.
Another strategy is to place the minimum bid and threaten to raise the bid to
EUR 90 if the other participant decides to make a counteroffer. However, if we
assume that communication between bidders is not possible, the threat solution
also fails.
You can place a high bid immediately, making it unattractive for Player B
to bid at all. With an initial bid of EUR 90.01, the minimum bid in the second
round is EUR 100.01, making it unattractive for Player B to bid. You would have
made a profit of EUR 9.99, the auctioneer would have made a loss of the same
amount, and Player B would be at plus or minus 0.
The EUR 100 auction underscores the importance of rules in auctions. Struc-
turally, it corresponds to a war of attrition, in which costs keep rising until one
of the participants gives up.16
16 The pre-emption game is the counterpart to the war of attrition. It involves the decision to
enter a new market. A company can, in this model, either develop a product or enter the mar-
ket. Entering the market early, before all other competitors, allows a monopoly position until
the next company enters the market. However, early entry comes at the expense of product
maturity, so companies must weigh the benefits of a (temporary) monopoly position against
the costs of inferior development. There is currently a trend towards early entry; beta ver-
sions of software are common practice. Certain market segments (early adopters) are willing
to buy products that are still under development. This makes it possible to enter the mar-
ket early while continuing or even accelerating the development phase. In this way, products
with little chance of success can be identified early on reducing the cost of a failed product
development.
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Rowohlt Taschenbuch, Reinbek bei Hamburg
Purchasing Negotiations
4
Abstract
Negotiations typically follow the demand specification and supplier selection
phases in procurement. Game theoretically optimized procurement negotia-
tions take place according to a predefined set of rules. It takes into account all
possible decisions of the participating suppliers. It is therefore an mechanism-
based process in which award decisions are made autonomously. Auctions
are a common type of mechanism, but not all mechanisms are necessarily
auctions.
4.1 The Basic Model of a Negotiation
A negotiation can be defined abstractly as a process by which a joint deci-

sion is made (see Pruitt 1981). Negotiations consist of a value creation part
and a distribution part. The value created in a negotiation can be quantified by
the improvement achieved in an agreement compared to a situation without an
agreement.
This chapter presents a basic bargaining model that can be applied to both
autonomous mechanisms and bilateral bargaining.
When a price is being negotiated, the reservation price is the price at which
one party would be in the same position as if no agreement were reached. The
reserve price is therefore the worst point that a negotiating party would be willing
to accept.
Figure 4.1 shows a bilateral negotiation in its simplest form. In this exam-
ple, the seller’s (S) reservation price is lower than the buyer’s (B) reservation

https://doi.org/10.1007/978-3-658-40868-8_4
72 4 Purchasing Negotiations
Reservation price Reservation price

seller buyer
Agreement
Advantage Advantage
seller buyer
S X B Price
Fig. 4.1 The geometry of distributive bargaining with one dimension, adapted from Raiffa
(1982)
price. All prices between the two reservation prices are points of possible agree-
ment, since both sides would benefit from agreement at any of these points. The
range of possible agreements is called the ZOPA (zone of possible agreements).
An agreement is not possible if the seller’s reservation price is higher than the
buyer’s reservation price. Value-creating actions in a negotiation aim to increase
the ZOPA. For example, if actions are taken to reduce a supplier’s costs, the sup-
plier’s reservation price moves to the left on the price axis, the ZOPA increases,
and the buyer has more room to reduce the price.
The BATNA (best alternative to negotiated agreement) is each side’s best alter-
native if no agreement is reached in the current negotiation. A side’s bargaining
position is fundamentally strengthened if its BATNA improves prior to the nego-
tiations. In terms of its effect in a bilateral negotiation, the BATNA is equivalent
to the reservation price because it limits possible agreements in the same way.
If an agreement is possible in principle, the question is how to reach it and
what the outcome will be. A “negotiation dance” begins with offers from each
side that are usually far from their own reservation price (see Raiffa 1982).
A significant advantage for one side in a negotiation is knowing the other
side’s reserve price or BATNA. Thus, a take-it-or-leave-it (TIOLI) offer can be
placed just above or below the other side’s reservation price. TIOLI offers are
typically used in B2C markets where customers have little bargaining power.
Its targeted use in business-to-business negotiations can yield good results if the
offer amount is chosen correctly. Former General Electric Vice President Lemuel
4.2 Central Auction Formats 73
Boulware pursued such a TIOLI strategy by making a good initial offer and not
revising it in subsequent negotiations (see Raiffa 1982).
A means of determining a reservation price is a cost breakdown, which is used
to estimate the supplier’s cost of providing the service. Mathematical forecasting
techniques such as Linear Performance Pricing (LPP) can also be used to estimate
costs.
In a classic bilateral negotiation, each side’s knowledge of the ZOPA plays
an important role. This is especially true for the question of who will make an
opening bid. If one has a poor understanding of the ZOPA, it is not advisable to
start the negotiation with an offer. On the other hand, an information advantage
can be used to place an effective anchor (see PON Negotiation Newsletter 2008).
Raiffa (1982) asks whether it would be easier to reach an agreement in a bilat-
eral negotiation if both players revealed their reservation prices and the final price
was calculated as the average of the two prices. However, it turned out that this
approach led to a higher proportion of negotiations ending in no agreement. This
was explained by the fact that players had an incentive to over- or underestimate
their reservation prices. Thus, a subsequent change in the reported reservation
price would imply that the reservation price was not initially reported truthfully.
Each side can improve its BATNA by negotiating with multiple parties
simultaneously. In this way, procurement can create competitive pressure and
get suppliers to quote prices closer to their reservation price. The following
chapters describe how to systematically improve competition among suppliers.
4.2 Central Auction Formats
An auction is a process by which goods, products, or services are bought or sold.

It is a structured form of negotiation among multiple parties to reach a common
decision on price, quantity, or other attributes.
When no further information is given, an auction can be assumed to be a
sales auction. An auction whose purpose is to buy a service is called a buy
auction or reverse auction. In the following, an auction refers to a buy auction
unless explicitly stated otherwise or implied by the context.
The primary goal of a sales auction is to maximize revenue. The purpose of a
reverse auction is to minimize costs. An auction format is economically efficient
if it ensures that the lowest cost seller or buyer with the highest valuation wins.
Although much of the economic research has focused on selling auctions,
fortunately most of the results can be applied to buying auctions as well. The
main difference between buying and selling auctions is the heterogeneity of the
products or services offered in buying auctions. This is minor for standardized

products, but significant for more complex products or services. This problem
does not arise in selling auctions because it is usually irrelevant to the seller
which buyer he receives the agreed price from.
The four basic auction formats are the English/Japanese auction, the Dutch
auction, the first-price sealed-bid auction, and the second-price sealed-bid auction.
Fig. 4.2 shows how the formats work in their buying and sales versions.
The basic functioning of the auction formats is the same for both purchase
and sales auctions. For example, the English auction starts with a price that is
favorable to the auction participants. This price decreases with each round until
only one bidder is willing to accept the price. This means that an English sales
auction has a low starting price and ascending prices. An English purchase auc-
tion, on the other hand, starts with a high price and gradually lowers it until only
one supplier is willing to accept the price.
The Dutch auction starts with a price that is disadvantageous to the partici-
pants, but improves with each round until at least one participant is willing to
accept the price. This means that the starting price is high and gets lower with
each round. In the reverse Dutch auction, the starting price is low but increases
with each round until a bidder is willing to accept the price.
In sealed-bid (first-price and second-price) auctions, bids are not visible to
other bidders. This prevents the exchange of information among auction par-
ticipants. In both sealed-bid first-price and second-price auctions, the winner is
the participant who submits the best bid.1 However, the two formats differ in
their pricing rules. In a first-price auction, the price offered by the winning bid-
der determines the final price; in a second-price auction, the second-best price
determines the final price.
At first glance, the second-price auction may appear to be disadvantageous
to the auctioneer. However, it must be assumed that auction participants take
the second-price rule into account in their decision making. In a game theoretic
analysis, it can be shown that it is optimal for participants in the second-price
auction to bid their reserve price. In effect, the second-price auction is similar to
the English auction, but it requires only one bid.
1 This rule may seem trivial, but it is not the case in all auctions that the best price wins. In
the average price auction, for example, the bidder with the bid that is closest to the mean or
median of all submitted bids wins (cf. Sect. 4.2.6).
English /Japanese Auction Dutch Auction First-price sealed-bid auction Second-price sealed-bid
Price
Price
Price
Price
Sale
4.2 Central Auction Formats
Round Round Participant Participant
Price
Price
Price
Price
Purchasing
Round Round Participant Participant
Price submitted Price submitted

Price steps Price steps
Winner and prize to be paid Winner
Price to pay
Fig. 4.2 The purchase auction mirrors the four basic auction formats of the sales auction
75
4.2.1 English and Japanese Auction
The English auction is an open outcry auction, which means that participants
can bid any price as long as it is an improvement over the last bid or starting
price from the auctioneer’s perspective. This means that “jump bids” are possible,
which involve a larger price change than is necessary to make a leading bid. A
jump bid is a signal that the bidder has room for further price adjustment. This
can intimidate weaker participants and cause them to give up prematurely, which
is not in the auctioneer’s interest. The English auction allows for a high degree
of information exchange between auction participants, which can be beneficial
to the auctioneer when there is uncertainty about the expected cost of a product
or service. A supplier observing the bids of other participants can reduce its
uncertainty about its own expected costs, assuming that the costs to be borne by
all suppliers are the same.
In the Japanese auction, price changes are set by the auctioneer. Participants
remain in the auction until they announce their withdrawal, which in the Japanese
auction was originally done by leaving the room. Subsequent re-entry is not
possible in the Japanese auction. In this way, the auction organizer receives more
information than in the English auction, since each participant’s willingness to
pay is made public. In an English auction, if a bidder does not bid in a round
that is not the final round, it is not clear whether the bidder’s reserve price has
been underbid or whether the bidder has temporarily withdrawn.
Ticker auctions are more common for purchase auctions because they allow
for better specification of the auction’s progress. The English ticker auction is
similar to the Japanese auction in that it specifies the price change per round.
However, they differ in their activity rules: The Japanese auction requires bid
confirmation in every round, while the English auction requires bid confirmation
only when explicitly specified.
In a Japanese reverse auction, an auction participant’s optimal bidding behav-
ior is simple: as long as the called price is higher than or equal to its reserve
price, the supplier will continue to participate in the auction. As soon as the
called price is lower than the reserve price, the bidder exits the auction. If all
participants follow this rule, the supplier with the lowest reserve price wins the
auction. The price to be paid is determined by the second-lowest reserve price
and the specified price change per round.
An example: Let’s say you want to buy an engine and you use a Japanese
purchase auction. Two vendors are participating in the auction, Vendor A and
Vendor B. For simplicity, let’s assume that the engines offered by the vendors
are of exactly the same quality, but the vendors differ in their reservation prices.
However, this information is known only to each supplier. The lowest price that
supplier A would accept is EUR 5,000, and for supplier B it is EUR 7,200. If
the starting price is EUR 10,000 and the price reduction is EUR 1,000, supplier
B will not participate at EUR 7,000 because its reservation price has been under-
cut. Therefore, the final price is also EUR 7,000. This was determined solely
by Supplier B’s willingness to pay as long as Supplier A had the lowest reser-
vation price. Even if Supplier A had accepted a price of EUR 1,000, the final
price would have been EUR 7,000 (Fig. 4.3). Therefore, if bidders’ reservation
prices are expected to differ significantly, Japanese or English auctions are not
recommended without additional measures.
Another element that determines the final price is the price reduction applied
per round. In the example above, Supplier A wins the auction with a price of EUR
7,000. This price is EUR 2,000 above his reservation price, but EUR 200 below
the reservation price of Supplier B. If the price decrease is set at EUR 1 per
round, it will take almost three thousand rounds (2802 to be exact) to go from a
Price
Round
Supplier A Supplier B
Fig. 4.3 Supplier A has a reserve price of EUR 5,000 and B has a reserve price of EUR
7,200. With a starting price of EUR 10,000 price decrements of EUR 1,000, B wins and the
final price is EUR 7,000
Price
Round
Supplier A Supplier B
Fig. 4.4 The reserve price for supplier A is EUR 7,200 and EUR 5,000 for supplier B. With
price reductions of EUR 1 per round, B wins again; the final price is EUR 7,199
starting price of EUR 10,000 to a price below Supplier B’s reserve price.2 The
final price would then be EUR 7,199, i.e. EUR 199 higher than in the previous
case, in which the price decrement was set to 1,000 euros (Fig. 4.4). A lower
price decrement can thus lead to an increase in the final price achieved.
The optimal price decrease is as close as possible to the lowest reserve price
in the round in which the second lowest reserve price is underbid. For example,
a round decrease of EUR 2,500 results in an optimal final price of EUR 5,000,
when the starting price is EUR 10,000.
2 This approach is practically only possible if participants can specify a bot to bid for them.
Otherwise, the large number of bids would not justify the effort. The online auction platform
eBay uses a proxy bidding process in which participants simply set a maximum bid. The bot
then automatically bids until the maximum price is reached. As in the English auction, the
second highest bid determines the final price. A special feature of eBay is that new partici-
pants can join the auction at any time. This makes sniping strategies possible, where a bid is
placed just before the auction ends. Since the number of bidders is usually fixed before the
auction starts, sniping strategies are not used in reverse auctions.
Therefore, an increase in the price decrease in the Japanese reverse auction

will result in lower prices if the difference between the reservation prices is large
enough. However, it is not only the size of the price decrement that is important,
but also the exact reservation prices of the auction participants. Ideally, from the
auctioneer’s point of view, the decrements must be set so that the price is as close
as possible to the lowest reservation price. However, the calculation of an optimal
price decrement is based on knowledge of the reservation prices, which in reality
is seldom available.
If the price decrement is set too high, there is an increased risk that both the
lowest and the second lowest reservation price will be undercut at the same time.
In this case, the procedure must be specified. A lottery procedure to determine
the price level accepted by both participants is one possibility, but this would be
disadvantageous to the auctioneer if the price reductions were large. An alterna-
tive would be to reduce the price reductions from the last price level accepted by
at least two bidders. Another option is to combine the English and Dutch auctions
(Sect. 4.3.7).
To answer the question of which price decrement to choose, a simulation was
run with the following parameters:
• Auction format: Japanese procurement auction. If the number of bidders

decreases from multiple bidders to zero within one round, the auction winner
is determined by lottery at the lowest previously accepted price.
• Participants: Four suppliers offer a homogeneous product, but have different
reservation prices.
• Distribution of reservation prices: To simulate reservation prices, a truncated
normal distribution was used with a mean of EUR 5,000 and three different
standard deviations (low, medium, high). This results in three categories of
bidder heterogeneity.
• Starting price: EUR 12,000.
• Price changes per round: The price changes per round were defined as a
percentage of the starting price.
• Repetitions: The simulation was carried out a total of 6000 times. The values
shown are smoothed averages.
It turns out that large price reductions are detrimental when the heterogene-
ity of reservation prices is low. Here, small price reductions per round should
be used. For medium and high price heterogeneity, price reductions in the
range of 10 to 12% of the initial price (i.e. EUR 1,200 to EUR 1,400) can
Low heterogeneity
Final price
Medium heterogeneity
High heterogeneity
Price decrement
Fig. 4.5 Simulation of price decrements with different bidder heterogeneity
improve the final result (Fig. 4.5). With the chosen distribution, low price het-
erogeneity means that the distance from the lowest to the average reservation
price is about EUR 770 (15%). With medium heterogeneity, this value becomes
EUR 2,222 (44%), and with high heterogeneity, it is EUR 3,061 (61%).
4.2.2 Dutch Auction
The Dutch reverse auction starts with a low price and increases it until at least
one bidder is willing to accept it (Fig. 4.6). There are two main variants of the
Dutch reverse auction: In the sudden death variant, the auction ends as soon as
a supplier accepts the price called, even if another supplier might have accepted
the price as well.
In the full step option, all participants have the opportunity to accept a price
(see Berz 2014). This may result in more than one supplier accepting a price.
One way to handle this tie is to reduce the price increment from the last price or
to have a final round with a sealed-first-price auction.
The Dutch auction requires more complex calculations on the part of the bid-
der than the English auction. During the auction, suppliers in the Dutch auction
do not receive any information about the bidding behavior of other participants.
Only at the end of the auction does the supplier know at what price the auction
has ended. Therefore, the supplier must decide before the auction what price he is
Price
Round
Price
Fig. 4.6 The course of a Dutch auction with a price increment of EUR 500, a starting price
of EUR 1,000 and two bidders
willing to accept. In this way, the auction is strategically equivalent to the sealed-
first-price auction, although a dynamic action may have a different psychological
effect than submitting a single bid and also reduce cognitive load.
When deciding on a starting price, the bidder weighs the probability of win-
ning against the profit margin in the event of a win. The higher the price chosen,
the lower the probability of winning. However, this also increases the profit mar-
gin if a higher price is offered. Again, the participant’s risk appetite plays a role.
The more risk-averse the bidder, the lower the winning bid. A risk-averse supplier
trades a lower margin for a higher probability of winning.
This calculation can be represented mathematically.
In an auction with two bidders, a bidder’s payoff depends on his production
costs c1 , his bid price p1 , and the probability P that he will win the auction. He
wins the auction if his price is lower than the price of the other participant. The
probability that bidder 1 wins can thus be represented as P(p1 < p2 ).
The payoff in the event of a win is the difference between the bid price and
the production costs. The expected payoff is the product of the payoff and the
probability of winning:
E[U1 ] = ( p1 − c1 )P( p1 < p2 )
Since suppliers have no information about the bids of other participants, a deci-
sion must be made based on probabilities. Assume that the suppliers’ production
costs are uniformly distributed within a certain corridor that is known to the
participants. In the uniform distribution, each cost point between the known
upper limit (cH ) and the lower limit (cL ) has exactly the same probability of
occurrence.3
The optimal bid price for supplier 1 can be calculated as follows on the basis
of this information (see Appendix for a mathematical derivation):
p1 = (c1 + c H )/2
This result can also be generalized to any number of participants, n:
pi = ((n − 1)ci + c H )/n
Therefore, each supplier’s bid price is always higher than its cost (as long the
bidder’s cost does not equal the upper limit cost cH ) and decreases with each
additional supplier. The increased competition is anticipated and the price is low-
ered to still have an acceptable chance of winning the auction. However, the
additional price reduction from additional suppliers becomes smaller and smaller
(Fig. 4.7). The largest price reduction effect can be expected from two to three
suppliers. An increase from four to five suppliers will have a less pronounced
effect. If there are only small differences in production costs between the sup-
pliers, an increase in the number of participants can also have a price-increasing
effect (see Sect. 4.3.1).
So far, risk neutrality has been assumed. For example, a risk-neutral individual
will value a EUR 100 payment with a 50% probability the same as a EUR
50 payment with a 100% probability.
A bidder’s risk appetite depends on his personality, but also on the economic
situation of the company he represents. If the overall market is tight, this will lead
to increased risk aversion. An entrepreneur with a full order book, on the other
hand, is more likely to take a higher risk when bidding in order to potentially
achieve a higher margin (Fig. 4.8).
3Other distributions, such as the normal distribution, can also be used as a basis, but this does
not fundamentally change the results.
Price
Participant
Bid price supplier 1
Fig. 4.7 The optimal bid price decreases with a higher number of participants, but always
remains above the supplier’s costs
In the Dutch auction and the sealed first-price auction (see Sect. 4.2.3),
increased risk aversion of the bidders leads to lower prices. Conversely, bidders’
risk affinity implies a bidding premium.4
Although price increments also play a role in the Dutch auction, they are less
complex than in the English auction. As in the English auction, the auctioneer’s
goal is to get as close as possible to the lowest price strategically chosen by the
participants. Unlike in the English auction, a larger price change (increment) can-
not have a price reducing effect. Therefore, small price increments are generally
advantageous for the auction, but the auction duration must also be taken into
account.
4The English and sealed-second-price auctions do not require strategic reasoning, as do the
Dutch and first-price auctions, so participants’ risk attitudes have no effect in these formats.
Price
Higher affinity for risk
Higher risk aversion

Suppliers
Risk aversion Risk neutrality
Risk affinity
Fig. 4.8 In the Dutch auction and the first-price auction, higher risk aversion of the suppliers
leads to lower bids. Conversely, risk affinity leads to higher bids
4.2.3 First-price Auction
In a sealed-first-price auction, suppliers bid without knowing the bids of other

bidders. A sealed-first-price auction is different from a request for quotation
(RfQ). A supplier may expect that there will be follow-up negotiations after
an RfQ. As a result, the supplier will typically bid a higher price than in a
sealed-first-price auction if there is a credible commitment.5 The strategic rea-
soning of a participant in a sealed-first-price auction is essentially the same as in
a Dutch auction.
In practice, however, there are differences in the final prices obtained between
the two formats (cf. Lucking-Reiley 1999; Cox et al. 1982), the direction of
which is not clear. Katok and Kwasnica (2007) find that Dutch auctions with a
short duration produce worse results than Dutch auctions with a longer duration.
They argue that a long auction process creates higher opportunity costs that may
5 The same applies to a Dutch auction followed by post-auction negotiations.

render bidders more willing to accept less favorable prices. I would add that a
longer duration in a Dutch auction usually corresponds to smaller price changes,
which tends to improve the outcome.
In the Dutch Sudden Death auction, suppliers can win with certainty if they
accept a certain price level. Individuals often have a preference for a particular
payoff that cannot be fully explained by expected values and for which they will
accept a less favorable price level. In the sealed-first-price auction, the possibility
of winning the auction with certainty does not exist at any time. This is an
advantage of the Dutch auction in the sudden death variant, even though ties may
be ignored.
Experimental studies also suggest that decision making is more complex in the
sealed first-price auction than in the Dutch auction. Decision-support systems that
display the profit associated with a price and the probability of winning reduced
final prices in the sealed-first-price auction, but had no effect in the Dutch auction
(cf. Fugger et al. 2017).
4.2.4 Second-price Auction
As in a sealed first-price auction, participants in a sealed second-price auction

submit bids that other participants cannot observe. However, in a sealed second-
price auction, also known as a Vickrey auction, the rules for winning and setting
prices are different (cf. Vickrey 1961). The participant with the lowest bid still
wins, but receives the second-lowest price. In this way, the second-price auction
is structurally identical to the English auction in that the price to be paid is also
determined by the second-lowest bid. However, the English auction requires more
steps.
Thus, the second-price sealed-bid auction can be considered a more efficient
form of the English auction.
From the buyer’s perspective, it may seem like a disadvantage to pay the
second lowest price instead of the lowest price. However, this view ignores the
fact that bidders make decisions based on the rules of the auction. For example,
in some sales auctions, it is common to pay a higher price than the called bid
price. This is expected by the participants. A surcharge of 20% will simply cause
bidders to reduce their bids by 20% on average.
Likewise, participants in a Vickrey auction understand that the price they
receive as the auction winner is determined by the second-lowest bid, not by
their own bid. Without examining incentives in detail yet, it can be seen that a
supplier will submit a lower bid in a second-price auction than in a first-price
auction. Furthermore, it can be shown that bidding at the actual minimum price
is a weakly dominant strategy (cf. Sect. 2.2).
To examine this in more detail, suppose there are n bidders participating in a
second-price sealed-bid auction. If there are two or more bids at the same price,
a lottery decides who wins the contract. If bidder 1’s cost is c1 , the supplier has
three strategies to choose from:
1. Underbid: He can bid below his costs.

2. Overbid: He can bid above his costs.
3. Bid truthfully: He can bid exactly his costs.
The only strategically relevant bid besides one’s own is the lowest bid submitted
by any other supplier, L. Three cases can be distinguished: the production costs
of bidder 1 can be (1) greater than, (2) less than, or (3) equal to L. The first two
possibilities are shown in Figs. 4.9 and 4.10.
Case 1: If bidder 1’s production cost is higher than the lowest bid of all other
suppliers (L), overbidding has no effect relative to truthful bidding, since bidder
1 would not win the auction even if the bid was truthful. Underbidding has no
effect as long as the bid is greater than L. As soon as the bid is less than L,
bidder 1 wins the auction at price L, but suffers a loss of C – L, which is worse
than bidding truthfully.
Case 2: If bidder 1’s production cost is less than L, then the strategy of bidding
below production cost is no different in effect than bidding truthfully; bidder 1
wins in either case and receives L as the price, for a profit of L – C. Bidding above
Production costs supplier 1

Lowest other bid
Bid supplier 1
Truthful
bidding
Underbid Overbid
Bid
Bid / Cost
Payoff
supplier 1 Negative effect Neutral effect
Fig. 4.9 Possible actions and payoffs in a second-price sealed-bid auction when production
cost is higher than the lowest bid of all other bidders (case 1)
Production costs supplier 1

Lowest other bid
Bid supplier 1
Truthful
bidding
Underbid Overbid
Bid
Bid / Cost
Payoff
supplier 1 Neutral effect Negative effect
Fig. 4.10 The different actions available in a sealed-second-price auction and the corre-
sponding payoffs when the production cost is lower than the lowest bid of all other suppliers
has no effect as long as the bid price is less than L. If the bid price is greater
than L, then L becomes the overall lowest price. The other supplier then wins the
award and pays the price bid by bidder 1, unless another bid is closer to L and
greater than L.
Case 3: Finally, there is the case where bidder 1’s production cost is exactly
equal to the lowest other bid submitted. In this case, bidding truthfully will result
in a potential auction win,6 but will not result in a monetary profit because bid-
der 1 will only receive the production cost as payment. If bidder 1 chooses to
underbid, bidder 1 will win, but will still have a zero profit because it will only
receive its production cost. If bidder 1 bids higher, it does not win the auction,
resulting in the same zero profit outcome.
It can be concluded that overbidding or underbidding in any of the possible
combinations does not lead to an improved payoff for the participant. The over-
bidding and underbidding strategies either have no effect or reduce the payoff
relative to truthful bidding. Thus, truthful bidding is a weakly dominant strategy.
In a second-price response, a supplier only knows the amount of his own bid and
does not know with certainty where the other bids are. Deviating from truthful
bidding in a second-price auction runs the risk of worsening the payoff.
In summary, overbidding and underbidding do not improve the participant’s
payoff in any of the possible constellations considered. The overbidding and
underbidding strategies either have no effect or reduce the payoff relative to
truthful bidding. Thus, truthful bidding is a weakly dominant strategy. In a
6The probability depends on how many other suppliers have bid exactly the same price. The
exact probability is 1/k with k as the total number of suppliers who have bid the lowest price.
second-price sealed-bid auction, a supplier only knows the price of its own bid
and does not know the prices of the other bids with certainty. Deviating from
truthful bidding in a second-price sealed-bid auction runs the risk of worsening
the bidder’s payoff.
Suspicious suppliers that do not trust the auction rules, will tend to bid close to
the optimal first-price auction price. If the auctioneer follows the announced rules,
the outcome will then be worse than in a simple first-price auction. Therefore,
the credibility of the announced auction rules plays a particularly important role
in the second-price auction.
Even when ignoring a potential credibility problem, the second-price auction
creates price uncertainty for participants because the realized price is largely
externally determined. The bid can only set a price floor, but in the case of a
winning bid, the realized price depends solely on the second lowest price. This
is also the case in the English auction, but here the perceived price uncertainty is
reduced by the round-by-round confirmation of the price.
Another challenge is the internal acceptance of a sealed second price auction.
Without sufficient consideration of the auction logic, stakeholders may question
in advance why only the second best price is accepted and not the best price.
After the auction, information about the willingness to sell of all participants in a
sealed second-price auction is available. If there is a large difference between the
best and second-best bids, an auction could be perceived as a failure, even though
the overall cost reduction achieved would otherwise be considered a success.
Information about the gap between the best and second-best reserve prices would
not be available after an English auction because the auction ends when the
second-lowest reservation price is underbid.
In 1990, the New Zealand government used a simultaneous sealed-bid second-
price auction. The licenses were largely split evenly, leading to seemingly
contradictory results. For example, one company that bid EUR 229,000 for a
license paid only EUR 57,000, while another company that bid EUR 146,000
for the same license paid EUR 114,000. Overall, auction revenues fell short of
expectations (EUR 20.6 million vs. EUR 142.8 million).7 In particular, the fact
that in some cases the second price was significantly lower than the first price led
to media outrage. The difficulty of communicating the results of a second-price
auction became apparent. As a result, the New Zealand government returned to
the use of first-price auctions (cf. Milgrom 2001).
7The exchange rate used to calculate values from New Zealand Dollar to EUR is from June
2020.
Despite its theoretical elegance, the Vickrey auction faces significant practical
challenges that must be addressed for an application of this auction format.
4.2.5 Ausubel Auction
The cost structure of many companies is characterized by fixed cost degression.

After a large initial investment, the fixed costs are spread over more and more
products as the number of units increases—the unit cost of production decreases.
If Apple had limited itself to producing a single first-generation iPhone, the cost
per unit would have been USD 150 million (see Yarow 2013). Scaling up pro-
duction is the only way to make many products affordable. Developing a vaccine
requires a significant initial investment. Ten years of development and costs of
more than USD 1 billion to market are not uncommon (see Baranov et al. 2017).
Figure 4.11 shows the cost curves of three suppliers that have high fixed costs
and decreasing unit costs.8 Supplier C’s unit costs decrease more slowly than
those of the other suppliers. Suppose the purchasing organization wants to buy a
total of four units.
In an English multi-object ticker auction, a price is announced for each round,
and firms then bid the quantity they are willing to supply at that price. As unit
costs fall, suppliers will always bid a quantity that makes the best use of their
production capacity, since this maximizes their margin. The maximum possible
quantity is bid until the price falls below the cost of production.
In an English auction with no limit on supplier capacity, Supplier A wins the
contract for four units at a price of EUR 31 million, resulting in a total margin
of EUR 2 million.9
Assuming that each supplier has a maximum production capacity of three
units, the three companies would offer the quantity of three units until the price
falls below their cost of production. In an English auction, the bid for three
units would also go to supplier A at a total price of EUR 30 million (EUR 10
million per unit). However, based on the information available, it is not clear from
which supplier the remaining unit should be purchased because there is no price
information for a single unit. Similarly, based solely on the information from the
auction, it is not clear that the bid to supplier A for three units makes sense. It
is also possible that supplier A is better at supplying one unit and that the other
8 The example is based on Baranov et al. (2017).

9 Effects of price decrements are not considered here.
90
Total cost per supplier Total cost per supplier

Costs in € million Unit costs in € million
Capacity g
Capacity limit
Quantity Quantity
4
Supplier A Supplier B Supplier C Supplier A Supplier B Supplier C
Fig. 4.11 Suppliers A, B and C have different cost structures. The capacity limit is three units for all suppliers
Table 4.1 The Ausubel

Best confirmed offer (EUR million)
auction reveals the
price/quantity combination Quantity Supplier A Supplier B Supplier C
that suppliers are willing to 1 26.75 28.00 27.00
supply. The winning price
2 28.75 29.00 30.00
is the second lowest price.
Only the winning bidder 3 29.75 30.00 33.00
knows the lowest price 4 – – –
three units are produced by another company. Without knowing the bids for the
other quantities, an optimal allocation is not possible.
In the Ausubel auction, a given unit price is announced, and then suppliers
are asked to specify all quantities they are willing to supply at the given unit
price. Under the assumption of positive economies of scale, the specification of
a minimum quantity would be sufficient, but quantity intervals can also be used.
The information thus obtained can be used to estimate the suppliers’ cost curves.
In this example, we could start with a starting price of EUR 30 million,
decreasing by EUR 0.25 million each round until only one supplier remains for
each quantity. The results of the auction are shown in Table 4.1.
The cost-optimal combination for the purchase of a total of four units is there-
fore three units from supplier A for EUR 29.75 million and one unit from supplier
C for EUR 27 million.10 The information that supplier C can bid competitively
for a single unit would not have emerged from the English auction. Here, three
units would have indicated that supplier C had submitted a bid that was 10%
higher than the next best bid.
4.2.6 Average Price Auction
While the goal of purchasing auctions is typically to minimize costs while taking
into account all differentiators, there are also auction formats designed to prevent
overly aggressive bids. This is especially relevant for contracts that are not fully
specified, where suppliers can impose cost overruns during the course of the
project.
10 This is the last accepted price from supplier C for one unit. The underlying assumption is
that bids for quantity price combinations are accepted as long as the called price is above the
cost.
Cost overruns and project delays are a significant problem for contractors. For
example, 77% of the largest public construction projects in Spain suffered from
average cost overruns of 22% of the budget (see Ganuza 1997).
In public construction projects, sealed-first-price auctions are often seen as
putting too much pressure on suppliers. While this would result in low prices, it
would also increase the likelihood of cost overruns or bankruptcies during project
delivery.
Average price auctions (APAs) were seen by some as a means of reducing
price pressure on suppliers, thereby reducing the likelihood of cost overruns or
bankruptcies.
There are several types of APAs. What they all have in common is that the
price that comes closest to a calculated average line wins the auction. The average
line can be calculated in several ways. It is common to exclude extreme values.
For example, 10% of the highest and lowest bids can be excluded from the
average line calculation to minimize the distorting effect of very high or very
low bids. You can also calculate the average line in multiple steps or exclude
all points above or below the average line. Two APAs are considered below (see
Spagnolo et al. 2006).
In a Type 1 APA, the winning bidder is the bidder whose bid is closest to the
average of all bids submitted. In a Type 2 APA, the winning bidder is the bidder
whose bid is below the average line and closest to the average (Fig. 4.12). At
the beginning of an APA, the auctioneer announces a reserve price and suppliers
submit their bids by specifying discounts from the reserve price.
Average price auction Average price auction

(type 1) (type 2)
Price
Price
Ø Ø
Participant Participant
Winner and price to be paid
Fig. 4.12 In APA Type 1, the bid that is closest to the average of all bids wins. In APA Type
2, of all bids below the average, the one that is closest to the average wins
It may seem that the APA is a friendlier form of auction that takes the edge
off aggressive competition to prevent cost overruns and bankruptcies. However,
the implications for supplier incentives need to be considered in detail.
The APA faces several challenges. Its central problem is that it facilitates
coordination between competitors and thus encourages the formation of cartels.
Under certain circumstances, the APA may lead to particularly fierce competition.
In particular, the APA Type 1 may facilitate agreements between bidders and
thus the formation of cartels. For example, if two out of three suppliers have
agreed on a certain price, it is impossible for the third supplier to break the cartel
under a Type 1 APA. Offering a price that deviates from the cartel price will
inevitably result in a losing bid, since the cartel prices will always be closer to
the average price.11 In addition, cartels can strengthen their pricing power by
bringing in other bidders whose role is to push the average price in a certain
direction by submitting high or low bids. For example, coordinated cartel bids
were a common practice in road construction contracts in Turin between 2000
and 2003 (see Conley and Decarolis 2016).
In a Type 2 APA (Fig. 4.12), a cartel agreement is easier to break up. For
example, if two suppliers agree on a cartel price, the third supplier could aggres-
sively underbid and win the auction if the other two bidders end up bidding above
average.
However, the more participants in a cartel, the more difficult it is for a single
participant to effectively break the cartel. If the auctioneer’s reserve price is EUR
100 and a total of five suppliers are participating in the auction, the participants
could agree that four bidders will offer the reservation price, while the fifth bidder
will offer EUR 99. The margin could then be divided among the participants. If
one of the four suppliers deviates from the agreement and wants to win the
auction on its own, it would have to choose its bid so that the average price falls
below EUR 99, which would only happen if the bid was EUR 96. The more
cartel bidders there are, the more aggressively the deviator would have to bid
to bring the average price below the cartel price. A supplier with a significant
cost advantage may therefore be forced to submit a lower bid than in a first-price
auction.
An experimental study showed that the bidding behavior of participants in a
APA remained largely unchanged compared to a first-price auction (see Chang
et al. 2015). The study suggests that the APA increases the margin of companies
11 With PC as the cartel price and P as the price of the competitor, this results in: |
PC+PC+P
3 −P |>| PC+PC+P
3 − PC |, as long as |P − PC| > 0.
that win a contract and reduces subsequent bankruptcies. However, the problem
of facilitating agreements between suppliers remains unresolved.
Other auction formats create less problematic incentives than the APA by
modifying the standard rules. For example, an English auction can be set up to
end when a certain number of participants remain in the auction (see Engel 2009).
The remaining participants are then evaluated and the award is decided based on
the evaluation. Due to the smaller number of participants, the evaluation effort is
lower. The level of competition intensity is controlled by the value of the number
of participants at which the modified English auction ends.
It should also be noted that poorly specified contracts are a cause of cost
overruns. Therefore, fixed-price contracts should generally be avoided for projects
with increased planning uncertainty.
4.2.7 Multi-good Auctions
Imagine you are attending a seminar with 15 other people. Your instructor tears
a EUR 500 note in half. All participants are asked to bid on each half of the bill
in a sealed, first-price auction. Subsequent trading of the bill halves during or
after the seminar is not permitted, nor is communication between participants. If
more than one participant submits the same bid, each bid will be determined by
lottery. What is your bid?
Each half of the note is worth EUR 250, but only if you have both. If a par-
ticipant has both halves of the note, they can exchange them at the nearest bank.
If only one half of the note is won, it is virtually worthless due to the auction
rules. Since there is a risk that the other half will not be won, participants will
adjust their bids downward. It is expected that the sum of the winning bids will
be below the value of EUR 500. This makes the auction format disadvantageous
for the auctioneer and a high-risk game for the participants.
The inefficiency arises because the format described above does not allow
auction participants to fully express their valuations. Economies of scale mean
that a supplier’s average unit cost decreases as output increases. In the case of
negative economies of scale, the average cost increases as output increases. If
there are subadditives or superadditives between lots that cannot be expressed in
the auction rules, suboptimal results are likely to occur.
A dynamic auction is better able to capture economies of scale or scope.
However, there is still an exposure risk. If a participant bids in sales auction for
multiple line items hoping to capture economies of scope but does not receive all
of them, he will likely overpay.
An auction in which bids can be submitted for all line items and for combi-
nations of those line items is called a combinatorial auction. One advantage of
combinatorial auctions is that they allow competition between large and small
suppliers. For example, suppose you are preparing an auction with 50 line items.
There are two companies that can bid on all line items and several smaller sup-
pliers that can only bid on a subset of line items. A bundle that includes all
items would limit competition to two companies. An individual price for each
item would unnecessarily increase transaction costs and prevent the capture of
economies of scale and scope. A combinatorial auction allows bids to be placed
on all possible combinations and the best combination to be determined with-
out requiring assumptions about the cost structure of the bidders. Combinatorial
auctions also avoid the exposure problem.
When all possibilities are considered in a combinatorial auction, the number
of possible bids increases exponentially with the number of line items. Even with
only 20 items, the number of possible combinations is over a million (Fig. 4.13),
with 30 items, it is over a billion. The large number of possible bids creates a
significant complexity in various parts of the procurement process, which often
requires the use of specialized software. We have developped several approaches
in Python to solve the WDP. Two key questions in this context are (see Parkes
2001):
1. What bid combinations are allowed (Mechanism Design Problem)?

2. What criteria will be used to decide who gets the contract for a package or
combination of packages? What combination of bids represents the lowest cost
combination (Winner Determination Problem, WDP)?
Special bidding languages have been developed for combinatorial auctions. The
most important of these are OR and XOR (exclusive OR) bidding languages. OR
bids allow the auctioneer to combine bids at will unless specificed otherwise.
XOR bids, on the other hand, allow the auctioneer to accept only one of the bids
submitted (ibid.). The XOR language is more explicit but also longer than the
OR language.
Transportation Services
A common application for combinatorial purchasing auctions is the procurement
of transportation services, where economies of scope play an important role. For
example, a particular route may be offered at a significantly lower cost if an empty
96
Number of possible combinations
Number of items
4
Fig. 4.13 The number of possible bids in a combinatorial auction increases exponentially
Fig. 4.14 A request with four different routes results in 15 combinations for which bids can
be submitted.
return trip can be avoided. As a simple example, suppose that transportation services
are to be procured for four routes:12
• Hamburg → Berlin
• Berlin → Hamburg
• Hamburg → München
• München → Berlin
There is no point in buying the individual routes separately because economies of

scope would not be captured. Due to the low complexity of the present example,
bids for all possible combinations can be submitted (Fig. 4.14). These are: all routes
(#0), all single routes (#1–#4), all two-way routes (#5, #10) and all three-way routes
(#11–#14). In total, there are 15 non-empty subsets resulting from the required
transport routes (according to the formula mentioned above, the number of possible
combinations is calculated as: 24 − 1 = 15).
12Transport volumes and times, as well as individual supplier ratings, are not considered for
simplicity.
Elbe Transport Spree Transport

#1 #2 #3 #4 #5 #6 #8 #9 #11 #1 #2 #3 #4 #5 #6 #8 #9 #11
Hamburg → Berlin 1 1 1 1 1 1 1 1
Berlin → Hamburg 1 1 1 1 1 1 1 1 1 1
Hamburg → München 1 1 1 1 1 1 1 1
München → Berlin 1 1 1 1
Bid 500 525 500 475 975 975 950 900 1325 525 500 525 500 1000 925 925 900 1375
Fig. 4.15 Two companies participate in the tender for transportation services: Elbe Trans-
port and Spree Transport. Both submit bids for the possible combinations of routes. In the
next step, the buyer must decide on the best possible combination of routes. The example is
based on Sheffi (2004)
As with the other auction formats, the goal from the buyer’s perspective is to
minimize costs by awarding the contract to the supplier with the lowest cost structure.
Additional requirements, such as a minimum number of suppliers, may be included
in the auction design.
The two competitors’ bids are shown in Fig. 4.15. Each route is to be procured
exactly once. What combinations of routes will fully satisfy demand at minimum
cost?
One option to cover the entire demand would be to buy all the individual routes
at once (#1 through #4). You could also select a two-pack and two individual routes
(e.g., #5, #3, #4). Since there is only one type of three-pack, there is only one
combination with this option that covers all routes (#11 and #4). This is also the
cheapest bid combination.
Elbe-Transport offers the combination #11 to #4 for EUR 1,800, Spree-Transport
for EUR 1,875. The best offer is therefore that of Elbe-Transport for EUR 1,800,
assuming that the offers of both companies are of equal value.
The purchasing process may require a minimum number of suppliers. In the
example, if the minimum number of suppliers is set to two, the combination of #11
(Elbe Transport) and #4 (Spree Transport) is the cheapest option, but it costs EUR
25 more than the price that can be achieved by using a single supplier. As the number
of variants increases, the complexity of the selection problem increases significantly,
requiring approximation methods of linear programming to find a solution.
The generalized Vickrey auction

In the Vickrey-Clark-Goves (VCG) mechanism, bidders are compensated for their
contribution to the final price. Their contribution is measured by the difference
between the realized final price and a hypothetical final price without their bid.
Table 4.2 When only one good is purchased in a procurement auction, the VCG mechanism
produces the same result as the second-price auction
Player A B C D
Cost 5 10 25 12
Realized cost 5 – – –
Sum of all realized cost 5
Cost without respective player 10 5 5 5
Transfer payment 5 – – –
Total payout 10 – – –
In the case of a single good, it is shown that the VCG mechanism is equiva-
lent to the second-price auction, since the contribution of the auction winner is
exactly equal to the difference between its cost and the cost of the second-best bid.
Thus, the transfer payment results in the auction winner receiving the second-lowest
price (Table 4.2). The only player who, according to the logic of the calculation,
contributes to minimizing the realized costs is the player with the minimal costs.
Despite its elegance, the VCG mechanism has serious drawbacks: In the case
of a procurement auction, it can lead to high costs under certain circumstances.
Collusion can also occur within a VCG auction, as illustrated by the following case
(see Conitzer and Sandholm 2006): A firm wishes to purchase two items, A and B,
using the VCG mechanism. Suppliers 1 and 2 participate in the auction and both
offer a price of EUR 100 for the package combination A + B. If the bids are equal,
both participants win with a probability of 50%. Regardless of which participant
wins, no transfer payments are due because neither participant contributed to the
improvement in realized costs. Therefore, the price paid to the auction winner is
EUR 100. Now, suppose that two additional suppliers (3 and 4) enter the auction,
each bidding EUR 0 for each lot: Supplier 3 bids EUR 0 for Lot A and Supplier 4
bids EUR 0 for Lot B. Therefore, the minimum-cost combination is to award Lot
A to Supplier 3 and Lot B to Supplier 4. Since the total realized cost would have
been EUR 100 without either Supplier 3 or Supplier 4, the transfer payment to each
supplier is EUR 100. This results in a total cost to the purchasing organization of
EUR 200. The allocation of lots in this case minimizes the cost to the suppliers,
assuming the information provided is true, but does not minimize the cost to the
purchasing organization. The example is a constructed extreme case, but it shows
that the VCG mechanism does not always lead to a cost-optimal result from the
auctioneer’s perspective.
4.3 Further Aspects of Auction Design
4.3.1 The Winner’s Curse
Imagine you are participating in an auction for a jar of coins. Each of the 30
participants can place a bid in a sealed, first-price auction. What would you bid,
and how would you feel if you found out you had won the auction?
Most people who win in this format say that they think they bid too high
(see PON Negotiation Newsletter 2008). Apparently, auction winners reassess
the value of the auctioned item based on the information that they have won the
auction. However, it is then too late to change the bid. The auction winner has
made the most optimistic bid for an item that has the same value to all bidders.
Typically, they overbid. This is known as the winner’s curse.
In a reverse auction, the winner’s curse results from underestimating expected
costs when costs are the same for all suppliers. The supplier with the most
optimistic cost expectation wins (see Fig. 4.16).
For the winner’s curse to occur, the realized costs of the participants must
be completely or largely the same. In the previous chapters, it was assumed that
suppliers reliably estimate the costs that will be incurred later and that these costs
The winner's curse in the purchasing auction

Stat. frequency
Ø Expected costs suppliers

= Realized costs when winning
Ø Bid
Min.
Bid
Loss winner
Costs / Bids
Fig. 4.16 In a reverse auction, the winner’s curse results from underestimating expected
costs when costs are the same for all suppliers. The supplier with the most optimistic cost
expectation wins
4.3 Further Aspects of Auction Design 101
are specific to each supplier. This is the private value model. The common-value
model assumes that suppliers have imperfect, but on average correct, information
(signals) about future costs. The realized costs are the same for each supplier.
Most auctions have both common and private value elements. For example,
common value in a reverse auction can come from raw material costs. Private
value, on the other hand, comes from technology or processes that are specific
to each supplier. The winner’s curse is stronger the more participants there are
in the auction, the more their cost expectations vary, and the greater the share of
common value elements in suppliers’ costs. Firms that expect their costs to be
higher than those of their competitors will act cautiously, since they would inter-
pret a win as the result of a particularly large expectation error; weaker suppliers
may be discouraged from participating in the auction.
The winner’s curse can be the auctioneer’s blessing. However, with more expe-
rience, suppliers will take the winner’s curse into account in their considerations
and switch to more conservative bidding.
The auction process can be simulated to illustrate the impact of countervailing
effects (cf. Lunanders 2002). When suppliers correctly anticipate the average
uncertainty but have individual expectation errors, we see that a second-price
auction always yields lower prices than a first-price auction in the common-
value situation, but this effect disappears as the number of suppliers increases.
This suggests that second-price auctions or English auctions should be used in
procurements with a high proportion of common value and a small number of
suppliers.
In Fig. 4.17, a similar simulation was performed,13 but now the suppliers
underestimate or overestimate the cost uncertainty. With an overestimation of
cost uncertainty, the anticipation of the winner’s curse in the first-price auction is
reflected in rising prices with more three suppliers. With an overestimation of cost
uncertainty, the prices obtained in the second price auction are on average lower
than the prices in the first price auction at all simulated points. However, prices
begin to rise with more than two suppliers.
When cost uncertainty is underestimated, second-price and first-price auctions
perform similarly with a small number of participants (<4).
The results of the second price auction can be further improved by making
the format dynamic. The English auction allows for an exchange of information
between participants, which can reduce supplier uncertainty.
Empirically, increasing the number of suppliers from three to six in a first-
price auction for public construction projects in New Jersey, USA, led to a median
13 Bidding functions for the Weibull distribution are based on Lunander (2002).
Simulation of purchasing costs in the common value model

First price auction (EPA) and second price auction (ZPA)
Costs
Reverse winner's curse

with overestimation
of uncertainty
Winner's curse with

underestimation
of uncertainty
Suppliers
FPA Underestimated cost uncertainty FPA Overestimated cost uncertainty
SPA Underestimated cost uncertainty SPA Overestimated cost uncertainty
Realized costs (suppliers)
Fig. 4.17 Simulation of a first- and second-price auction with overestimation and underes-
timation of cost uncertainty
price increase of 15% (cf. Hong and Shum 2002). Construction projects are char-
acterized by a relatively high degree of cost uncertainty on the part of suppliers.
Accordingly, expanding the pool of suppliers, especially in a first-price auction,
leads to more conservative supplier bids and thus higher prices.
When planning an auction, it is helpful to take the supplier’s perspective and
ask how much common value is involved. If there is a significant amount of
common value, the English auction should be preferred. In addition, the price
uncertainty for suppliers should be reduced as much as possible. If this is
sufficiently successful, the number of suppliers can be expanded. However, if
auction participants underestimate the true price uncertainty, this can result in
prices below realized costs. Another common approach is to reduce the common
value element in the auction through price adjustment clauses that reduce sup-
pliers’ exposure to, for example, changes in raw material prices. In this way, a
common-value auction can be transformed to some extent into a private-value
auction.
4.3.2 Monetization of the Advantages and Disadvantages

of an Offer
Unlike a reverse auction, price is usually not the only relevant decision criterion
in a reverse auction. Factors such as a supplier’s delivery performance, quality,
or financial condition also play a role and should be considered when making an
award decision.
A common solution is to define minimum requirements that must be met to
continue the buying process. However, if only price is used to determine the
purchase decision after successful qualification, remaining differences between
competitors are not taken into account.
To facilitate a rational decision in a reverse auction, relevant non-monetary
factors should be evaluated beforehand and a comparison price derived (cf.
Fig. 4.18). This can be done by awarding bonuses and mali: The disadvantage of
a bid is monetized as a malus, which is added to the bid price. An advantage is
monetized as a bonus, which is deducted from the bid price.
Auction winner
Offer price Bonus Comparison Comparison Malus Offer price

Supplier A price A price B Supplier A
Fig. 4.18 To make the bid prices in the auction comparable, the advantages and disadvan-
tages of the bids must be monetized. In the example, after applying the bonus and penalty,
Supplier A wins the auction even though its bid price is higher than Supplier B’s bid price
(cf. Berz 2014)
4.3.3 Credibility of the Mechanism
For a procurement mechanism to have the desired effect, the process must be
understood and perceived as credible by suppliers. Once the mechanism has been
implemented, the buyer has an incentive to renegotiate or otherwise deviate from
the communicated course of the mechanism.
While the implementation of the mechanism is optimal in advance, once it
is implemented, there may be a temptation to improve the outcome by devi-
ating from the communicated rules. This creates the usual problem of time
inconsistency associated with threats and promises (see Sect. 3.11). If the
supplier anticipates this problem, he will bid more conservatively during the bid-
ding process. The time inconsistency problem can be overcome by self-binding
mechanisms (see Dixit and Nalebuff 2008), such as:
1. create legally binding contracts,

2. build and leverage reputation; or
3. appointing an agent.
Credibility is a key component of a successful procurement mechanism. Without

credibility, even the most sophisticated mechanism will not have its intended
effect.
4.3.4 (Stochastic) Reserve Prices
In a reverse auction, the reservation price is the highest possible final price at
which the auction can end. If the final price is higher than the reserve price, the
auction ends without a result. A reserve price in this context is different from a
start price, which is sometimes used in dynamic auction formats.
An open reserve price is announced at the start of the auction; a hidden reserve
price is announced at the end of the auction, even though it was determined before
the auction started.
It is also possible to define random reserve prices (cf. Rieck et al. 2015).
The use of a stochastic reserve price can be useful in the second-price auction
to mitigate the problem of large differences between the first and second prices
(cf. Sect. 4.2.4). In a reverse second-price sealed-bid auction with a stochastic
reservation price (also known as a Rieck auction), the auction winner receives
the second-best price if the reserve price is above the second-best price. If the
reserve price is less than the second-best price, it replaces the second-best price
and determines the final price. If the reserve price is lower than the best price,
there are two basic options: Either the auction automatically becomes a first-
price auction, in which case the winning bid is paid as the purchase price, or the
auction is declared unsuccessful and must be repeated.
4.3.5 Duration of the Auction
In dynamic auctions, the duration of the auction can be limited. In the 18th and
19th centuries, candle auctions were popular in Great Britain. The sales auction
ended when the candle went out. Whoever had the highest bid at that time won
the auction. Predefined auction endings can be classified as (a) a hard, (b) a soft,
and (c) a random (cf. Roth and Ockenfels 2002). With a hard end, the auction
duration is predetermined from the outset. For example, on eBay, an auction
duration of between one and ten days can be chosen. When the specified time
is reached, the auction ends. This often causes the decisive price movements to
occur only shortly before the end of the auction, sometimes through the use of
sniping software that places a bid just before the auction ends.
With a soft end, the auction duration is based on the time of the last bid. For
example, the auction time may be extended 30 minutes after the last bid. If no
bids are placed within the remaining time, the auction ends.
Random auction duration is another way to determine when the auction will
end. The candle auction described above also has a random component, since
the exact time the candle expires can be limited but not predicted with certainty.
De Oliveira et al. (2019) report on public procurement auctions in Brazil that
start with an English auction after the first bids are submitted and use random
durations ranging from one second to 30 minutes. The data analysis shows that
longer running auctions lead to lower prices. However, the random end of the
auction has a different effect: Auction participants have an incentive to maintain
a leading position for as long as possible. This can be achieved by submitting
very frequent bids with minimal price reductions, which can be facilitated by the
use of auction bots. As a result, the popularity of bid bots increased dramatically
in the years following the introduction of random auction durations in Brazilian
public tenders.
4.3.6 Ambiguity in the English Auction
The English auction offers advantages over other auction formats under cer-
tain circumstances (see Sect. 4.3.1). One challenge with the English auction is
motivating firms to participate. If suppliers realize during the auction that their
chances of winning are slim, there is a risk that they will leave the auction.
A reduction in the number of participants usually results in higher prices, so
a procurement mechanism should be designed to maximize the number of par-
ticipants. Demotivation during the auction essentially occurs when a participant
realizes that
1. the distance to other bids is too large or

2. there are many other suppliers participating in the auction. The chances of
having a cost advantage are thus perceived to be slim.
In the standard English auction, bidders can see the number of other bidders and
how far apart their bids are. It may be strategically useful to provide bidders
with only the information that motivates them to continue participating and to
withhold information that would discourage them. The following English auction
specifications are used for this purpose (cf. Eichstätt 2006):
• Blind auction: Only the participant with the currently best bid is informed
about his leading position.
• Best price auction: All participants are informed of the amount of the current
best bid.
• Rank auction: Bidders learn their current rank based on their last bid.
• English rank auction: The rank of the respective bidder and the price of the
leading bid are communicated.
• All price auction: The prices of all current bids are communicated (Fig. 4.19).
Based on the number of auction participants (high, low) and the distribution of
production costs (high heterogeneity, low heterogeneity), a recommendation for
modifying the English auction can be derived (Fig. 4.20).
When there is high heterogeneity and a large number of suppliers, there are
two potentially demotivating factors that the blind auction does not reveal. When
there is high heterogeneity and a small number of suppliers, the ranked auction
communicates only the position of each participant, not the distance to other bids.
When the number of participants is large but the distances between participants
are small, the best-price auction reveals the distance to the best bid, but not the
Amount
Leading of the
leading Amount of
position Ranking
bid all bids
(Yes / No)
Blind auction ✓ x x x
Best Price Auction (✓) ✓ x x
Rank auction ✓ x ✓ x
English rank auction ✓ ✓ ✓ x
All price auction (✓) (✓) (✓) ✓
✓ Directly communicates
(✓) Can be derived from information provided
x Not communicated and not derivable
Fig. 4.19 Depending on the format, different amounts of information are shared with the
participants in the English auction
Fig. 4.20 The number of Number of bidders

suppliers and the
heterogeneity of their cost High Low
structures lead to different
Heterogeneity
recommendations (adapted Blind

High
from Eichstädt 2006) Rank auction

auction
Best price English rank

Low
auction auction
total number of participants. When there is little heterogeneity and a small num-
ber of suppliers, all information can be revealed because no demotivating effect
is expected. The English Rank Auction or the English Auction in its standard
format are therefore possible.
Looking at the previous considerations from the perspective of the auction par-
ticipant, the chosen format can be used to draw conclusions about the competitive
structure (assumed from the buyer’s perspective). It should also be noted under
what circumstances an auction format was developed. Was it designed specifi-
cally for the current procurement, or is it a generic design that will be used for
all cases?
4.3.7 The English-Dutch Auction
The advantages and disadvantages of the English and Dutch auctions have been
presented in the respective chapters. The English auction has its strength in
common-value situations (cf. Sect. 4.3.1), while the Dutch auction benefits from
the risk aversion of the participants. However, the English auction can facilitate
collusion among bidders (cf. Sect. 3.5). In addition, weaker participants may be
discouraged from participating in the English auction as there is less room for
participants with higher costs to win the auction.
Klemperer (1998, 2002) proposes a combination of the two formats to exploit
the advantages of each approach and compensate for the disadvantages. The
Klemperer auction begins with an English auction until only two bidders remain,
who then compete in a Dutch auction (Fig. 4.21).
The final stage can also motivate weaker bidders to participate by giving
higher-cost suppliers a chance to win the auction. The final sealed-bid, first-price
auction discourages cooperation between suppliers, while the exchange of infor-
mation useful to the buyer is still possible in phase 1. The English-Dutch auction
format is particularly suitable when the market conditions of a sourcing situation
are unclear.
References 109
The English-Dutch Auction

Price
(1) English auction start
(2) End English auction only

2 participants left
(3) Dutch auction / FPSB
Supplier A Supplier B Supplier C
Costs Strategic margin
Fig. 4.21 The hybrid English-Dutch auction format begins with an English auction and ends
with a sealed-bid, first-price auction
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len von Internetauktionen bis Investmentbanking, 2nd edn. Schaffer-Poeschel, Stuttgart
Chang WS, Chen B, Salmon T (2015) An Investigation of the Average Bid Mechanism for
Procurement Auctions. Manag Sci 61(6):1237–1254
Conitzer V, Sandholm T (2006) Failures of the VCG mechanism in combinatorial auctions
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on Autonomous agents and multiagent system. Hakodate, Japan pp 521–528
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Econ 1(S):61–99
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Random Auction Closing in Brazil. World Bank Group Policy Research Working Paper
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Business & Life. W.W. Norton & Company, New York
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among german corporations. In: Gimpel H, Jennings NR, Kersten GE, Ockenfels A,
Weinhardt C (eds) Negotiation, Auctions and Market Engineering. Lecture Notes in Busi-
ness Information Processing, vol 2. Springer, Berlin/Heidelberg
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R, Eßig M, Lasch R, Stölzle W (eds) Supply management research: aktuelle Ergebnisse
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in dutch auctions. Exp Econ 11(S):344–257
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cations. Eur Econ Rev 42(3–5):757–769
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v. 05.10.2020
Data-based Identification
of Cooperation between Suppliers 5
Abstract
This chapter shows how a purely data-based approach can be used to identify
cartels or restricted competition between suppliers.
A cartel is a long-term cooperation between competitors. A milder form is

competitive restraint, which is not necessarily illegal but also economically unde-
sirable. Collusion involves anticompetitive agreements but does not necessarily
have the continuity of a cartel. Game theory suggests several ways to deal with
cartels, collusion, and restrained competition (see Sect. 3.5).
Cartels thrive in an environment where the behavior of other cartel bidders can
be observed. The English auction is therefore susceptible to collusion. In cer-
tain average-price auctions, price collusion among suppliers can be particularly
effective (see Sect. 4.2.6).
This chapter presents a purely data-driven approach to identifying supplier
segments that are likely to be characterized by cooperative supplier behavior.
One example of a particularly creative cartel agreement was in the market
for turbine generators. These are needed, for example, to generate electricity in
coal-fired or nuclear power plants. In the late 1950s, the U.S. market for turbine
generators was divided among three companies: General Electric, Westinghouse,
and Allis-Chalmers, which were able to operate very profitably in the favorable
market conditions of that decade. In addition, they were able to increase their
profitability through an agreement made between representatives of the three
companies in a hotel room. All requests made on days 1 through 17 of the lunar
calendar were for GE, days 18 through 25 were for Westinghouse, and days 26
through 28 were for Allis-Chalmers. The companies that were not scheduled to
make a profit still participated in the bidding, but submitted inflated bids so that

https://doi.org/10.1007/978-3-658-40868-8_5
114 5 Data-based Identification of Cooperation between Suppliers
Undirected network Directed network Bipartites network
Node Edge
Fig. 5.1 Basic graph types are undirected, directed, and bipartite networks
the company designated by the calendar always received the contract. Because of
the unusual use of the lunar calendar, the Department of Justice did not discover
the illegal arrangement until the 1960s (see Kreps 2019).
Could this case have been detected earlier by the approach described in this
chapter? Almost certainly, yes.
First, I briefly review some elements of graph theory that are necessary for
understanding the rest of the section. I then describe the approach developed
by Wachs and Kertész (2019) which can be used to determine the probability
of cooperation between suppliers based on the structure and frequency of their
interactions.
Graph theory is the study of relationships between objects using graphs, where
objects are vertices (nodes) and relationships are edges. An example of an appli-
cation of graph theory is finding the shortest path in a network in which all points
must be visited at least once. This so-called traveling salesman problem can be
applied to many other questions, such as the optimal order in which an employee
should pick up products for a delivery.
A network (graph) can be directed or undirected (Fig. 5.1). In a directed
network, there is an asymmetric relationship between two nodes. For example,
one node may be the sender of a message and the other the receiver. A bipartite
network is a graph in which there are two different types of nodes, and edges
exist only between different node types.
The approach presented here is based on four steps (Fig. 5.2). In the first step,
the purchasing data is mapped as a bipartite graph. The suppliers involved in a
bid are nodes on the left side, and the contracts are nodes on the right side.
In a second step, the bipartite network is transformed into a co-bidding
network by projection, in which competition and cartel relationships between
suppliers are represented.
5 Data-based Identification of Cooperation between Suppliers 115
Procurement data
Bipartite network Undirected co-bid network
L1 C1
L2 C2
L1 L4
L3 C3
L2 L5
L4 C4
L3
L5 C5
Bidders Contracts
(1) (2)
Undirected co-bid network

Group detection algorithm Collusion risk per group
high
G2
Exclusivity
High risk of
L1 L4 collusion
Group 2
L2 L5
G1
Group 1
L3
low
low Coherence high
(3) (4)
Fig. 5.2 Algorithmic methods of network analysis can provide information about possible
group structures among suppliers
In the third step, supplier groups are identified. One possibility to do this is
the Walktrap algorithm. This is suitable for graphs with a very high number of
points, because the computation with the Walktrap algorithm is faster than with
other algorithms. The groups are determined by a random sequence of points
from point to point along the existing edges. If several random walks end within
the same set of points of a given length, this is a signal for a closely connected
group.
In the final step, the collusion risk for each group is determined using only
two criteria: a group’s exclusivity and coherence. It has been shown empirically
that a group of suppliers with both high exclusivity and high coherence has an
increased risk of collusion.
High exclusivity means that the supplier group has little or no external rela-
tionships (Fig. 5.3). The coherence of a subnetwork is an expression of the
homogeneity of connections within that group (Fig. 5.4). Mathematically, coher-

ence is calculated as the ratio of the geometric mean to the arithmetic mean of an
edge’s weight. The weight of a node is defined as the number of nodes connected
to that node (cf. Onnela et al. 2005).
In general, a co-bid event is always represented by the same weight in an edge.
However, a weighted edge model would also be plausible, where the importance
of an edge is determined by the volume negotiated in the contract.
The Georgian public procurement co-bidder network is shown in Fig. 5.5.1
The dataset contains more than 260,000 records of contracts, vendors, the bids
submitted, the final price, and the estimated price or budget.
The analysis shows that a large number of smaller groups are at risk of col-
lusion. The threshold was set above 0.8 for coherence and exclusivity. Further
analysis of the risk group shows that this group has higher relative costs than
other suppliers. Relative cost is the ratio of allocated budget to actual cost. The
average relative cost difference between the risk and non-risk groups is 2.8%.
This also indicates significant average savings potential (Fig. 5.6).
1 This can be accessed from a freely available platform: https://tenders.procurement.gov.ge.

5
High coherence No coherence Medium coherence High coherence

Data-based Identification of Cooperation between Suppliers
Fig. 5.3 Examples of coherence values of networks: the nodes represent suppliers, the edges express the frequency of interaction between
suppliers
117
Group A Group B
External
connections
Internal connections= 10 Internal connections= 20

External connections= 2 External connections= 2
Exclusivity = 10/12 = 0.85 Exclusivity = 20/22 = 0.91
Fig. 5.4 A group’s exclusivity is calculated as the ratio of the sum of its internal connections
to all connections
Fig. 5.5 The Georgian public procurement data co-bidding network from 2013 to 2016 (left)
and the 2016 filtered data (right). Each edge represents a tender in which two suppliers bid
together
5
Detected groups and risk of collusion
1.0
0.8
0.6
Exclusivity
0.4
0.2
Data-based Identification of Cooperation between Suppliers
0
0.2 0.4 0.6 0.8 1.0
Coherence
Fig. 5.6 Results of the analysis of public procurement data in Georgia in 2016. A threshold of 0.8 was used for coherence and exclusivity.
The size of the dots corresponds to the number of members in a group
119
References
Kreps DM (2019) Microeconomics for managers, 2nd edn. Princeton University Press,
Princeton
Onnela JP, Saramäki J, Kertéz J, Kaski K (2005) Intensity and coherence of motifs in
weighted complex networks. Phys Rev E 71:065103
Wachs J, Kertész J (2019) A network approach to cartel detection in public auction markets.
Nat Sci Rep 9:10818
Case Studies
6
Abstract
This chapter presents three applications of game theoretical negotiation design.
The first involves parts sourced from different suppliers whose offerings do not
fully overlap. The second example shows how the Chilean government was
able to purchase school lunches at substantial savings, while improving the
quality of the meals and increasing the average profit margins of the suppliers.
The final example describes the construction of a factory in Mexico that was
awarded to a general contractor. Due to the size of the contract, the savings
resulted in a 20% improvement in EBIT.
6.1 A Multi-good Auction with Partial Monopoly

Markets
Consider the following situation: A company purchases approximately USD 15

million in parts annually. As part of a cost reduction program, the company
wants to renegotiate prices on 10,000 parts. There are four known suppliers.
The purchase volume can be shifted completely between the suppliers as long
as the agreement does not exceed their production capacity. The main supplier,
which provides about 60% of the parts ordered to date, has been struggling with
quality problems that led to the CEO’s dismissal. An additional supplier has
been identified that meets the certification requirements and is highly motivated
to generate new business. However, a visit to his production facility revealed that
he has relatively low production capacity.
A Request for Quotation (RfQ) results in the following coverage: Approx-
imately 26% of the parts can be supplied by all suppliers, while 18% of the

https://doi.org/10.1007/978-3-658-40868-8_6
122 6 Case Studies
price-weighted purchase volume can be supplied by only one supplier. There is

a high degree of price heterogeneity in some segments.
Without going into all the details of this sourcing situation, there are some
key challenges:
1. To what extent are there common value elements and how can pricing
uncertainty be reduced for suppliers?
2. How to create the best possible competition among suppliers in the context of
partial monopoly segments?
3. How can the high degree of price heterogeneity be dealt with?
4. How can the complexity be kept low?
With raw material costs accounting for approximately 35% of production costs
there was a large common value component. When suppliers are exposed to
a high degree of price uncertainty, this results in price mark-ups that typically
overcompensate for the price uncertainty. The price uncertainty for suppliers was
reduced by setting different prices for different titanium price ranges. In this way,
suppliers can expect higher prices when raw material costs increase and lower
prices when raw material costs decrease.
To maximize competition without creating a combinatorial auction with
210000 − 1 different bids (cf. Sect. 4.2.7), the individual products were combined
into a total of five lots. Two of the lots were monopoly lots, which could not be
awarded in an auction, as this might constitute the offense of creating the appear-
ance of competition. To qualify for continued participation in the auction, the
suppliers of the monopoly lots were offered a target price that was significantly
lower than the original price. In both cases, the offer was accepted.
To reduce price variance prior to the final auction, auction participants were
played back the price ranges they were in. They were given the opportunity to
revise their prices. The amount of the revised price resulted in a ranking of the
suppliers, which determined the order in which they were considered in the final
Dutch auction. Representatives of all participating companies were present at the
final auction. The final step in the procurement process took about three hours.
In the end, a cost saving of 18% was achieved, which far exceeded expectations
due to the savings already achieved in advance.
The example shows how practical alternatives to combinatorial auctions can be
used to provide incentives for cost reduction even in (partial) monopoly markets.
6.2 Chilean School Meals 123
6.2 Chilean School Meals
Economists often quote the following saying: There is no such thing as a free
lunch. This is not a reference to the fact that most university cafeterias charge
for their food, but rather to the fact that even at a price of EUR 0.00, there is an
opportunity cost.
But if you take the phrase a little more literally, the Chilean government has
managed to do the impossible: On behalf of the Chilean government, the Junta
Nacional de Auxilio Escolar y Becas (JUNAEB) purchases USD 0.5 billion worth
of school lunches annually, feeding 2.5 million children in primary and secondary
schools. Given Chile’s high poverty rate, the government-funded meals are an
important part of the daily diet for many children and adolescents. In addition,
the free meals are intended to improve school attendance and reduce dropout
rates (see Catalán et al. 2009).
Prior to 1999, the procurement process for school meals was not optimal:
Vendors were requested to develop specific proposals to serve individual school
districts. The evaluation of the submitted proposals was based on largely arbitrary
criteria. Despite JUNAEB’s considerable bargaining power at the time, synergies
and economies of scale were not systematically captured.
It was not until the University of Chile became involved that a fully digital
procurement process was developed and has been in place since 2004. It is based
on a combinatorial sealed-bid multi-unit auction in which bids can be placed on
all combinations, which is briefly described below (see Olivares et al. 2012).
Chile is divided into approximately 100 school districts. The supply of schools
in each district is a unit of the tender. Contracts are awarded for three years, so
about one-third of all contracts are renewed each year. Because of the length of
the contract, possible fluctuations in consumption, and the exact meals required,
the bidding process is not trivial. Suppliers quote prices for different quantitiy
scenarios: more than 104%, 100 to 80%, 80 to 60%, and less than 60% of the
original forecast. This makes the risk more calculable for the supplier, which
benefits the buyer in the form of lower prices. In total, 30 different meal types
are defined, so the different scenarios and the number of school districts that can
be bid on create a significant level of complexity.
An important factor in awarding contracts is the potential for economies of
scale and synergies among suppliers when multiple lots are awarded to a single
supplier. There may be a trade-off in ensuring long-term competitiveness as the
concentration of suppliers increases. A smaller number of suppliers would have
greater bargaining power in the long run. In addition, the impact of a failure is
124 6 Case Studies
greater in a concentrated structure than in a diversified one. For these reasons,

the maximum number of packages a supplier could win was limited.
The new process resulted in an estimated annual savings of 22%, while sig-
nificantly improving the quality of the food supplied. Most interestingly, since
implementing the improved sourcing process, suppliers have increased their aver-
age profit from 3.2% to 5.9%. This demonstrates that a well-designed sourcing
process with systematic sourcing criteria for suppliers to follow, and a process
for leveraging economies of scale and scope, can create a win-win situation for
all parties.
6.3 Building a Factory in Mexico
Mediavilla et al. (2020) describe the case of a Spanish Tier 1 and Tier 2 auto-
motive supplier that wanted to build a new plant in Mexico as part of a planned
expansion. At the time, this investment represented the second highest amount
ever spent by the company.
As part of the procurement project, the existing procurement strategy was eval-
uated and structured interviews were conducted with relevant stakeholders. In a
subsequent group discussion with the management, the procurement was classi-
fied in the Kraljic Matrix. It turned out that the procurement had a high profit
relevance with a low supply risk, which, based on the Kraljic Matrix (Fig. 6.1),
led to the recommendation leverage, i.e. the use of bargaining power.
Following the development of the technical specification, a total of 16 compa-
nies were invited to submit a project proposal. Nine of these companies submitted
a proposal, and after evaluation of the proposals, four companies were invited to
final negotiations.
The first phase was a reverse Japanese auction; in the second phase, suppliers
received exclusive offers. The order in which bidders received these offers was
based on their ranking in the first phase; if accepted, there was an immediate
binding award. If rejected, the next highest ranked supplier received an offer
(Fig. 6.2).
In this particular case, the supplier that submitted the best bid in the first stage
immediately accepted the offer. Mediavilla et al. (2020) note that the third-placed
bidder was then willing to undercut the final price. However, because this bid was
submitted outside the defined mechanism, it could not be considered. Compared
to the lowest initial bid, a savings of 24% was achieved, which translated into an
EBIT improvement of approximately 20% for the company.
6.3 Building a Factory in Mexico 125
Leverage Strategic
• Use of bargaining • Development of

power long-term supplier
relationships
• Product substitution
high
• Make-or-Buy
• Establishing a
long-term supplier • Preparation for a
Influence on profit
relationship possible crisis

• Demand forecasts as
accurate as possible
Non-critical Bottleneck
• Standardization • Reduction of
dependency, finding
• Efficient processes or developing
• Demand pooling alternatives
low
• Reducing the
consequences of
dependency: hedging
against premium
low high
Delivery risk
Fig. 6.1 Based on the Krajlic Matrix, negotiations can be classified and possible strategies
identified (cf. Kraljic 1983; Mediavilla et al. 2020)
126 6 Case Studies
1. Japanese auction 2. Ranking 3. Offers according to ranking
…
2.
1 1.
2 …
3
4
Price steps Offer Acceptance
Fig. 6.2 The final negotiation phase for the construction of the Mexican factory represented
in simplified form
References
Catalán J, Epstein R, Guajardo M, Yung D, Henríquez L, Martínez C, Weintraub G (2009)

No such thing as a free lunch? OR/MS Today, pp 32–35
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ment: an empirical study of the Chilean school meals auction. Manag Sci 58(8):1458–
1481
Application and Limits of Game
Theoretical Optimization 7
Abstract
How does a game theoretically optimized negotiation (GON) differ from
an eAuction? When should a GON be used, and when are other forms of
negotiation more appropriate?
In a game theoretically optimized negotiaiton (GON), all aspects of negotia-

tion are optimized using game theoretical principles (see Chaps. 2 and 3) to
create intense competition among bidders and to capture economies of scale and
scope which benefits both sides. In most cases, reverse auctions are used, but
they are not necessarily part of a GON.
A GON enables transparent and competitive negotiations, even for the most
complex sourcing. It consists of four essential elements: sourcing and negotiation
design, supplier communication, and implementation.
In the sourcing design, the services to be procured are structured and often
grouped into lots. In this way, switches for transparent and effective competition
can be set from the outset. In addition, highly complex procurements that would
fail in a standard sourcing auction can be handled this way.
The negotiation design answers the following questions: Who participates,
when is what information shared, and how is the winner determined? Negotiation
design goes beyond the selection of an auction format. Auction formats and other
negotiation mechanisms are adapted to the situation and combined with each
other to achieve the best possible outcome in the given situation. A monetary
evaluation of the pros and cons of different bids provides an accurate comparison
between suppliers (see Sect. 4.3.2).
How hard would a football team work if the players did not understand the
rules of the game or were not sure that they would be applied? Probably not at

https://doi.org/10.1007/978-3-658-40868-8_7
128 7 Application and Limits of Game Theoretical Optimization
all. Supplier communication is therefore an important element of a GOV and of

an eAuction (see Sect. 4.3.3).
As a basic requirement, an GON requires sufficient lead time to make an award
decision. This will vary from case to case, but a minimum lead time of 12 weeks
to the negotiation should be expected. In addition, multiple suppliers (at least
two, preferably three or more) should be able to provide the product or service.
The award should be attractive to suppliers. The GON is sometimes associated
with increased effort for suppliers, which they will only undertake if there is the
possibility of a high payoff at the end.
While GON has the advantage of transparency in the case of high com-
plexity, another requirement for its usefullness is the specifiability of the
service (Fig. 7.1). In creative work, the service cannot be specified in advance
because the specification is iterative and part of the service delivered. This is also
the case in agile projects, where the scope of the project is determined as the
project progresses. Prestigious construction projects, such as the Sydney Opera
House, have a lower level of specifiability because public prestige projects are
expected to undergo significant changes.
However, not all construction projects have a low level of specifiability. For
example, a prefabricated single-family home can be well specified. As described
in Sect. 6.3, the construction of a new factory for a Spanish automotive supplier
could be specified well which created significant value for the company.
For projects with low specifiability, it is recommended to negotiate bilaterally
with suppliers. Reputation is a key factor in the choice between service providers
(see Borsing-Koch and Heinrich 2012). For low complexity, good comparability
and specifiability, an e-procurement auction can be used. However, principles
such as commitment and transparent communication to bidders and an effective
choice of auction type are also crucial for an eAuction.
For sufficient specification, it is not necessary to know the exact value of all
variables. For example, in the case of mobile phone contracts, it is not clear in
advance how many minutes and how much data volume will be used. However,
this uncertainty can be very well represented by simulating the usage behavior
of different user groups. The mobile operators’ offers are then translated into
expected costs by simulating usage patterns. The provider with the best expected
cost wins the bid.
Reference 129
Award methods
SOV
High
Auction
Specifiability
Low
Other negotiation
methods
Low High
Complexity
Fig. 7.1 If the basic requirements (lead time, project size, and competition) are met, the use
of an SOV is recommended, especially if the service is well specified and complex
Reference
Brosing-Koch J, Heinrich T (2012) Reputation and mechanism choice in procurement auc-

tions: an experiment. Prod Oper Manag 23(2):210
Conclusion
8
“Theory without practice is empty, practice without theory is blind.” Game the-
ory is the mathematics of strategic interaction. Human behavior is not completely
predictable, but the interplay of game theory and practice has created applications
that provide clear value to their users. In practical situations, an elaborate map-
ping of utility functions, as is common in economics, is often not feasible. Rather,
it is a matter of applying the principles of game theory and economics.
Purchasing in high-volume situations that are attractive to suppliers and whose
performance can be well specified has proven to be particularly productive for
the application of game theory. After being used by technology and automotive
OEMs, more and more companies in other industries are recognizing the benefits
of game theoretically optimized negotiations. If you find the content presented in
this book interesting or have any comments, your input is greatly appreciated. I
welcome any feedback or questions you may have, and I encourage you to apply
the ideas presented here to your own life or work. Please don’t hesitate to contact
me and let’s continue the conversation!

https://doi.org/10.1007/978-3-658-40868-8_8
Appendix—Derivation of Optimal Bid
in a First Price Auction 9
Dutch and sealed-bid first-price auctions require more complex calculations on

the part of auction participants than English or second-price auctions, where the
amount of the bid or withdrawal from the auction simply depends on the reserve
price. As long as the price is above the reserve price, it is advantageous for the
bidder to continue participating in the English auction.
In the Dutch auction and the sealed-bid first-price auction, the auction partic-
ipant must decide which bid to submit. The exact choice of the bids of the other
participants is unknown, but the participants know the probability distribution
from which the respective production costs of the auction participants result. For
simplicity, the distribution is assumed to be homogeneous.
The situation can therefore be represented as a decision problem with inter-
dependencies, which can be analyzed more precisely using a mathematical
formulation. The core of the decision problem for the auction participant is a
trade-off between the probability of winning and the size of the win. The lower
the bid price, the higher the probability of winning the auction. However, this
also reduces the profit margin if the auction is won.
Suppose there are n bidders who compete for an award and only differ in terms
of price. The bidders’ costs ci , i = 1, 2, …n result from an uniformly distributed
probability between cL and cH , thus ci ∼ U(cL , cH ), cL thus denotes the lowest
and cH the highest possible costs within the probability distribution.1
The probability distribution of the costs is known to all participants, but the
cost is a private information of the respective supplier. This is the private value
1 In the case of a continuous probability distribution, the probability of drawing the same
numbers twice is formally zero. However, since practical considerations are made with
rounded numbers, the probability that two or more equal cost expressions exist increases as
the numbers are rounded.

https://doi.org/10.1007/978-3-658-40868-8_9
134 9 Appendix—Derivation of Optimal Bid in a First Price Auction
case of the procurement auction. The cumulative distribution function of the

production cost expression is therefore
0 if x < cL
x−c L
F(x) = c H −c L if c L ≤ x ≤ c H
1 if x > cH
In this case, the expected payoff function of both suppliers can be represented as
the product of the probability of winning and the difference between price and
cost, as well as the product of the probability of not winning and the resulting
payoff. If the payoff for not winning is assumed to be zero, the expected payoff
simplifies to
E[Ui ] = Pi (W )((Pi − ci ))αi
Where α i defines the degree of risk aversion of the player. Pi (W ) is the probability
that player i wins, Pi is the price submitted by player i. The probability of winning
can be represented as Pi (W ) = P(Pi ; P−i ), where P−i denotes the lowest bid
of all other auction participants. Since a uniform distribution was assumed, the
probability of winning can be described by
n−1
c H − Pi
Pi (W ) = P(Pi < P−i ) =
c H − cL
If, for the sake of simplicity, an equal distribution in the interval [0,1] is assumed,
that is, cL = 0 and cH = 1, then P(W ) is simplified to P(Pi ; P−i ) = (1 − Pi )n − 1 .
Player 1’s expected utility is shown in Fig. 9.1 as a function of his realized costs
and the chosen bid. In the illustration, it is assumed that a total of three suppliers
participate in the auction.
It can be seen that lower costs lead to higher expected utility than higher costs,
because on the one hand the probability of winning is higher, and on the other
hand the realized payoff in case of winning is also higher. It is assumed that a
bid is only made above cost. Below cost, the expected utility is zero. Formally,
expected utility can be expressed as

E[Ui ] = max 0, (1 − Pi )(Pi − ci )∝i .
In Fig. 9.1 it can be seen that a bid above own cost and below the maximum
possible cost represents the optimal bid amount. The exact expression depends on
9 Appendix—Derivation of Optimal Bid in a First Price Auction 135
Expected payoff
Bid player 1
Fig. 9.1 The lower Player 1’s realized cost, the more room he has to set his price. The graph
shows the trade-off between profit and probability of winning. It is assumed that players do
not bid below their own cost.
the number of auction participants and the supplier’s risk aversion. The distance
between the cost and the optimal bid can also be called the strategic margin.
Mathematically, an extreme or inflection point can be calculated by finding points
where the first derivative of the function is zero. Without further knowledge of the
form of the function, the second derivative would also be required to determine
the nature of the extreme point. Under the given parameters, however, this step
can be omitted because the function is obviously concave (Fig. 9.1).
The first derivative of the expected utility is zero at the maximum:
∂Ui
= (1 − Pi )n−2 (Pi − ci )αi −1 (αi + ci (n − 1) − Pi (αi + n − 1)) = 0
∂ Pi
This calculates the reaction function, which can also be referred to as the Optimal
Response Function, for the price parameter as
αi + ci (n − 1)
Pi (ci ) =
αi + n − 1
136 9 Appendix—Derivation of Optimal Bid in a First Price Auction
As already shown in Fig. 4.7 in Sect. 4.2.2, the strategic margin in this model
decreases as the number of participants increases. Thus, more competition leads
to lower prices, assuming that the number of auction participants is known to
each participant. It is also clear that when risk aversion is higher, suppliers lower
their prices to reduce the risk of zero utility.

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ISBN 978-3-658-40867-1 ISBN 978-3-658-40868-8 (eBook)

Hamburg, Germany Christoph Pfeiffer

3.12 The Ultimatum Game and the Perception of Fairness . . . . . . . . . 66

© The Author(s), under exclusive license to Springer Fachmedien Wiesbaden 1

Result in € / population / license

Game theory was developed by John von Neumann as a way to mathematically

© The Author(s), under exclusive license to Springer Fachmedien Wiesbaden 7

2.1 Normal Form

Payoff player 2 Payoff player 2

Payoff player 1 Payoff player 1

Payoff player 2 Payoff player 2

Fig. 2.1 A general two-player game in normal form

2.3 Nash Equilibrium

A Nash equilibrium (NE) is a combination of strategies in which no player can

Unfortunately, the strategy described in the movie is not a Nash equilibrium,

2.4 Randomized Strategies and Second Mover

Under certain circumstances, it is advantageous for players not to follow a deter-

Left Center Right

Static probability analysis

Probability goalkeeper left = 1/3

Probability goalkeeper right = 1/3

A good approximation can be obtained by trial and error. For example, if

shooter improves by another 2 percentage points to 82% compared to the first

2.5 Extensive Form

100 % 100 % 30 % 100 % 100 %

...% hit probability

2.6 Backward Induction

might include increasing the amount itself with each round.

Fig. 2.10 The centipede game with 10 rounds

The Quantal Response Equilibrium (QRE) is a statistical solution concept in game

7 In extensive games, the Agent-Quantal-Response-Equilibrium (AQRE) is also used (cf.

Probabilities envelope forwarding AQRE

2.7 Evolutionary Game Theory

Fig. 2.12 The hawk-dove Hawk Dove

Low conflict costs (C<20) High conflict costs (C=40)

by employees who follow a conflict-avoiding strategy. The tyrant’s aggressive

2.8 Mechanism Design

In mechanism design, rules are developed to achieve predefined goals. A set of

Another requirement for a mechanism may be that it induces participants to be

Fig. 2.14 Dictatorial 0% 50 % 100 %

A similar concept is used in the creation of parity shareholder structures to

Levitt S, Chiappori P, Groseclose T (2002) Testing mixed-strategy equilibria when players

3.1 Price Guarantees—A Case for the Cartel Office?

© The Author(s), under exclusive license to Springer Fachmedien Wiesbaden 31

to as the Bertrand equilibrium.

3.2 Location Choice

3 The principle of minimal differentiation goes back to Hotelling (1929).

Site selection Result

4The number of locations from 0 to 100, including 0 and 100, is 101.

Site selection Result

Site selection Result

3.3 Number Selection and Level n Rationality

In a group of 50 people, each person is asked to pick a whole number between

1/3 including own

1: Choose purely randomly 50 16

2: Think that others select 17 5

3: Think that others 5 2

The expected mean can be calculated based on the Poisson distribution in

3.4 The Tragedy of the Commons

9 The example is from Binmore (2007), pp. 27–28.

3.5 Price Fixing

Instead of competing fiercely, companies can also move toward cooperative