Problem Set Barg PAUTA Fall 2024

Problem Set on Sequential Bargaining
Solutions
Games & Strategies - Fall 2024

Gino Loyola
February 28, 2024
Department of Management Control and Information Systems, University of Chile, Diagonal Paraguay
257, Of. 1902, Santiago, Chile. E-mail: gloyola@fen.uchile.cl, Tel.: (562) 22 978 37 68
1
1. Sequential negotiation with exogenous and endogenous externalities. Two
parties, A and B, want to divide an asset resembling a cake of size 1. The negotiating
mechanism is as follows. A makes a sharing-rule o¤er, (x; 1 x); where x is the fraction
going to A, and 1 x is the fraction gotten by her counterpart. Player B can accept or
reject that o¤er. If he rejects, both players receives nothing. The objective functions
of parties are given by:
uA = x A (1 x)
uB = (1 x) B x;
where A and B are non-negative constants that represent each player’s sensitivity to
a negative externality because of the cake fraction going to his/her rival (i.e., some
kind of envy).
(a) Find the set of SPE of this game.
(b) Assume now that in a stage before the negotiation process takes place, both parties
can choose their respective sensitivities ’s: Draw the extensive form (i.e., a decision
tree) of this game (the complete game).
(c) Find the set of SPE of the complete game proposed in part (b). Adopt and make
explicit the assumptions you consider pertinent to …nd a solution.
SOLUTION
(a) Applying backward induction, we begin with the last subgame. In this subgame, player
B accepts player A’s o¤er i¤:
1
(1 x) Bx 0 () x ,
1+ B
and rejects it otherwise.

In the …rst subgame, player A chooses x such that
maxx A (1 x)
x
subject to
0 x 1 (1)
x A (1 x) 0 (2)
1
x ; (3)
1+ B
which is equivalent to the following program:
maxx A (1 x)
x
subject to
A 1
x : (4)
1+ A 1+ B
2
Note that the interval for x de…ned by (4) is not empty as long as A B 1. Otherwise,
there is a negotiation breakdown. Thus, we have to analyze two cases.
Case 1: A B 1. There is a corner solution so that:
1
x = ;
1+ B
and, therefore, the SPE of the game is described by:

1
1 accepts if x 1+ B
= x = ; B=
1+ B rejects otherwise
Thus, there is a unique equilibrium and a unique agreement.
Case 2: A B > 1. There not exist an x that satis…es constraint (4), and therefore,
the negotiation breaks down. The SPE of the game is given by:
1
1 accepts if x 1+ B
= x = + "; B =
1+ B rejects otherwise
with " > 0:
(b) hInsert Figure 1i
(c) We apply the backward induction methodology. Notice that in the second stage (the
negotiation game), the players’payo¤s depend on the speci…c case that takes place:
Case 1: A B 1. Payo¤s evaluated at the Nash equilibrium of the second stage are
given by:
1 A B
uA = >0
1+ B
uB = 0.
Case 2: A B > 1. Payo¤s evaluated at the Nash equilibrium of the second stage are
given by:
uA = 0
uB = 0.
Given that, for player A to attain an agreement (Case 1) is a strictly dominant strategy.
Although player B is indi¤erent between the two cases, we will assume, for simplicity,
that he/she will also prefer the agreement. Consequently, the programs both players
must solve in the …rst stage (choosing ) are now described.
Player A
maxx( B) A [1 x( B )]
A
subject to
1
x( B ) =
1+ B
A B 1
A 0;
3
which is equivalent to
1
max A 1
A 1+ B
subject to
A B 1
A 0;
1
Given that 1+ B
1 < 0, this problem has a corner solution such that
A = 0: (5)
Player B
max [1 x( B )] B x( B )
B
subject to
1
x( B ) =
1+ B
A B 1
B 0:
After substituting the …rst constraint into the objective function, we get that player
B’s payo¤ is zero. Thus, such player is indi¤erent with respect to the optimal level of
externality as long as the second constraint is satis…ed, that is:
B =f B : A B 1g : (6)
All the previous analysis implies that the SPE of the complete game is characterized
by:
Optimal strategy for A
1
1+ B
if A B 1
A = 0; x( B) = 1
1+ B
+ " if A B >1
Optimal strategy for B

1
accepts if x( B) 1+ B
B = B : B < 1; B 1 .
rejects if x( B) > 1+ B
2. Ultimatum Game with explicit asymmetric outside options. Two parties, A

and B, must divide between both of them a surplus resembling a cake of size 1. If as
a result of an agreement, party i = A; B receives a portion xi 2 [0; 1] of the surplus,
his/her preferences are represented by the function:
Ui (xi ) = xi :
In case of disagreement, players A and B receive a payo¤ uA = 0 and uB = 0:1,

respectively.
4
(a) Characterize the set of possible agreements if the bargaining process is conducted in
accordance with the Ultimatum Game (UG). For your answer, assume that player A
is the proposer.
SOLUTION
hInsert Figure 2i
De…ne x as the fraction gotten by player A in case of agreement. Because backward induction,
we start with the stage in which player B accepts player A’s o¤er if
1 x 0:1 , x 0:9,
In the second stage, player A chooses x so that
maxx
x
subject to
0 x 1
x 0
x 0:9,
which is equivalent to
maxx
x
subject to
0 x 0:9
This problem has a corner solution such that
x = 0:9
and
accepts if x 0:9
= x = 0:9; B = :
rejects otherwise
3. UG with risk aversion & asymmetric outside options. Two parties, A (she)
and B (he), want to split an asset of size . The bargaining procedure to be adopted
has the following schedule. Player A makes a sharing o¤er (x; x); where x is the
fraction this player obtains, and x is the fraction her counterpart receives. Player
B can accept or reject such an o¤er. If he accepts, there is an agreement. If he rejects
it, there is a disagreement and each player gets his/her outside option, which is zero
for player A and U B > 0 for player B. The objective functions are represented by:
uA = x1
uB = x;
where 2 (0; 1) is the coe¢ cient of relative risk aversion of player A.
5
(a) Depict this game through a decision tree (the extensive form of the game).
(b) Find the set of SPE, characterizing all the equilibrium paths and outcomes resulting
from the negotiation process.
SOLUTION
(a) hInsert Figure 3i
(b) By applying backward induction, we begin with the second subgame (second stage).
In this stage, player B accepts player A’s o¤er if
( x) UB , x U B;
In the …rst subgame (…rst stage), player A must choose x that solves
maxx1
x
subject to
0 x (7)
x1 0 (8)
x U B; (9)
where (7) is the feasibility constraint, (8) is the participation constraint of player A, and (9)
represents an agreement condition. This program is equivalent to
maxx1
x
subject to
0 x U B: (10)
Notice that the interval for x de…ned by constraint (10) is nonempty as long as
UB : (11)
Hence, two cases arise from condition (11).
Case 1. If condition (11) is veri…ed, there exists a corner solution such that:
x = U B: (12)
In this case, the equilibrium of this game is characterized by the following set:
accepts if x UB
= x = U B; B :
rejects if x > UB
Thus, there exists a unique equilibrium, and thereby, a unique agreement. The equilibrium
payo¤s are given by:
(( U B )1 ; U B ):
6
Case 2. If condition (11) is not veri…ed, there not exist an x satisfying (10), and hence, a
negotiation breakdown occurs. In this case, the SPE of the ultimatum game is described by
the following set:
accepts if x UB
= x = U B + "; B ;
rejects if x > UB
with " > 0: The equilibrium payo¤s are given by:
(0; U B ):
4. O¤er-Countero¤er & Inside Options. Two parties, A (o¤erer, she) and B (coun-
tero¤erer, he), want to split a cake of size . The negotiation mechanism is a potentially
two-stage process with the following schedule.
At t = 1, party A makes a sharing o¤er, (x1 ; x1 ), so that if there is an agreement, x1
is the portion gotten by this player, and x1 the portion of her counterpart. Party B
can accept or reject that o¤er. If he accepts it, each party receives his/her respective
fraction of the cake. If he rejects it, each party receives in the …rst period his/her
respective inside option. In the latter case, negotiation moves to a second stage.
At t = 2, party B makes a sharing countero¤er (x2 ; x2 ); so that if there is an
agreement, x2 is the portion this player gets and x2 is the portion obtained by his
opponent. Party A can accept or reject such a countero¤er. If she accepts it, each party
receives his/her respective fraction of the cake. If she rejects it, each party receives
his/her respective outside option.
Assume that A and B share the same discount factor 2 (0; 1). Both players are risk-
neutral with objective functions, if there exists an agreement in period t, described
by:
uA
t = xt
B
ut = xt ;
The outside option and inside option of player i are, respectively, U i 0 and mi 0
for all i = A; B.
Finally, assume that the following condition holds:
UA + UB :
(a) Draw the extensive form of this game.
(b) Find the set of SPE, characterizing the two agreements this negotiation process can
generate.
(c) Based on your answer in part (b), provide an economic intuition for the condition
determining what type of agreement is attained in the negotiation process.
(d) Based on your answer in part (b), discuss which are the sources of bargaining power
in this game.
SOLUTION
7
(b) Because this is a sequential game, we adopt the SPE as an equilibrium notion. Conse-
quently, we apply backward induction.
Period t = 2.
In this period, player A accepts B’s o¤er if and only if
x2 U A,

On his part, player B makes a countero¤er x2 such that
max x2
x2
subject to
0 x2 (13)
x2 U B (14)
x2 U A ; (15)
where (289) is a feasibility constraint, (290) is a participation constraint for the counter-
o¤erer and (291) represents the agreement condition in the second-period negotiation. This
problem is equivalent to the following program:
minx2
x2
subject to
UA x2 UB (16)
Note that the interval for x2 described by (292) is never empty as the following condition is
always satis…ed:
UA UB
,
UA + UB : (17)
Thus, the optimal strategy for B is x2 = U A . That countero¤er would be accepted by player
A, and thereby, it would be always a potential agreement in t = 2.
Period t = 1.
In this stage player B accepts what player A o¤ers if
x1 mB + ( x2 )
()
x1 mB ( x2 )
()
x1 mB ( U A) x1 ;
8
and rejects it otherwise. On his part, player A chooses x1 such that
maxx1
x1
subject to
0 x1 (18)
x1 m A + x 2 (19)
x1 x1 ; (20)
After substituting x2 = U A , and since x1 and mA ; ; U A 0, the previous problem is
equivalent to
maxx1
x1
subject to
mA + U A x1 x1 (21)
Interval (296) is nonempty if
mA + U A mB ( U A)
()
mA + mB (1 ) . (22)
After de…ning m (1 ) , we can characterize two possible subcases.
Subcase 1.1: mA + mB m. In this case, the optimal strategy for A is x1 = x1 ; and thus,
there will be an agreement during period t = 1 (no delay). That agreement implies a sharing
rule (x1 ; x1 ) = (x1 ; x1 ).
Subcase 1.2: mA + mB > m. In this case, the optimal strategy for A is x1 = x1 + "A (with
"A > 0), and thus, there will be an agreement during period t = 2 (delay). That agreement
implies a sharing rule (x2 ; x2 ) = (U A ; U A ).
(c) The condition for an agreement with delay can be rewritten as
mA + mB + > :
This condition suggests that the game will end with an agreement in t = 2 if the
overall bene…ts from a delay (the sum of inside options and the present value of the
pie distributed in t = 2) exceeds the bene…ts from a no delay (the value of the pie
distributed in t = 1). Therefore, higher inside options and lower impatience increase
the probability of attaining an agreement with delay.
(d) Agreement 1.1.
@x1
> 0;
@U A
@x1
< 0;
@mB
@x1
< 0:
@
Thus, whereas the outside option is a source of bargaining power for A, the inside
option is a source of bargaining strength for B.
9
Agreement 1.2.
@x2
> 0:
@U A
Then, the outside option is a source of bargaining power for A:
5. Ultimatum Game with explicit values. Two parties, A and B, must divide be-
tween both of them a surplus resembling a cake of size 2. If as a result of an agreement,
party i = A; B receives a portion xi 2 [0; 2] of the surplus, his/her preferences are rep-
resented by the function:
Ui (xi ) = xi :
In case of disagreement, players A and B receive a payo¤ UA = 0:5 and UB = 1,
respectively.
(a) Characterize the set of possible agreements if the bargaining process is conducted in
accordance with the Ultimatum Game (UG). For your answer, assume that player A
is the proposer.
SOLUTION
Let us de…ne x as the fraction going to A in case of agreement. By backward induction, we
begin with the stage in which player B accepts player A’s o¤er if:
2 x 1
,
x 1;
In the …rst stage, player A chooses x so that:
maxx
x
subject to
0 x 2
x 0:5
x 1,
which is equivalent to the following program:
maxx
x
subject to
0:5 x 1:
It is easy to check that this problem has a corner solution given by
x = 1.
The SPE of this ultimatum game is then characterized by
accepts if x 1
= x = 1; B :
rejects otherwise
10
6. O¤er-Countero¤er, Inside Options and Multiple Surplus. Two parties, A (of-
ferer, she) and B (countero¤erer, he), want to divide up a two-period stream of positive
surplus ( ; ). The bargaining procedure to be used is a process that potentially takes
2 periods in accordance with the following schedule.
In t = 1, party A makes an o¤er to divide the surplus stream, (x1 ; x1 ), so that if
there exists an agreement, x1 is the fraction going to her in each period and x1
the fraction gotten by her counterpart in each period. Party B has three alternatives:
opt-out, accept, or defer. If he decides to opt-out, there is a permanent disagreement
(the game is over) and each party receives a two-period stream of outside options.
If he accepts, there is an agreement and each party receives a two-period stream of
agreement shares. If he defers, each party receives his/her inside option in the …rst
period. In the latter case, the …rst-period surplus vanishes and the negotiation of the
second-period surplus moves to a next round.
In t = 2, party B makes a countero¤er (x2 ; x2 ); so that if there exists an agreement,
x2 is the fraction of the second-period surplus obtained by him and x2 is the fraction
going to his counterpart. Party A has two alternatives: opt-out or accept. If she opts
out, parties get their second-period outside options. Otherwise, if she accepts, there is
an agreement and each player receives his/her respective fraction of the second-period
surplus.
Assume that A and B exhibit the same discount factor 2 (0; 1). Both players are
risk-neutral so that, in case of agreement, payo¤ functions at period t are described
by:
uA
t = xt
B
ut = xt :
Outside options and inside options to player i are, respectively, U i = 0 and mi 0 for
i = A; B.
(a) Draw a tree representing this negotiation game.
(b) Find the Nash equilibrium of the game that represents the second-period negotiation
round.
(c) Find the SPE of the complete game and characterize all the bargaining outcomes.
(d) Based on part (c), discuss on the sources of bargaining power in this negotiation game.
SOLUTION
(b) Since this is sequential game, the equilibrium notion adopted is the SPE. Thus, we
apply backward induction.
Period t = 2.
11
x2 0,
and opts out otherwise.
max x2
x2
subject to
0 x2 (23)
x2 0 (24)
x2 0; (25)
where (23) is the feasibility constraint, (24) is the countero¤erer’s participation constraint
and (25) represents the agreement condition in the second period negotiation. This problem
is equivalent to the following program:
minx2
x2
subject to
0 x2 (26)
Note that the interval for x2 described by (26) is never empty as the surplus is positive.
Thus, the optimal strategy for B is x2 = 0. That countero¤er would be accepted by player
(c) In order to …nd the SPE of the complete game we proceed by characterizing the Nash
equilibrium of the subgame starting at the …rst period, but taking into account the
equilibrium characterized in part (b).
Period t = 1.
In this stage, B compares the payo¤ coming from three alternatives:
(i) Opt-out: (1 + )U B = 0
(ii) Accept: (1 + )( x1 )
(iii) Defer: mB + ( x2 ) = mB + .
Given the assumptions of the model, Opt-out is a strategy strictly dominated by defer, and
hence, the relevant comparison is between (ii) and (iii).
Thus, player B accepts A’s proposal i¤
(1 + )( x1 ) mB +
()
mB
x1 x1 ;
1+
and defer otherwise. On her part, A chooses x1 such that
max(1 + )x1
x1
subject to
0 x1 (27)
(1 + )x1 mA + x2 (28)
x1 x1 ; (29)
12
After substituting x2 = 0, and since x1 and mA ; 0, the previous problem is equivalent
to
max(1 + )x1
x1
subject to
mA
x1 x1 (30)
1+
mA mB
1+ 1+
()
mA + mB . (31)
Hence, there exist two possible subcases.

Case 1: mA + mB . In this case, the optimal strategy for A is x1 = x1 ; and hence, there
is an agreement at t = 1 (no delay). That agreement implies a sharing rule (x1 ; x1 ) =
(x1 ; x1 ).
Case 2: mA + mB > . In this case, the optimal strategy for A is x1 = x1 + "A (with
"A > 0), and thereby, there is an agreement at t = 2 (agreement with delay or transitory
disagreement). That agreement involves a sharing rule (x2 ; x2 ) = (0; ).
(d) Sources of bargaining power.
Agreement 1
@x1
> 0;
@U A
@x1
< 0;
@mB
@x1
< 0:
@
Outside option is a source of bargaining power for A (last-responder advantage) and inside
option is a source of bargaining power for B (…rst-responder advantage).1 Patience rate (a
larger ) is a source of bargaining strength for B (…rst-responder advantage).
Agreement 2
@x2
> 0:
@U A
Outside option is a source of bargaining power for A (last-responder advantage).2 There is
also a clear last-proposer advantage for B since the agreement is attained with delay.
1
The outsie option e¤ect is not directly observed in this model because outside options are normalized to
zero.
2
The outsie option e¤ect is not directly observed in this model because outside options are normalized to
zero.
13
7. Collective Bargaining & Strike. Two parties, A (a company’s management, she)
and B (a union’s negotiators, he), want to divide up a two-period stream of positive
surplus ( ; ). The bargaining procedure to be used is a process that potentially takes
2 periods in accordance with the following schedule.
the fraction gotten by her counterpart in each period. Party B has two alternatives:
accept or defer. If he accepts, there is an agreement and each party receives a two-
period stream of agreement shares. If he defers, there is a strike and each party receives
his/her inside option in the …rst period. In the latter case, because the strike the …rst-
period surplus vanishes and the negotiation of the second-period surplus moves to a
next round.
In t = 2, party B makes a countero¤er (x2 ; x2 ); so that if there exists an agreement,
x2 is the fraction of the second-period surplus obtained by him and x2 is the fraction
going to his counterpart. Party A has two alternatives: accept or opt-out. If she
accepts, there is an agreement and each player receives his/her respective fraction of
the second-period surplus. Otherwise, if she opts out, the strike ends and the second-
period surplus is divided according to the last collective bargaining process, which
implies to give player A a fraction 2 (0; 1) and player B the remaining part of this
surplus.
by:
uA
t = xt
B
ut = xt :
Inside option to player A is the possibility of replacing workers during the strike, but
only for some minimal services. This inside option is represented by mA 0. In turn,
inside option to player B comes from a fund that the union has saved to help workers
to resist during the strike. This inside option is represented by mB 0.
round.
(e) Based on your answer in part (c), provide an economic intuition for the condition
determining the ocurrence of a strike during the negotiation process.
SOLUTION
14
(b) Since this is a sequential game, the equilibrium notion adopted is the SPE. Thus, we
Period t = 2.
x2 ,

max x2
x2
subject to
0 x2 (32)
x2 (1 ) (33)
x2 ; (34)
where (32) is the feasibility constraint, (33) is the countero¤erer’s participation constraint
and (34) represents the agreement condition in the second period negotiation. This problem
minx2
x2
subject to
x2
It is trivial to check that this program has a corner solution, and thus, the optimal strategy
for B is x2 = . That countero¤er would be accepted by player A, and thereby, it would
be always a potential agreement in t = 2.
Period t = 1.
In this stage, B compares the payo¤ coming from two alternatives:
(ii) Accept: (1 + )( x1 )
(iii) Defer: mB + ( x2 ) = mB + ( ).
(1 + )( x1 ) mB + (1 )
()
(1 + ) mB
x1 x1 ;
1+
15
max(1 + )x1
x1
subject to
0 x1 (35)
(1 + )x1 mA + x2 (36)
x1 x1 ; (37)
Notice that x1 < because < 1. Then, after substituting x2 = , and since mA ; ; ;
0, the previous problem is equivalent to
max(1 + )x1
x1
subject to
mA +
x1 x1 (38)
1+
mA + (1 + ) mB
1+ 1+
()
mA + mB :
Hence, there exist two possible cases.

Case 1: mA + mB . In this case, the optimal strategy for A is x1 = x1 ; and hence,
there is an agreement at t = 1 (no delay, no strike). That agreement implies a sharing rule
(x1 ; x1 ) = (x1 ; x1 ).
Case 2: mA + mB > . In this case, the optimal strategy for A is x1 = x1 + "A (with
"A > 0), and thereby, there is an agreement at t = 2 (agreement with delay and transitory
disagreement or strike). That agreement involves a sharing rule (x2 ; x2 ) = ( ; (1 ) ).
Agreement 1
@x1
= > 0;
@ +1
@x1 1
= < 0;
@mB +1
@x1 1
= (mB + ) < 0:
@ ( + 1)2
Outside option is a source of bargaining power for A (last-responder), which in this model
is represented by the portion gotten by A in the last collective bargaining process.
Inside option is a source of bargaining power for B (…rst-responder advantage), which in the
context of a collective bargaining process highlights the relevance of the size of the strike
fund saved by the union.
16
Patience rate (a larger ) is a source of bargaining strength for B (…rst-responder advantage),
but only as long as the strike fund is su¢ ciently low, i.e., mB < (1 ) .
Agreement 2
@x2
= > 0:
@
Outside option is a source of bargaining power for A (last-responder advantage).
There is also a clear last-proposer strategic advantage for B since the agreement is reached
with delay.
(e) The condition for an agreement with delay (i.e., a strike) is given by
mA + mB > :
This condition suggests that parties will prefer a strike if the overall bene…ts of a strike (the
sum of inside options) exceeds the overall costs of it (the …rst-period surplus that is not
generated because the strike). Therefore, higher inside options (both the size of the strike
fund of the union and the extent to which the law allows the …rm to replace workers during
the strike) increase the probability of a strike during a collective bargaining process.
8. Takeover & UG. Investor Beta (he) wants to buy company Alpha (she). On the
one hand, if Beta would control this company, he estimates that the company would
take a value of > 0 under his management. On the other hand, the capital market
assigns a value to the company under the current management equal to v0 = 0. The
selling process is as follows. First, Alpha makes a take-or-leave-it o¤er to investor Beta
consisting of a sale price x. Beta can accept or reject such an o¤er. If he accepts it,
the company is sold to him for a price x. Otherwise, if he rejects the o¤er, the takeover
fails. Assume that investor Beta’s outside option is zero.
(a) Draw a tree representing this bargaining game.

SOLUTION
A representation of this UG is contained in Figure 8.
(b) Characterize the agreement of this takeover bargaining game.
SOLUTION
The equilibrium notion to be applied is the SPE. Consequently, by backward induction, we
begin with the stage in which player Beta accepts player Alpha’s o¤er if:
x 0,x ;
In the …rst stage, player Alpha chooses x so that
max x
x
subject to
0 x
x 0
x :
17
It is trivial to see that the previous program is equivalent to
max x
x
subject to
0 x ;
from which is easy to check that this problem has a corner solution given by
x = :
The SPE of this ultimatum game is then characterized by
accepts if x
= x = ; Beta :
rejects otherwise
Therefore, there is a unique agreement in which the equilibrium payo¤s are given by ( ; 0):
9. Collective Bargaining, Floor & Strike. Two parties, A (a company’s manage-

ment, she) and B (a union’s negotiators, he), want to split a two-period stream of
positive surplus ( ; ). Consider that, according to a recent labor reform, the sharing
rule agreed during the last collective bargaining process provides a ‘‡oor’the current
bargaining process must guarantee to workers. In other words, any o¤er or counterof-
fer made during the current negotiaton process must satisfy this ‡oor. To that end,
suppose that the last collective bargaining process gave player A a fraction 2 (0; 1)
of the surpluses and player B the remaining portion.
The bargaining procedure to be used is a process that potentially takes two periods in
accordance with the following schedule.
the fraction gotten by her counterpart in each period. Party B has two alternatives:
accept or defer. If he accepts, there is an agreement and each party receives a two-
period stream of agreement shares. If he defers, there is a strike and each party receives
his/her inside option during the …rst period. In the latter case, the strike implies that
the …rst-period surplus vanishes and the negotiation of the second-period surplus moves
to a next round.
In t = 2, party B makes a countero¤er (x2 ; x2 ); so that if there exists an agree-
ment, x2 is the fraction of the second-period surplus obtained by him and x2 is
the fraction going to his counterpart. Party A has two alternatives: accept or opt-out.
If she accepts, there is an agreement and each player receives his/her respective frac-
tion of the second-period surplus. Otherwise, if she opts out, the strike ends and the
second-period surplus is divided according to the last collective bargaining process.
by:
uA
t = xt
B
ut = xt :
18
Inside option to player A is the possibility of replacing workers during the strike, but
only for some minimal services. This inside option is represented by mA 2 [0; ]. In
turn, inside option to player B comes from a fund that the union has saved to help
workers to resist during the strike. This inside option is represented by mB 2 [0; ].
round.
For your answer, consider only the agreement(s) reached without delay.
SOLUTION
(b) Since this is sequential game, the equilibrium notion adopted is the SPE. Thus, we
Period t = 2.
x2 ,

max x2
x2
s:t:
0 x2 (39)
x2 (1 ) (40)
x2 ; (41)
where (39) is the feasibility constraint modi…ed by the legal ’‡oor’, (40) is the countero¤erer’s
participation constraint and (41) represents the agreement condition of the second period
negotiation. Since and are positive, this problem is equivalent to the following program:
minx2
x2
s:t:
x2
It is trivial to check that this program has a corner solution, and thus, the optimal strategy
for B is x2 = . That countero¤er would be accepted by player A, and thereby, it would
have always a potential agreement in t = 2.
19
Period t = 1.
In this stage, B compares the payo¤ coming from two alternatives:
(ii) Accept: (1 + )( x1 )
(iii) Defer: mB + ( x2 ) = mB + ( ).
(1 + )( x1 ) mB + (1 )
()
(1 + ) mB
x1 x1 ;
1+
max(1 + )x1
x1
s:t:
0 x1 (42)
(1 + )x1 mA + x2 (43)
x1 x1 (44)
where (42) is the feasibility condition modi…ed by the legal ‡oor, (43) is the participation
constraint for A and (44) is the agreement condition of the negotiation held at the …rst
period.
After substituting x2 = , from (43) we obtain that
(1 + )x1 mA +
,
mA +
x1 >0 (45)
1+
Thus, (43) implies the l.h.s. of (42), and thereby, we can omit the last constraint from the
problem.
Furthermore, notice that both (44) and the r.h.s. of (42) impose an upper bound over x1 ,
but it is ambiguous which of both bounds is smaller. Speci…cally, notice that
(1 + ) mB mB
x1 = +
1+ 1+ 1+
| {z } | {z }
<1 0 since mB
and thus, we cannot say unambigously whether x1 is greater or smaller than . Hence,
all of which we know is that by combining the constraints (44) and the r.h.s. of (42), it is
veri…ed that
x1 min fx1 ; g (46)
20
Therefore, using (45) and (46) we conclude that the original problem is equivalent to
max(1 + )x1
x1
s:t:
mA +
x1 min fx1 ; g (47)
1+
From this, the natural solution candidate is a corner solution from above, but only as long
as (47) is nonempty. Since the upper bound is indeterminate, we consider two cases.
Case I: min fx1 ; g = x1 , or equivalently,
(1 + ) mB
x1 =
1+
,
mB (1 ): (48)
Thus, the relevant upper bound is x1 , and (47) is nonempty if

mA + (1 + ) mB
x1 =
1+ 1+
,
mA + mB ; (49)
and empty, otherwise.

Thus, from the last condition we conclude that, under Case I, there exist two additional
subcases:
Subcase I.1: mA + mB (condition (49) is satis…ed). In this subcase, the optimal
strategy for A is x1 = x1 ; and hence, there is an agreement at t = 1 (no delay, no strike).
That agreement implies a sharing rule in both periods given by (x1 ; x1 ) = (x1 ; x1 ).
Subcase I.2: mA + mB > (condition (49) is not satis…ed). In this subcase, the optimal
strategy for A is x1 = x1 + "A (with "A > 0), and thereby, there is an agreement at t = 2
(agreement with delay and transitory disagreement or strike). That agreement involves a
sharing rule only in the second period given by (x2 ; x2 ) = ( ; (1 ) ).
Case II: min fx1 ; g= , or equivalently,

(1 + ) mB
< x1 =
1+
,
mB < (1 ): (50)
Thus, the relevant upper bound is , and (47) is nonempty if

mA +
1+
,
mA ; (51)
21
and empty, otherwise.
Thus, from the last condition we conclude that, under Case II, there exist other two additional
subcases:
Subcase II.1: mA (condition (51) is satis…ed). In this subcase, the optimal strategy
for A is x1 = ; and hence, there is an agreement at t = 1 (no delay, no strike). That
agreement implies a sharing rule in both periods given by (x1 ; x1 ) = ( ; (1 ) ).
Notice that this agreement gives workers the legal ‡oor (1 ) over the two-period surplus
stream.
Subcase II.2: mA > (condition (51) is not satis…ed). In this subcase, the optimal
strategy for A is x1 = x1 + "A (with "A > 0), and thereby, there is an agreement at t = 2
(agreement with delay and transitory disagreement or strike). That agreement involves a
sharing rule only in the second period given by (x2 ; x2 ) = ( ; (1 ) ).
Agreement I.1
@x1
= > 0;
@ +1
@x1 1
= < 0;
@mB +1
@x1 1
= (mB + ) < 0:
@ ( + 1)2
Last responder’s outside option is a source of bargaining power for A, which in this model is
represented by the portion gotten by A in the last collective bargaining process.
First-responder’s inside option is a source of bargaining advantage for B, which in the context
of a collective bargaining process highlights the relevance of the size of the strike fund saved
by the union.
Patience rate (a larger ) is a source of bargaining strength for B (…rst-responder advantage),
but only as long as the strike fund is su¢ ciently low, i.e., mB < (1 ) .
Agreement I.2
@x1
= > 0:
@
The interpretation of this result is twofold. On the one hand, it can represent the idea that
outside option is a source of bargaining power for A (last-responder advantage). On the
other hand, it can represent the role played by the legal ‡oor protecting workers, as we can
compute
@( x1 )
= > 0;
@(1 )
which suggests that the larger what the union obtained in the last bargaining process, the
larger the fraction workers get in the current negotiation.
10. UG with risky outside option and risk-aversion. Two parties, A (she) and B
(he), must split a cake of size > 0. While player A is risk-neutral, player B is risk-
averse. In more concrete terms, if W represents …nal wealth, utility functions of these
22
two parties are given by uA (W ) = W and uB (W ) = W 1 , where 2 (0; 1) measures
the risk aversion degree of B. In case of agreement, party A receives x 2 [0; ] and her
counterpart receives x. Otherwise, in case of disagreement, each party gets her/his
outside option. Whereas A’s outside option is given by U A > 0, outside option of B is
risky: with probability p 2 (0; 1) player B obtains a …nal wealth of W1 > 0 and with
probability 1 p he gets zero …nal wealth.
(a) Characterize the equilibrium and possible outcomes of this negotiation game assuming
that the bargaining process is conducted as the ultimatum game in which A plays the
role of proposer.
SOLUTION
A representation of this game is contained in Figure 10.
By applying backward induction, we begin with the second subgame. In this stage, player
B accepts player A’s o¤er if
( x)1 pW11
,
1
x p1 W1 ;

In the …rst subgame, player A must choose x that solves
max x
x
subject to
0 x (52)
x UA (53)
1
x p1 W1 ; (54)
where (52) is the feasibility constraint, (53) is the participation constraint of player A, and
(54) represents an agreement condition. This program is equivalent to
max x
x
subject to
1
UA x p1 W1 : (55)
1
UA + p1 W1 ; (56)

1
x = p1 W1 :
23
( ( 1
)
1 Accepts if x p W1
1
SP E(U G) = x = p 1 W1 ; B 1 :
Rejects if x > p 1 W1
1
( p 1 W1 ; pW11 ):
Case 2. If condition (56) is not veri…ed, there not exist an x satisfying (55) , and hence, a
the following set:
( ( 1
)
1 Accepts if x p 1 W1
SP E(U G) = x = p 1 W1 + "; B 1 ;
Rejects if x > p 1 W1
(U A ; pW11 ):
(b) Identify formally and discuss intuitively all the sources of bargaining power present in
this game.
SOLUTION
Sources of bargaining power:
(i) Last-proposer advantage (bargaining strength for player A): The classical strategic ad-
vantage of the …rst-moving player in an UG.
(ii) Last-responder’s outside option (bargaining strength for player B). In particular:
@x p 1 W1
= <0
@p 1
@x 1
= p1 < 0:
@W1
(iii) Last-responder’s risk-aversion degree (bargaining weakness for player B). In particular:
@x
> 0;
@
as p 2 (0; 1). Intuition: If B is more risk-averse, he prefers more (relatively) a riskless and
lower portion of the cake coming from an agreement than a risky outside option. Equivalently,
we can say that B is willing to pay a higher risk-premium to get for sure the amount x
rather than to get the expected amount pW1 .
11. O¤er-Countero¤er & Risk Aversion. Two parties, A (o¤erer, she) and B (coun-
tero¤erer, he), want to split a cake of size . The negotiation mechanism is a potentially
At t = 1, party A makes a sharing o¤er, (x1 ; x1 ), so that if there is an agreement,
x1 is the portion gotten by this player, and x1 the portion of her counterpart.
24
Party B can accept or reject that o¤er. If he accepts it, each party receives his/her
respective fraction of the cake. If he rejects it, negotiation moves to a second stage.
agreement, x2 is the portion this player gets and x2 is the portion obtained by
his opponent. Party A can accept or reject such a countero¤er. If she accepts it, each
party receives his/her respective fraction of the cake. If she rejects it, each party re-
ceives his/her respective outside option. Assume that A and B share the same discount
factor 2 (0; 1). If W represents …nal wealth, utility functions of the two parties are
given by
uA (W ) = W 1 ;
uB (W ) = W 1 ;
where ; 2 (0; 1) measure the risk aversion degree of A and B, respectively. Outside
option of player i is risky: with probability p 2 (0; 1) player i obtains a …nal wealth of
Wi > 0 and with probability 1 p she/he gets zero …nal wealth, for i = A; B.
1 1
p1 WA + p 1 WB : (57)
(a) Depict the extensive form of this game.
(b) Find the SPE set and characterize the outcome this negotiation process generates.
(c) Based on your answer in part (b), discuss which are the sources of bargaining power
in this game.3
SOLUTION
(a) See Figure 11.
Period t = 2.
x21 pWA1
,
1
x2 p1 WA ,

3
Recall that
@af (y) @f (y)
= ln(a)af (y) .
@y @y
25
max( x2 )1
x2
subject to
0 x2 (58)
( x2 ) 1
pWB1 (59)
1
x2 p1 WA ; (60)
where (58) is a feasibility constraint, (59) is a participation constraint for the counter-o¤erer
and (60) represents the agreement condition in the second-period negotiation. Since p,WA >
0, it follows that (60) is a su¢ cient condition for the l.h.s. of (58). Similarly, since p,WB > 0
then (59) is a su¢ cient condition for the r.h.s. of (58). The above program is then equivalent
to
max( x2 )1
x2
subject to
1 1
p1 WA x2 p 1 WB. (61)
Note that
@( x2 ) 1
= (1 )( x2 ) < 0;
@x2
and therefore our natural candidate is a corner solution from below. This will be true if the
interval for x2 described by (61) is nonempty. This is indeed true as, by assumption, the
following condition is always satis…ed:
1 1
p1 WA p 1 WB.
,
1 1
p1 WA + p 1 WB. : (62)
1
Thus, the optimal strategy for B is x2 = p 1 WA . That countero¤er would be accepted by
player A, and thereby, it would be always a potential agreement in t = 2.
Period t = 1.
( x1 )1 ( x2 )1
()
1
x1 1 ( x2 )
()
1 1
x1 1 ( p1 WA ) x1 ;
26
and rejects it otherwise. On his part, player A chooses x1 so that
max x11
x1
subject to
0 x1
1
x1 (x2 )1
x 1 x1
1
After substituting x2 = p 1 WA , and since x1 , the previous problem is equivalent to
max x11
x1
subject to
1 1
1 p1 WA x1 x1 . (63)
Note that
@x11
= (1 )x1 > 0;
@x1
and thus our natural candidate is a corner solution from above. This is true if the interval
for x1 described by (298) is nonempty. That is, as long as
1 1
1 p1 WA x1 (64)
,
1 1 1 1
1 p1 WA 1 ( p1 WA )
, (65)
1 1
1 1 1
1 p1 WA : (66)
1 1
This is indeed true because the parameters of the model and initial assumptions ensure that
1 1
1 1 1 1 1 1
1 p1 WA < p 1 WA < p 1 WA + p 1 WB :
| 1 {z
1
}
<1
Therefore, the optimal strategy for A is x1 = x1 ; and thus, there will be an agreement during
period t = 1 (no delay). That agreement implies a sharing rule (x1 ; x1 ) = (x1 ; x1 ).
(c) Sources of bargaining power
(i) Last-responder’s outside option (bargaining strength for player A). In particular:
@x 1
= 1 1 >0
@WA p 1 1
@x 1 WA
= 1 > 0;
@p p 1 1 1
27
since < 1.
(ii) Risk-aversion degree: Own risk aversion level is source of bargaining weakness and rival’s
risk aversion is source of bargaining power. In particular:
@x 1 ln p
= WA <0
1)2
1 1
@ p 1 1 (
is true as p 2 (0; 1) and thereby, ln p < 0, and

1
@x 1 p 1 WA
= (ln ) >0
1)2
1
@ 1 (
is true as 2 (0; 1) and thereby, ln < 0, and also because assumption given by condition
1
(57) implies that p 1 WA < 0.
Intuition: If a player is more risk-averse relative to her/his counterpart, she/he will prefer
more (relatively) a riskless and lower portion of the cake coming from an agreement than a
risky outside option coming from a disagreement.
(iii) First-responder’s patience: Patience is a source of bargaining power for B:
1
@x 1 p1 WA
= < 0;
@ 1 1
which is true as < 1, and because assumption given by condition (57) implies that
1
p 1 WA < 0.
(iv) Last-proposer moving advantage: If B is fully patient ( = 1), B can extract all the
1
surplus after giving A just a fraction p 1 WA of the cake consistent with her outside option.
12. O¤er-Countero¤er, Inside Options & Asymmetric Risk Aversion. Two par-
ties, A (o¤erer, she) and B (countero¤erer, he), want to split a cake of size . The
negotiation mechanism is a potentially two-stage process with the following schedule.
x1 is the fraction gotten by this player, and x1 the fraction of her counterpart.
respective fraction of the cake. If he rejects it, each party receives in the …rst period
his/her respective inside option. In the latter case, negotiation moves to a second
stage.
agreement, x2 is the fraction this player gets and x2 is the fraction obtained by
his opponent. Party A can accept or reject such a countero¤er. If she accepts it,
each party receives his/her respective fraction of the cake. If she rejects it, each party
receives his/her respective outside option.
Assume that A and B have the same discount factor 2 (0; 1). While player A is risk-
neutral, player B is risk averse. In more concrete terms, if W represents …nal wealth,
utility functions of these two parties are given by uA (W ) = W and uB (W ) = W 1 ,
where 2 (0; 1) measures the risk aversion degree of B.
In addition, whereas A’s outside option implies a …nal wealth level of WA > 0 received
with certainty, outside option of B is risky: with probability p 2 (0; 1) player B obtains
28
a …nal wealth of WB > 0 and with probability 1 p he gets zero …nal wealth.
The inside option of player i implies to receive a wealth level of mi 0 for all i = A; B.
1
WA + p 1 WB : (67)
(a) Draw the extensive form of this game expressing all the …nal payo¤s in present value
terms.
generate.
determining what type of agreement is reached in the negotiation process.
(d) Based on your answer in part (b), discuss the role played by inside options, outside
options and patience as sources of bargaining strength/weakness in this game. (Hint:
…nding the speci…c partial derivatives is not necessary as direct inspection is enough
to determine the sign of such derivatives).
SOLUTION
(a) Draw the extensive form of this game expressing all the …nal payo¤s in present value
terms.
hInsert Figure 12i
generate.
Because this is a sequential game, we adopt the SPE as an equilibrium notion. Consequently,
we apply backward induction.
Period t = 2.
x2 WA ,

max( x2 )1
x2
subject to
0 x2 (68)
( x2 ) 1
pWB1 (69)
x2 WA ; (70)
29
and (70) represents the agreement condition in the second-period negotiation. This problem
max( x2 )1
x2
subject to
1
WA x2 p 1 WB (71)
Note that the interval for x2 described by (71) is never empty as by condition (67), the
following inequality is always satis…ed:
1
WA p 1 WB
,
1
WA + p 1 WB : (72)
Thus, the optimal strategy for B is x2 = WA . That countero¤er would be accepted by player
Period t = 1.
1
( x1 ) 1 mB + ( x2 )1
()
h i11
1
x1 mB + ( x2 )1
()
h i11
x1 m1B + ( WA )1 x1 ;
maxx1
x1
subject to
0 x1
x1 m A + x 2
x1 x1
After substituting x2 = WA , and since x1 and mA ; ; WA 0, the previous problem

becomes equivalent to
maxx1
x1
subject to
mA + WA x1 x1 (73)
30
h i11
mA + WA m1B + ( WA )1
()
h i11
mA m1B + ( WA )1 WA mA : (74)
We can therefore characterize two possible subcases.

Subcase 1.1: mA mA . In this case, the optimal strategy for A is x1 = x1 ; and thus, there
will be an agreement during period t = 1 (no delay). That agreement implies a sharing rule
(x1 ; x1 ) = (x1 ; x1 ) and equilibrium payo¤s (x1 ; ( x1 )1 ).
Subcase 1.2: mA > mA . In this case, the optimal strategy for A is x1 = x1 + "A (with
implies a sharing rule (x2 ; x2 ) = (WA ; WA ) and equilibrium payo¤s (mA + WA ; m1B +
1
( WA ) ).
determining what type of agreement is reached in the negotiation process.
From the converse of (74), the condition for an agreement with delay can be rewritten as
mA > mA :
This condition suggests that player A prefers a delay and reach an agreement in t = 2 if
her inside option is su¢ cienlty high. Notice that direct inspection of the above condition
indicates that larger inside options (either mA or mB ) and lower impatience (higher )
increase the probability of attaining an agreement with delay.
(d) Based on your answer in part (b), discuss the role played by inside options, outside
options and patience as sources of bargaining strength/weakness in this game. (Hint:
…nding the speci…c partial derivatives is not necessary as direct inspection is enough
to determine the sign of such derivatives).
Agreement 1.1.
Simple inspection reveals the following signs:
@x1
> 0;
@WA
@x1
< 0;
@mB
@x1
< 0:
@
Thus, whereas the outside option is a source of bargaining power for A (last responder’s
outside option), the inside option and patience degree are sources of bargaining strength for
B.
Agreement 1.2.
31
@x2
= 1 > 0:
@WA
Then, the outside option is a source of bargaining power for A(last responder’s outside
option).
13. UG with interdependent outside options. Two …rms operating in the same
industry, A and B, want to split the gains of a possible merger, represented by > 0.
The rule to be used for that division is similar to the ultimatum game in which …rm A
plays the role of proposer. If the proposal made by …rm A is accepted by …rm B, their
payo¤s are represented by uA = x and uB = x. Otherwise, there is a disagreement
and a price war is unleashed. In that scenario, …rm i gets
U i = (1 j )v
for i; j = A; B and i 6= j, where v > 0 and j 2 (0; 1) represents the ability …rm j has
to decrease …rm i’s pro…ts in case of a price war.
(a) Represent this game using a decision tree.
(b) Find the SPE of this bargaining situation and characterize all their possible outcomes.
(c) Discuss the role played by parameters ’s in the bargaining outcomes of this model.
SOLUTION
(a) See Figure 13.

(b) By applying backward induction, we begin with the second subgame (second stage).
In this stage, player B accepts player A’s o¤er if
( x) UB , x U B;
In the …rst subgame (…rst stage), player A must choose x that solves
maxx
x
subject to
0 x (75)
x UA (76)
x U B; (77)
where (75) is the feasibility constraint, (76) is the participation constraint of player A, and
(77) represents an agreement condition. This program is equivalent to
maxx1
x
subject to
UA x U B: (78)
32
UA + UB : (79)

x = U B: (80)
accepts if x UB
= x = U B; B :
rejects if x > UB
( U B ; U B ):
Case 2. If condition (79) is not veri…ed, there not exist an x satisfying (78), and hence, a
the following set:
accepts if x UB
= x = U B + "; B ;
rejects if x > UB
(U A ; U B ):
(c) Considering the value of outside options we can rewrite condition (79) as follows
(1 B )v + (1 A )v :
Parameters ’s play therefore a dual role in the negotiation outcome. On the one side, an
increase of either A or B makes more likely an agreement because this fact reduces the
outside options. The intuition of this result is that when i increases, the deterrent power of
…rm i increases because its threat will be more destructive with its rival if a price war …nally
materializes.
On the other side, conditional on that an agreement exists, whereas the destructive ability
A is a source of negotiating strength for the proposer, such an ability for the responder
plays no role at all. To check that, rewrite
x = (1 A )v
and compute
@x
= v > 0;
@ A
and
@x
= 0:
@ B
33
14. O¤er-Countero¤er & Asymmetric Negative Externality. Two parties, A (of-
ferer, she) and B (countero¤erer, he), want to split a cake of size . The negotiation
mechanism is a potentially two-stage process with the following schedule.
is the fraction gotten by this player, and x1 the fraction of her counterpart. Party
B can accept or reject that o¤er. If he accepts it, each party receives his/her respective
fraction of the cake. If he rejects it, the negotiation moves to a second stage.
Assume that A and B have the same discount factor 2 (0; 1). In case of agreement
at period t, utility functions of A and B are given by
uA
t = xt
uB
t = ( xt ) B xt ;
for t = 1; 2, where B is a non-negative constant that represents the marginal disutility

for player B because an envy-type externality. Player i’s outside option is U i 0 for
i = A; B: Finally, assume that the following condition holds:
U A (1 + B) + UB : (A1)

SOLUTION
See Figure 14.
(b) Find the set of SPE and indicate which is (are) the outcome(s) of this negotiation
process.
SOLUTION
Period t = 2.
x2 U A,
max( x2 ) B x2
x2
s:t:
0 x2 (81)
( x2 ) B x2 UB (82)
x2 U A: (83)
34
and (83) represents the agreement condition in the second-period negotiation. Since U A 0,
U
it follows that (83) is a su¢ cient condition for the l.h.s. of (81). Similarly, since 1+ BB <
to
min(1 + B )x2
x2
s:t:
UB
UA x2 (84)
1+ B
Note that
@(1 + B )x2
= 1 + B > 0;
@x2
interval for x2 described by (84) is nonempty. This is indeed true as, by assumption (A1),
the following condition is always satis…ed:
UB
UA
1+ B
,
U A (1 + B ) + U B : (85)
Period t = 1.
( x1 ) B x1 [( x2 ) B x2 ]
()
[ (1 + B )x2 ]
x1
1+ B
()
[ (1 + B )U A ]
x1 x1 ;
1+ B
maxx1
x1
subject to
0 x1
x1 x2
x1 x1
35
After substituting x2 = U A , and since x1 and U A ; 0, the previous problem becomes
equivalent to
maxx1
x1
subject to
U A x1 x1 : (86)
[ (1 + B )U A ]
UA
1+ B
()
(1 ) 0;
which is always true because < 1 and > 0. Thus, the optimal strategy for A is x1 = x1 :
The unique outcome of this negotiation process is therefore an agreement during period t = 1
(no delay). That agreement implies a sharing rule (x1 ; x1 ) = (x1 ; x1 ).
(c) Discuss the role played by externalities, outside options and patience as sources of
bargaining strength/weakness in this game. (Hint: …nding the speci…c partial deriv-
atives is not necessary as direct inspection is enough to determine the sign of such
derivatives).
SOLUTION
We can rewrite x1 as follows
(1 )
x1 = + U A:
1+ B
@x1
> 0;
@U A
@x1
< 0:
@ B
Also notice that
@x1
= + U A < 0;
@ 1+ B
since > (1 + B )U A because assumption (A1). Thus, we have:
(i) The outside option is a source of bargaining power for A (last responder’s outside option)
(ii) The negative externality is a source of bargaining power for B (…rst responder’s exter-
nality level)
(iii) Patience degree is a source of bargaining strength for B (…rst responder’s patience level).
15. O¤er-Countero¤er, Asymmetric Externality and Inside Options. Two par-

ties, A (o¤erer, she) and B (countero¤erer, he), want to split a cake of size . The
36
stage.
Assume that A and B exhibit the same discount factor 2 (0; 1). Outside options and
inside options to player i are, respectively, U i 0 and mi 0 for i = A; B. In case of
agreement at period t, utility functions of A and B are given by
uA
t = xt
B
ut = ( xt ) B xt ;
for t = 1; 2, where B is a non-negative constant that represents the marginal disutility

for player B because an envy-type externality. Finally, assume that the following
condition holds:
U A (1 + B ) + U B : (A1)
SOLUTION
See Figure 15.
process.
SOLUTION
Period t = 2.
x2 U A,

max( x2 ) B x2
x2
s:t:
0 x2 (87)
( x2 ) B x2 UB (88)
x2 U A: (89)
37
and (89) represents the agreement condition in the second-period negotiation. Since U A 0,
U
it follows that (89) is a su¢ cient condition for the l.h.s. of (87). Similarly, since 1+ BB <
to
min(1 + B )x2
x2
s:t:
UB
UA x2 (90)
1+ B
Note that
@(1 + B )x2
= 1 + B > 0;
@x2
UB
UA
1+ B
,
U A (1 + B ) + U B : (91)
Period t = 1.
( x1 ) B x1 mB + [( x2 ) B x2 ]
()
mB [ (1 + B )x2 ]
x1
1+ B
()
mB [ (1 + B )U A ]
x1 x1 ;
1+ B
maxx1
x1
subject to
0 x1
x1 m A + x 2
x1 x1
38
After substituting x2 = U A , and since x1 and mA ; U A ; 0, the previous problem
becomes equivalent to
maxx1
x1
subject to
mA + U A x1 x1 : (92)

mB [ (1 + B )U A ]
mA + U A
1+ B
()
(1 + B )mA + mB (1 ) : (93)
Therefore, there are two possible negotiation outcomes:

1. If (93) holds true, the optimal strategy for A is x1 = x1 and there will be an agreement
during period t = 1 (no delay). That agreement implies a sharing rule (x1 ; x1 ) =
(x1 ; x1 ).
2. If (93) does not hold, the optimal strategy for A is x1 = x1 + " (with " > 0) and there
will be an agreement during period t = 2 (delay). That agreement implies a sharing rule
(x2 ; x2 ) = (U A ; U A ).
(c) Identify the sources of bargaining strength/weakness in this negotiation game.
SOLUTION
1. Agreement without delay
(1 ) mB
x1 = + U A:
1+ B

@x1
> 0;
@U A
@x1
< 0;
@ B
@x1
< 0
@mB
Also notice that
@x1
= + U A < 0;
@ 1+ B
since > (1 + B )U A because assumption (A1). Thus, in the agreement without delay we
have:
(ii) The negative externality is a source of bargaining power for B (…rst responder’s exter-
nality level)
39
(iii) The inside option is a source of bargaining power for B (…rst responder’s inside option)
(iv) Patience degree is a source of bargaining strength for B (…rst responder’s patience level).
The intuition behind these results is the fact that player B enjoys a pivotal position in this
game. In fact, when for B either (i) his payo¤ from rejecting increases (his inside option mB ),
(ii) his impatience level decreases (higher ), or (iii) his envy level increases (higher B ), B
becomes a tougher negotiator because his threat on rejecting when facing a low o¤er is more
credible. As a result, B gets a larger fraction of the cake under division in the agreement
without delay.
2. Agreement with delay
(i) Last-proposer advantage: Player B gets almost all the surplus after giving player A only
her outside option.
(ii) Last-responder outside option:
@x2
= 1 > 0:
@U A
16. O¤er-Countero¤er, Negative Externalities and Inside Options. Two parties,

A (o¤erer, she) and B (countero¤erer, he), want to split a cake of size . The negotia-
tion mechanism is a two-period o¤er-countero¤er process with the following schedule.
stage.
Player i has a discount factor i 2 (0; 1) for i = A; B. Outside options and inside
options to player i are, respectively, U i 0 and mi 0 for i = A; B. In case of
agreement at period t, utility functions of A and B are given by
uA
t = xt A( xt )
B
ut = ( xt ) B xt ;
for t = 1; 2, where A ; B are non-negative constants that represent the marginal disu-
tility for players A and B, respectively, because an envy-type externality. Finally,
assume that the following condition holds:
U A (1 + B) + U B (1 + A) (1 A B ): (A1)
(b) Find the set of SPE and characterize which is (are) the outcome(s) of this negotiation
process.
40
(c) Identify formally and describe intuitively the sources of bargaining strength/weakness
in this negotiation game.
SOLUTIONS
SOLUTION
See Figure 16.
process.
SOLUTION
Period t = 2.
x2 A( x2 ) UA
,
UA + A
x2
1+ A

max( x2 ) B x2
x2
s:t:
0 x2 (94)
( x2 ) B x2 UB (95)
UA + A
x2 : (96)
1+ A
where (FC) is a feasibility constraint, (PC) is a participation constraint for the counter-
o¤erer and (AC) represents the agreement condition in the second-period negotiation. Since
U A; A 0, it follows that (AC) is a su¢ cient condition for the l.h.s. of (FC). Similarly,
UB
since 1+ B < then (PC) is a su¢ cient condition for the r.h.s. of (FC). The above program
is then equivalent to
min(1 + B )x2
x2
s:t:
UA + A UB
x2 (97)
1+ A 1+ B
Note that
@(1 + B )x2
=1+ B > 0;
@x2
41
UA + A UB
1+ A 1+ B
,
U A (1 + B ) + U B (1 + A) (1 A B ): (98)
U +
Thus, the optimal strategy for B is x2 = A1+ AA . That countero¤er would be accepted by
player A, and thereby, it would be always a potential agreement in t = 2.
Period t = 1.
( x1 ) B x1 mB + B [( x2 ) B x2 ]
()
mB B[ (1 + B )x2 ]
x1
1+ B
() h i
U A+ A
mB B (1 + B) 1+ A
x1 x1 ;
1+ B
maxx1 A( x1 )
x1
s.t.
0 x1 (FC)
x1 A( x1 ) mA + A [x2 A( x2 )] (PC)
x1 x1 (AC)
U A+ A
After substituting x2 = 1+ A
, and since x1 < because assumption (A1), the previous
program is equivalent to
max(1 + A )x1
x1
s.t.
mA + A U A + A
x1 x1 (99)
1+ A
Since the objective function is strictly increasing in x1 , this problem has a corner solution
42
from above as long as (99) is nonempty. Thus, A will choose x1 = x1 if
mA + AU A + A
x1
1+ A
()
h i
U A+ A
mB (1 + B) mA + AU A +
B 1+ A A
1+ B 1+ A
()
(1 + B )mA + (1 + A )mB (1 B )(1 A B) +( B A )(1 + B )U A ; (100)
and x1 = x1 + ", otherwise, with " > 0.

Therefore, there are two possible negotiation outcomes:
1. If (100) holds true, there will be an agreement during period t = 1 (no delay). That
agreement implies a sharing rule (x1 ; x1 ) = (x1 ; x1 ).
2. If (100) does not hold, there will be an agreement during period t = 2 (delay). That
U + U
agreement implies a sharing rule (x2 ; x2 ) = ( A1+ AA ; 1+ AA ).
(c) Identify the sources of bargaining strength/weakness in this negotiation game.
SOLUTION
1. Agreement without delay
(1 B) mB UA + A
x1 = + B
1+ B 1+ B 1+ A
Taking partial derivatives we obtain

@x1 B
= > 0;
@U A 1+ A
@x1 1
= <0
@mB 1+ B
Also notice that
@x1 B
= ( U A) > 0
@ A (1 + A )2
and
@x1 U (1 + B ) (1 A B)
= A < 0;
@ B (1 + A ) (1 + B)
since > U A and (1 A B) > (1 + B )U A because assumption (A1).

Lastly, notice that
@x1 mB (1 B)
= <0
@ B (1 + B )2
if
mB < (1 B) ;
43
which follows from condition (100) as long as A B . Otherwise, the sign of the last
derivative is ambiguous.
Thus, in the agreement without delay we have:
(ii) The negative externality is a source of bargaining power for A (last responder’s negative
externality), but a source of bargaining power for B as long as he is more impatient than
A:4
(iii) The inside option is a source of bargaining power for B (…rst responder’s inside option)
(iv) Patience degree is a source of bargaining strength for B (…rst responder’s patience level).
The intuition behind these results is the fact that player B enjoys a pivotal position in this
game. In fact, when for B either (i) his payo¤ from rejecting increases (his inside option
mB ), (ii) his impatience level decreases (higher B ), or (iii) his envy level increases (higher
B as long as A B ), B becomes a tougher negotiator because his threat on rejecting
when facing a low o¤er is more credible. As a result, B gets a larger fraction of the cake
under division in the agreement without delay.
2. Agreement with delay
Recall that
U + A
x2 = A
1+ A
(i) Last-proposer advantage: To see that, assume that A = 0 and then player B gets almost
all the surplus after giving player A only her outside option.
(ii) Last-responder’s outside option:
@x2 1
= > 0:
@U A 1+ A
(iii) Last-responder’s negative externality:
@x2 UA
= 2 > 0;
@ A ( A + 1)
which is true by assumption (A1).
17. O¤er-Countero¤er, Wealth Marginal Utility and Collective Bargaining. Two

parties, A (a union’s negotiators, she) and B (a company’s management, he), want to
divide up a positive surplus (annual company’s pro…ts). This collective bargaining
process is conducted in accordance with the two-period o¤er-countero¤er model with-
out inside options in which A is the o¤erer and B is the countero¤erer.
If W represents …nal wealth, utility functions of these two parties are given by uA (W ) =
W and uB (W ) = W , where ; > 0.
In case of disagreement, and in accordance with the law, the surplus is divided accord-
ing to the last collective bargaining process, which implies to give player A a fraction
2 (0; 1) of the surplus under division and player B the remaining part of this surplus.
Assume that A and B exhibit the same discount factor 2 (0; 1).
4 @( x1 )
Since it is a zero-sum game it follows that @ B
> 0 if mB < (1 B) , which follows from condition
@( x1 )
(100) as long as A B. Also, it is veri…ed that @ A
< 0 by assumption (A1).
44
process.
(c) Discuss the role played in the outcome of the current bargaining process by: (i) the
outcome coming from the last bargaining process, and (ii) the wealth marginal utility
parameters and .
SOLUTION
(a) See Figure 17.
process.
SOLUTION
Period t = 2.
x2
,
x2 ,

max ( x2 )
x2
s:t:
0 x2 (101)
( x2 ) (1 ) (102)
x2 : (103)
o¤erer and (103) represents the agreement condition in the second-period negotiation. Since
> 0, it follows that (103) is a su¢ cient condition for the l.h.s. of (101) and (102) is a
su¢ cient condition for the r.h.s. of (101). The above program is then equivalent to
max ( x2 )
x2
s:t:
x2 : (104)
It is trivial to check that this program has a unique solution that satis…es (104), and thus,
the optimal strategy for B is x2 = . That countero¤er would be accepted by player A,
and thereby, it would have always a potential agreement in t = 2.
45
Period t = 1.
( x1 ) ( x2 )
()
x1 (1 (1 )) x1 ;
max x1
x1
s.t.
0 x1 (FC)
x1 x2 (PC)
x1 x1 (AC)
After substituting x2 = , and since x1 < , the previous program is equivalent to
max x1
x1
s.t.
x1 x1 (105)
Since the objective function is strictly increasing in x1 , this problem has a corner solution
from above as long as (105) is nonempty, which is always true because
(1 (1 ))
,
(1 ) 0: (106)
Hence, A will always choose x1 = x1 .

Therefore, the unique negotiation outcome is an agreement in period t = 1 (no delay). That
agreement implies a sharing rule (x1 ; x1 ) = (x1 ; x1 ).
(c) Discuss the role played in the outcome of the current bargaining process by: (i) the
outcome coming from the last bargaining process, and (ii) the wealth marginal utility
parameters and .
SOLUTION
(i) The result of the last collective bargaining process introduces some inertia in the current
bargaining outcome as
@x1
= >0
@
(ii) The rule of adopting the last bargaining process’s outcome in case of disagreement
implies that the outside option is computed by evaluating the utility function of each player in
monetary payo¤s and (1 ) . As a consequence, the wealth marginal utility parameters
play no role at all in the bargaining outcome because these parameters cancel out when
comparing the disagreement utility level with that level in the agreement scenario.
46
18. OCG, inside options & deadline (60 points). Two parties, A (o¤erer, she) and B
(countero¤erer, he), want to split a cake of an initial size equal to . The negotiation
mechanism is a potentially two-stage process with the following schedule.
At t = 1, party A makes a sharing o¤er x1 , so that if there is an agreement, x1 is
the fraction gotten by this player and the remaining fraction goes to her counterpart.
his/her respective inside option. In the latter case, the cake under division decreases
to a size (with 0 < < 1), over which a bargaining process is conducted in a second
stage.
At t = 2, party B makes a sharing countero¤er x2 , so that if there is an agreement,
x2 is the fraction gotten by his opponent and he receives the remaining fraction of the
cake under division. Party A can accept or reject such a countero¤er. If she accepts it,
Assume that A and B share the same discount factor 2 (0; 1) and that both players
are risk-neutral. The outside option and inside option of player i are, respectively,
U i 0 and mi 0 for all i = A; B.
(a) Draw the extensive form of this game. (10 points)
(b) Find the set of SPE, characterizing all the outcomes this negotiation process can gen-
erate. (30 points)
(c) Based on your answer in part (b), provide an economic intuition for the condition deter-
mining an agreement with delay and/or a permanent disagreement in the negotiation
process. (10 points)
in the agreement(s) without delay found in this game. (10 points)
SOLUTION
(a) Seet Figure 18
Period t = 2.
x2 U A,
47
max x2
x2
subject to
0 x2 (107)
x2 U B (108)
x2 U A ; (109)
minx2
x2
subject to
UA x2 UB (110)
Note that the interval for x2 described by (110) is nonempty as long as
UA UB
,
UA + UB : (111)
Thus, the optimal strategy for B is characterized by
UA if (111) holds
x2 =
UA "B if (111) does not hold
with "B > 0. Thus, the outcome of the second-period negotiation is
agreement if (111) holds
Outcome at t = 2 =
disagreement if (111) does not hold
Period t = 1.
To solve the game of this period, we consider the two previous cases separately.
Case 1. Condition (111) holds (i.e., agreement at t = 2)
Player B accepts what player A o¤ers if
x1 mB + ( x2 )
()
x1 mB ( x2 )
()
x1 mB ( U A) x1 ;
maxx1
x1
s:t:
0 x1 (112)
x1 m A + x 2 (113)
x1 x1 (114)
48
where (112) is a feasibility constraint, (113) is the participation constraint for A and (114)
is the agreement condition of the negotiation held at the …rst period.
After substituting x2 = U A , from (113) we obtain that
x1 mA + U A > 0: (115)
Thus, (113) implies the l.h.s. of (112), and thereby, we can omit the last constraint from the
problem. Moreover, notice that x1 < since under Case 1, U A < . Thus, (114) implies
the r.h.s. of (112), and thereby, we can also omit the last constraint from the problem.
maxx1
x1
s:t:
mA + U A x1 x1 (116)
as (116) is nonempty. This is true if:
mA + U A x1 = mB ( U A)
,
mA + mB (1 ) ; (117)
otherwise; this interval is empty.
subcases:
Subcase 1.1: mA + mB (1 ) (condition (117) is satis…ed). In this subcase, the
optimal strategy for A is x1 = x1 ; and hence, there is an agreement at t = 1 (no delay).
That agreement implies a sharing rule given by (x1 ; x1 ) = (x1 ; x1 ).
Subcase 1.2: mA + mB > (1 ) (condition (117) is not satis…ed). In this subcase, the
optimal strategy for A is x1 = x1 + "A (with "A > 0), and thereby, there is an agreement
at t = 2 (agreement with delay and transitory disagreement). That agreement involves a
sharing rule in the second period given by (x2 ; x2 ) = (U A ; U A ).
Case 2. Condition (111) doesn’t hold (i.e., disagreement at t = 2)

x1 mB + U B
()
x1 mB UB x1 ;
maxx1
x1
s:t:
0 x1 (118)
x1 mA + U A (119)
x1 x1 (120)
49
is the agreement condition of the negotiation held at the …rst period. Since mA + U A > 0
and x1 < , (119) and (120) are su¢ cient conditions for the l.h.s. and r.h.s. of (118),
respectively. Thus, the previous program can be simpli…ed to
maxx1
x1
s:t:
mA + U A x1 x1 (121)
as (121) is nonempty. This is true if
mA + U A x1 = mB UB
,
mA + mB + U A + U B ; (122)
otherwise; this interval is empty.

subcases:
Subcase 2.1: mA + mB + U A + U B (condition (122) is satis…ed). In this subcase,
the optimal strategy for A is x1 = x1 ; and hence, there is an agreement at t = 1 (no delay).
That agreement implies a sharing rule given by (x1 ; x1 ) = (x1 ; x1 ).
Subcase 2.2: mA + mB + U A + U B > (condition (122) is not satis…ed). In this subcase,
the optimal strategy for A is x1 = x1 + "A (with "A > 0), and thereby, there is a permanent
disagreement (disagreement in both periods).
(c) (i) The condition for an agreement with delay can be rewritten as
mA + mB + >
overall bene…ts from a delay (the sum of inside options plus the present value of the
cake divided at t = 2) exceeds the bene…ts from a no delay situation (the value of
the cake distributed in t = 1). Therefore, higher inside options and lower impatience
increase the region for attaining an agreement with delay. However, this region will
be smaller if the e¤ect of a deadline is more severe over the cake under division in the
second period (i.e. if the parameter is lower).
(ii) The condition for a permanent disagreement can be rewritten as
mA + mB + U A + U B >
This condition suggests that the game will end with a permanent disagreement at t = 2 if
the overall bene…ts from a delay (the sum of inside options plus the present value of the
outside options received at t = 2) exceeds the bene…ts from a no delay situation (the value
of the cake distributed at t = 1). Therefore, higher inside options, lower impatience and
higher outside options increase the region for a complete negotiation breakdown.
50
(d) Agreement 1.1 (agreement without delay)
@x1
= > 0;
@U A
@x1
= 1 < 0;
@mB
@x1
= ( U A ) < 0;
@
@x1
= <0
@
Thus, if the e¤ect of the deadline is more severe over the cake under division (lower
), it is a source of bargaining power for A, but a source of weakness for B. This
phenomenon comes from the fact that the alternative scenario under agreement 1.1 is
a potential agreement at t = 2 in which B plays the role of proposer, and thus, the
horizon of a smaller surplus in the second period makes him a softer negotiator in the
…rst period.
This alternative scenario also explains why the outside option is a source of bargaining
power for A. Moreover, since B has a pivotal position in the game, he enjoys from a
bargaining advantage coming from a larger inside option and a lower impatience rate
(larger ).
Agreement 2.1 (agreement without delay)
@x1
= < 0;
@U B
@x1
= 1 < 0;
@mB
@x1
= U B < 0;
@
Then, the outside option is a source of bargaining power for B: This property comes
from the fact that agreement 2.1 has a disagreement at t = 2 as an alternative scenario,
and thus, it is an outcome similar to that stemming from a one-shot UG.
Moreover, since B plays a pivotal role in the game, he enjoys a bargaining strength
from a larger inside option and a lower impatience rate.
19. OCG with positive externalities. Two parties, A (o¤erer, she) and B (counterof-
ferer, he), want to split a cake of size 1. The negotiation mechanism is a potentially
At t = 1, party A makes a sharing o¤er, (x1 ; 1 x1 ), so that if there is an agreement, x1
is the portion gotten by this player, and 1 x1 the portion of her counterpart. Party B
fraction of the cake. If he rejects it, negotiation moves to a second stage.
At t = 2, party B makes a sharing countero¤er (x2 ; 1 x2 ); so that if there is an
agreement, 1 x2 is the portion this player gets and x2 is the portion obtained by his
51
Let WA and WB be the wealth level received by players A and B, respectively, in case
of agreement or disagreement. Then, their utility functions are given by
uA = WA
uB = WB + WA
where 2 (0; 1) is player B’s marginal utility because of a positive externality coming
from a sentiment like compassion or generosity.
Assume that A and B share the same discount factor 2 (0; 1).
In order to compute outside options, assume that the wealth received in case of a per-
manent disagreement is VA 2 (0; 21 ) for player A and VB 2 (0; 21 ) for player B.

(b) Find the SPE of this game and characterize all the outcomes of this negotiation process.
(c) Discuss the role played by the positive externality in this bargaining model.
SOLUTION
(a) Insert Figure 19
(b) Because this is a sequential game, we adopt the SPE as equilibrium notion. Conse-
Period t = 2.
x2 VA ,
max1 x2 + x 2
x2
subject to
0 x2 1 (123)
1 x2 + x2 VB + VA (124)
x2 VA ; (125)
min(1 )x2
x2
subject to
1 VB VA
VA x2 min ;1 (126)
1
52
Notice that the interval (126) is always nonempty because
(i) VA < 1=2 by assumption, and
(ii)
1 VB VA
VA
1
()
VA + VB 1;
which is true since VA ; VB < 12 .

The above problem has then a corner solution from below; hence, the optimal strategy for
B is x2 = VA . That countero¤er would be accepted by player A, and thereby, it would be
always a potential agreement in t = 2.
Period t = 1.
1 x1 + x 1 (1 x2 + x 2 )
()
1 (1 VA + VA ) x1 (1 )
()
1
x1 + VA x1 ;
1
and rejects it otherwise. On his part, player A chooses x1 solving
maxx1
x1
subject to
0 x1 1 (127)
x1 x2 (128)
x1 x1 ; (129)
where (127) is a feasibility constraint, (128) is a participation constraint for the o¤erer and
(129) represents the agreement condition in the …rst-period negotiation. After substituting
x2 = VA , since ; VA > 0 the above problem is equivalent to
maxx1
x1
subject to
VA x1 min fx1 ; 1g (130)
Note that interval (130) is always nonempty because

(i) VA < 1 since by assumption ; VA < 1, and
53
(ii)
V A x1
,
1
VA + VA
1
,
1
0;
1
since ; < 1 by assumption. The previous program has therefore a corner solution from
above such that
x1 = min fx1 ; 1g :
Notice that
x1 1
,
1
+ VA 1
1
,
VA
1 VA
where the model’s assumptions guarantee that 2 (0; 1).

Therefore, the optimal strategy for A can be written as
x1 if
x1 =
1 if >
Since this o¤er is accepted by B no matter what of the two values x1 takes, there is a unique
agreement reached at t = 1 (no delay) that implies a sharing rule (x1 ; 1 x1 ).
(c) The compassion level is a source of bargaining weakness for player B because
@x1 1
= > 0.
@ (1 )2
This a very intuitive result because it means that if player B is more generous or
compassionate, he is more willing to sacri…ce in favor of player A and concede a larger
fraction to his counterpart.
20. UG with inequity aversion. (40 points). Two players, A (proposer, she) and B
(responder, he), want to split a surplus of size 1 following the rules of the ultimatum
game. If the proposal made by A is accepted by B, their payo¤s are represented by
uA = x;
uB = (1 x) jx (1 x)j
54
where 2 (0; 1), 6= 1=2, represents a coe¢ cient of inequity aversion and j::j represents
the absolute value operator.5 Otherwise, there is a disagreement, case in which each
player receives his/her outside option which are normalized to zero.
(a) Represent this game using a decision tree (10 points)
(b) Find the SPE of this bargaining situation and characterize all their possible negotiation
outcomes. Compute the equilibrium payo¤s (uA ; uB ) in each case (20 points)
(c) Discuss the role played by the parameter in the bargaining outcomes of this model.
(10 points)
SOLUTION
(a) See Figure 20.
(b) By applying backward induction, we begin with the second subgame. In this stage,
player B accepts player A’s o¤er if
(1 x) jx (1 x)j 0 (131)
,
jx (1 x)j 1 x
,
1 x 1 x
2x 1
and rejects it otherwise. From the r.h.s. of (131), we obtain the following condition:
1+
x : (132)
1+2
In turn, from the l.h.s. of (131), we obtain the following conditions:
1 1
x 1 2
if < 2
1 1 (133)
x 1 2
if > 2
Then, to solve the …rst subgame we have to consider two cases: (i) < 21 , and (ii)
> 21 .
Case 1: < 12 . In the …rst subgame, player A must choose x that solves
maxx
x
subject to
0 x 1 (134)
x 0 (135)
1+
x (136)
1+2
1
x (137)
1 2
5
Recall that
jxj a () a x a:
55
where (134) is the feasibility constraint, (135) is the participation constraint of player A,
and (136) and (137) represent the two agreement conditions above derived.
Notice that (136) implies the r.h.s. of (134) since > 0. Also, it is possible to show that
(136) implies (137) since 2 > 0. Thus, the previous program is equivalent to
maxx
x
subject to
1+
0 x : (138)
1+2
Notice that the interval for x de…ned by constraint (138) is nonempty since > 0. Therefore,
there is a corner solution given by
1+
x = : (139)
1+2
The equilibrium of this game is characterized by the following set:
1+
1+ accepts if x 1+2
= x = ; B :
1+2 rejects otherwise
Thus, there exists a unique equilibrium, and thereby, a unique agreement. Since x > 1=2,
the equilibrium payo¤s are given by:
1+
(uA ; uB ) = ;0 :
1+2
Case 2: > 21 . In the …rst subgame, player A must choose x that solves
maxx
x
subject to
0 x 1 (140)
x 0 (141)
1+
x (142)
1+2
1
x (143)
1 2
and (142) and (143) represent the two agreement conditions above derived.
Notice that (142) implies the r.h.s. of (140) since > 0. Also, since 2 (1=2; 1); (141)
implies (143). Thus, the previous program is equivalent to
maxx
x
subject to
1+
0 x : (144)
1+2
56
Notice that the interval for x de…ned by constraint (144) is nonempty since > 0. Therefore,
there is a corner solution given by
1+
x = :
1+2
The equilibrium of this game is characterized by the following set:
1+
1+ accepts if x 1+2
= x = ; B :
1+2 rejects otherwise
Thus, there exists a unique equilibrium, and thereby, a unique agreement. Since x > 1=2,
the equilibrium payo¤s are given by:
1+
(uA ; uB ) = ;0 :
1+2
(c) From (139) we get
@x 1
= < 0:
@ (2 + 1)2
Thus, the inequity aversion is a source of bargaining power for the responder in the
UG. This is true because when the responder is inequity-averse, he is more willing to
reject a proposer’s o¤er seen as too inequitable. That is, his threat to reject becomes
more credible.
21. OCG, asymmetric risk aversion & deadline (50 points). Two parties, A (o¤erer,
she) and B (countero¤erer, he), want to split a cake of an initial size equal to . The
respective fraction of the cake. If he rejects it, the negotiation moves to a second stage.
In the latter case, the cake under division decreases to a size (with 0 < < 1).
A and B share the same discount factor 2 (0; 1). Outside options are risky such that,
in case of disagreement, player i receives a wealth W1 > 0 with probability p > 0 and
zero wealth with the remaining probability for i = A; B.
Assume that whereas player A is risk neutral, player B is risk averse. Speci…cally, B’s
utility function is, in case of agreement or disagreement, given by
u(W ) = W 1 ;
where W represents wealth and 2 (0; 1) is a parameter measuring the risk aversion
degree.
Finally, assume that
1
pW1 + p 1 W1 : (A2)
57
erate. (30 points)
(c) Based on your answer in part (b), discuss the role of parameters , and as sources
of bargaining power in the agreement(s) found in this game. (10 points)
SOLUTION
Period t = 2.
x2 pW1 ,

max( x2 )1
x2
subject to
0 x2 (145)
( x2 ) 1
pW11 (146)
x2 pW1 ; (147)
max( x2 )1
x2
subject to
1
pW1 x2 p 1 W1 (148)
The derivative of the objective function with respect to x2 is
(1 )( x2 ) 0
because x2 < by the r.h.s. of (148). Thus, the solution candidate is a corner solution
from below. Note that the interval for x2 described by (148) is nonempty since
1
pW1 p 1 W1
,
1
pW1 + p 1 W1 ; (149)
58
which is true by assumption (A2). Thus, the optimal strategy for B is x2 = pW1 , which
would be aceepted for A. The outcome of the second-period negotiation is therefore a
potential agreement.
Period t = 1.
( x1 )1 ( x2 )1
()
1
x1 1 ( x2 )
()
1
x1 1 ( pW1 ) x1 ;
maxx1
x1
s:t:
0 x1 (150)
x1 x2 (151)
x1 x1 (152)
After substituting x2 = pW1 , from (151) we obtain that
x1 pW1 > 0: (153)
Thus, (151) implies the l.h.s. of (150), and thereby, we can omit the last constraint from
the problem. Moreover, notice that x1 < since under assumption (A2), pW1 < . Thus,
(152) implies the r.h.s. of (150), and thereby, we can also omit the last constraint from the
problem.
maxx1
x1
s:t:
pW1 x1 x1 (154)
as (154) is nonempty. That is, if
1
pW1 x1 = 1 ( pW1 )
,
1 1
pW1 1 (1 1 ) ; (155)
1
which is true because assumption (A2) implies that pW1 < ; and also because 1 <
1
1 1 as ; < 1.
59
Thus, the optimal strategy for A is x1 = x1 ; and hence, there is an agreement at t = 1 (no
delay). That agreement implies a sharing rule given by (x1 ; x1 ) = (x1 ; x1 ).
(c) (i) Patience is a source of bargaining power for player B since
@x1 1
= ( pW1 ) < 0
@ 1 ( 1)
Since B has a pivotal position in the game, he enjoys from a bargaining advantage
coming from a lower impatience rate (larger ) because he will be more willing to
reject a low o¤er in the …rst period and wait for a larger payo¤ from a potential
agreement in the second period.
(ii) The severity of the deadline is a source of bargaining power for player A and a source of
bargaining weakness for player B because
@x1
= 1 < 0:
@ 1
Thus, if the e¤ect of the deadline is more severe over the cake under division (lower ), it
is a source of bargaining power for A, but a source of weakness for B. This phenomenon
comes from the fact that the alternative scenario for a …rst-period agreement is a potential
agreement at t = 2 in which B plays the role of proposer, and thus, the horizon of a smaller
surplus in the second period makes him a softer negotiator in the …rst period.
(iii) Risk aversion is a source of bargaining weakness for player B since
@x1 1 ln
= ( pW1 ) > 0
1)2
1
@ 1 (
because ln < 0 as < 1:

If player B is more risk averse, he will be more willing to accept a lower fraction of the cake
obtained with certainty in case of agreement rather than a higher but risky outside option
in case of disagreement.
22. OCG with symmetric positive externalities (50 points). Two parties, A (o¤erer,
she) and B (countero¤erer, he), want to split a cake of size 1. The negotiation mech-
anism is a potentially two-stage process with the following schedule.
is the portion gotten by this player, and 1 x1 the portion of her counterpart. Party B
agreement, 1 x2 is the portion this player gets and x2 is the portion obtained by his
60
uA = WA + A WB
uB = WB + B WA
where i 2 (0; 1) is player i’s marginal utility because of a positive externality coming
from a sense of altruism for i = A; B:
Assume that A and B share the same discount factor 2 (0; 1).
In order to compute outside options, assume that the wealth received in case of a
permanent disagreement is VA 2 (0; 12 ) for player A and VB 2 (0; 12 ) for player B.
VA
A : (A1)
1 VB
(30 points)
(c) Discuss the role played by the positive externality in this bargaining model. (10 points)
SOLUTION

Period t = 2.
x2 + A (1 x2 ) VA + A VB
,
VA A (1 VB )
x2 ,
1 A

max1 x2 + B x2
x2
subject to
0 x2 1 (156)
1 x2 + B x2 VB + B VA (157)
VA A (1 VB )
x2 ; (158)
1 A
and (158) represents the agreement condition in the second-period negotiation. Assumption
61
(A1) ensures that (158) is a su¢ cient condition for the l.h.s. of (156). This problem is then
equivalent to the following program:
min(1 B )x2
x2
subject to
VA A (1 VB ) 1 VB B VA
x2 min ;1 (159)
1 A 1 B

(i)
VA A (1 VB )
1
1 A
()
VA + A VB 1;
1
which is true since VA ; VB < 2
and A < 1.
(ii)
VA A (1 VB ) 1 VB B VA
1 A 1 B
()
VA + VB 1;
B is
VA A (1 VB )
x2 = :
1 A
That countero¤er would be accepted by player A, and thereby, it would be always a potential
agreement in t = 2.
Period t = 1.
1 x1 + B x1 (1 x2 + B x2 )
()
VA A (1 VB )
1 1 (1 B) x1 (1 B)
1 A
()
1 VA A (1 VB )
+ x1 x1 ;
1 B 1 A
maxx1 + A (1 x1 )
x1
subject to
0 x1 1 (160)
x1 + A (1 x1 ) (x2 + A (1 x2 )) (161)
x1 x1 ; (162)
62
x2 = VA 1A (1A VB ) , from (161) we obtain:
(VA + A VB ) A
x1 0;
1 A
where the last inequality follows because it is equivalent to

VA
A ;
1 VB
which is true by assumption (A1). Thus, (PC) is a su¢ cient condition for the l.h.s. of (FC).
The previous program becomes then equivalent to
max(1 A )x1
x1
subject to
(VA + A VB ) A
x1 min fx1 ; 1g (163)
1 A
Interval (163) is always nonempty because its r.h.s. is larger than its l.h.s:
(i)
(VA + A VB ) A
x1
1 A
,
1 A
(1 ) + 0;
1 B 1 A
which is true since ; A; B < 1.

(ii)
(VA + A VB ) A
1
1 A
,
(VA + A VB ) 1;
which is true since by assumption ; A < 1 and VA ; VB < 1=2:

The previous program has therefore a corner solution from above such that
x1 = min fx1 ; 1g :
Therefore, the optimal strategy for A can be written as
x1 if min fx1 ; 1g = x1
x1 =
1 if min fx1 ; 1g = 1
Since this o¤er is accepted by B no matter what of the two values x1 takes, there is a unique
agreement reached at t = 1 (no delay) that implies a sharing rule (x1 ; 1 x1 ).
63
(c) The own altruism level i is a source of bargaining weakness for player i because
@x1
= (VA + VB 1) < 0,
@ A ( A 1)2
and the rival’s altruism level j is a source of bargaining strength for player i because
@x1 1
= > 0:
@ B ( B 1)2
his a very intuitive result because it means that if a player is more altruistic or generous,
she/he is more willing to sacri…ce in favor of her/his rival and to concede a larger
fraction to her/his counterpart.
23. UG with generalized inequity aversion. (40 points). Two players, A (proposer,
she) and B (responder, he), want to split a surplus of size 1 following the rules of
the ultimatum game. If the proposal made by A is accepted by B, their payo¤s are
represented by
uA = x Ajx (1 x)j
uB = (1 x) B jx (1 x)j
where A and B represent coe¢ cients of inequity aversion and j::j represents the
absolute value operator, with A 2 (1=2; 1) and B 2 (0; 1=2).6 Otherwise, there is
a disagreement, case in which each player receives his/her outside option which are
normalized to zero.
outcomes. (30 points)
SOLUTION
player B accepts player A’s o¤er if
(1 x) jx (1 x)j 0
B (164)
,
B jx (1 x)j 1 x
,
1 x 1 x
2x 1 (165)
B B
6
Recall that
jxj a () a x a:
64
and rejects it otherwise. From the r.h.s. of (165), we obtain the following condition:
1+ B
x : (166)
1+2 B
In turn, from the l.h.s. of (165), we obtain the following condition
1 B
x : (167)
1 2 B
maxx A j2x 1j
x
subject to
0 x 1 (168)
x A j2x 1j 0 (169)
1+ B
x (170)
1+2 B
1 B
x (171)
1 2 B
where (168) is the feasibility constraint, (169) is the participation constraint of player
A, and (170) and (171) represent the two agreement conditions above derived.
Notice that (170) implies the r.h.s. of (168) since B > 0. Also, it is possible to show that
(170) implies (171) since 2 B > 0. Thus, the previous program is equivalent to
maxx A j2x 1j
x
subject to
x 0 (172)
x A j2x 1j 0 (173)
1+ B
x : (174)
1+2 B
The value taken by the objective function depends on the sign of the term inside the brackets.
That is: 8
< x(1 2 A ) + A if x > 1=2
uA = x if x = 1=2
:
x(1 + 2 A ) A if x < 1=2
We have thus two possible equilibrium candidates depending on the value of x.

Case 1: x 1=2 . Player A must solve7
7
Recall that A > 1=2 by assumption.
65
maxx(1 2 A) + A
x
subject to
1
x (175)
2
A
x (176)
2 A 1
1+ B
x : (177)
1+2 B
Notice that
A 1+ B
2 A 1 1+2 B
,
1+ B A 0;
which is true because A < 1 and B > 0. The previous then problem becomes
maxx(1 2 A) + A
x
subject to
1 1+ B
x (178)
2 1+2 B
Notice that the interval for x de…ned by constraint (178) is nonempty since
1 1+ B
<
2 1+2 B
,
1 > 0:
Therefore, since A > 1=2, there is a corner solution from below given by
1
x = : (179)
2
The equilibrium candidate under this case is characterized by the following set:
1+ B
1 accepts if x 1+2
= x = ; B B :
2 rejects otherwise
Player A’s equilibrium payo¤ is given by:
uA = x (1 2 A ) + A
1
= (1 2 A ) + A
2
1
= :
2
66
Case 2: x < 1=2 . Player A must solve8
maxx(1 + 2 A) A
x
subject to
x 0 (180)
x(1 + 2 A ) A 0 (181)
1+ B
x (182)
1+2 B
1
x< : (183)
2
1 1+ B
Since A > 0 and 2
< 1+2 B
, it follows that this problem is equivalent to
maxx(1 + 2 A) A
x
subject to
A 1
x< : (184)
1+2 A 2
The last interval is nomempty because
A 1
<
1+2 A 2
()
1 > 0:
Therefore, there is a solution converging to a corner solution from above given by

1
x = "
2
with " ! 0. The equilibrium candidate under this case is characterized by the following set:
1+ B
1 accepts if x 1+2
= x = "; B B :
2 rejects otherwise
Player A’s equilibrium payo¤ is given by:
uA = x (1 + 2 A ) A
1
= " (1 + 2 A ) A
2
1
= (1 + 2 A )"
2
1
<
2
Finally, player A compares the payo¤ coming from each case:
8
Recall that A > 1=2 by assumption.
67
Case 1: uA = 21
Case 2: uA < 21
The SPE is therefore described by Case 1, which implies that at the equilibrium there is a
perfectly equitable sharing rule.
24. OCG, risk averse o¤erer & deadline (60 points). Two parties, A (o¤erer, she)
and B (countero¤erer, he), want to split a cake of an initial size equal to 1. The
in case of disagreement, player i receives a wealth W1 > 0 with probability p > 0 and
Assume that whereas player B is risk neutral, player A is risk averse. Speci…cally, A’s
u(W ) = W 1 ;
degree.
xA + xB > ; (A1)
where xi denotes the minimum fraction of the cake player i needs to accept an agree-
ment at t = 2.
erate. (30 points)
(c) Describe the role played by the parameters , and in the likelihood of a permanent
disagreement. Justify formally your answer and provide an economic intuition. (10
points)
(d) Based on your answer in part (b), identify and discuss the sources of bargaining
strength/weakness in the agreement(s) found in this game. (10 points)
SOLUTION
68
Period t = 2.
x12 pW11
,
1
x2 p1 W1 ,
max x2
x2
subject to
0 x2 (185)
x2 pW1 (186)
1
x2 p1 W1 ; (187)
minx2
x2
subject to
1
p1 W1 x2 pW1 (188)
Thus, the solution candidate is a corner solution from below. Notice however that the interval
for x2 described by (188) is empty since
1
p1 W1 > pW1
,
1
p1 W1 + pW1 >
,
xA + xB >
1
which is true by assumption (A1). Thus, the optimal strategy for B is x2 = p 1 W1 "
(with " > 0), which would be rejected by A. The outcome of the second-period negotiation
is therefore a potential disagreement.
Period t = 1.
1 x1 pW1
()
x1 1 pW1 x1 ;
69
maxx11
x1
s:t:
0 x1 1 (189)
1
x1 pW11 (190)
x 1 x1 (191)
From (190) we obtain
1 1
x1 1 p 1 W1 > 0 (192)
given that by assumption ; p; W1 > 0. Thus, (190) implies the l.h.s. of (189), and thereby,
we can omit the last constraint from the problem. Moreover, notice that since x1 < 1,
condition (191) implies the r.h.s. of (189), and thereby, we can also omit the last constraint
from the program to be solved.
maxx11
x1
s:t:
1 1
1 p1 W1 x1 x1 (193)
(1 )x1 > 0
1 1
because x1 1 p 1 W1 by the l.h.s. of (193) and < 1. Thus, the solution candidate is
a corner solution from above, but only as long as (193) is nonempty. That is, if
1 1
1 p1 W1 x1 = 1 pW1
,
1 1
1 p1 W1 + pW1 1; (194)
which can be true or not according to the assumptions of the model. Thus, the optimal
strategy for A is described by
x1 if (194) holds true

x1 =
x1 + " otherwise
with " > 0. Therefore, this game has two possible negotiation outcomes:
1. If (194) is veri…ed, there will be an agreement without delay characterized by the sharing
rule (x1 ; 1 x1 ) = (x1 ; 1 x1 ):
2. If (194) is not veri…ed, there will be a permanent disagreement (disagreement in both
periods) and players will receive at t = 2 their outside options: (pW11 ; pW1 ):
70
(c) The condition for a permanent disagreement is given by
1
1 < ( p) 1 W1 + pW1 : (195)
Then, a permanent disagreement is more likely if:
(i) Player are less impatient. In that case increases, which implies that the r.h.s. of (195)
increases. This property highlights the idea that impatience is a friction that facilitates to
reach an agreement because it makes haggling more costly.
(ii) Parameter plays no role on the likelihood of a permanent disagreement..
(iii) Player A is less risk averse. If decreases then 1 1 decreases as well. Since 1 1 > 1
1
and p < 1, this implies that ( p) 1 increases and, thereby, the r.h.s. of (195) increases.
The intuition of this result is that when player A becomes less risk averse, he is more willing
to prefer a risky outside option rather than a fraction of the cake obtained with certainty
thanks to an agreement.
(d) (i) First-proposer advantage: Since the alternative scenario for the agreement at t = 1
is a disagreement at t = 2, the game resembles a one-shot ultimatum game. Thus,
the proposal power for player A constitutes a source of bargaining power for her.
Consequently, A obtains all the surplus under division once B receives the present
value of his outside option.
(ii) First-responder’s patience: It is a source of bargaining power for player B since

@x1
= pW1 < 0
@
Given that B has a pivotal position in the game, he enjoys from a bargaining advantage
coming from a lower impatience rate (larger ) because he will be more willing to reject a
low o¤er in the …rst period and wait for a larger payo¤ in the second period.
(iii) Since the agreement comes from a kind of one-shot ultimatum game, the …rst-responder’s
outside option constitute a source of bargaining power for player B:
@x1
= W1 < 0
@p
@x1
= p<0
@W1
25. OCG, altruistic o¤erer & inside options (50 points). Two parties, A (o¤erer, she)
and B (countero¤erer, he), want to split a cake of size . The negotiation mechanism
is a potentially two-stage process with the following schedule.
is the portion gotten by this player, and x1 the portion of her counterpart. Party B
fraction of the cake. If he rejects it, each party receives in the …rst period his/her
agreement, x2 is the portion this player gets and x2 is the portion obtained by his
71
uA = WA + A WB
uB = WB
where A 2 (0; 1) is player A’s marginal utility because of a positive externality coming
from a sentiment of altruism:
Assume that A and B are fully patient and thus share the same discount factor = 1.
In order to compute outside options, assume that the wealth received in case of a
permanent disagreement is Vi 2 (0; 2 ) for player i = A; B. Inside option to player A is
mA = 0 and to player B is given by mB 2 (0; ).
VA
A : (A2)
VB
(30 points)
(c) Discuss the role played by the positive externality in this bargaining model. (10 points)
SOLUTION
Period t = 2.
x2 + A( x2 ) VA + A VB
,
VA A( VB )
x2 ,
1 A

max x2
x2
subject to
0 x2 (196)
x2 V B (197)
VA A( VB )
x2 ; (198)
1 A
72
and (282) represents the agreement condition in the second-period negotiation. Assumption
(A2) ensures that (282) is a su¢ cient condition for the l.h.s. of (280). Also, VB > 0
guarantees that (281) is a su¢ cient condition for the r.h.s. of (280). This problem is thus
equivalent to the following program:
minx2
x2
subject to
VA A( VB )
x2 VB (199)
1 A
VA A( VB )
VB
1 A
()
VA + VB ;

B is
VA A( VB )
x2 = :
1 A
agreement in t = 2.
Period t = 1.
x1 mB + ( x2 )
()
VA A( VB )
mB x1
1 A
()
VA A( VB )
x1 mB x1 ;
1 A
maxx1 + A( x1 )
x1
subject to
0 x1 (200)
x1 + A( x1 ) x2 + A( x2 ) (201)
x1 x1 ; (202)
73
VA A( VB )
x2 = 1 A
, from (285) we obtain:
VA + A VB A
x1 0;
1 A
where the last inequality follows because it is equivalent to

VA
A ;
VB
which is true according to assumption (A2). Thus, (PC) is a su¢ cient condition for the l.h.s.
of (FC). The previous program becomes then equivalent to
max(1 A )x1
x1
subject to
VA + A VB A
x1 min fx1 ; g (203)
1 A
Interval (203) is empty or nonempty depending on what is its upper bound. In fact, we have:
(i)
VA + A VB A
x1 <
1 A
,
(1 A )mB > 0; (204)
which is true because A < 1 and mB > 0. Thus, interval (203) is empty.
(ii)
VA + A VB A
1 A
,
VA + A VB ;
which is true since by assumption A < 1 and VA ; VB < =2: Thus, interval (203) is nonempty.
We have thus two cases:
Case 1. x1 . The optimal strategy for A is x1 = x1 + " with " > 0.
Case 2. < x1 . The previous program has a corner solution from above and the optimal
strategy for A is x1 = :
Therefore, there are two possible bargaining outcomes:
1. Agreement with delay. This outcome emerges if
(VA + A VB )
mB :
1 A
The sharing rule is (x2 ; x2 ).

2. Agreement without delay. This outcome emerges if
(VA + A VB )
mB > :
1 A
The sharing rule is ( ; 0).
74
(c) The altruism level A is a source of bargaining weakness for player A only in the
agreement with delay. In fact, it is veri…ed that
@x2 1
= (VA + VB ) < 0.
@ A ( A 1)2
This a very intuitive result because it means that if player A is more altruistic or
generous, she is more willing to sacri…ce herself in favor of her rival and to concede a
larger fraction to her counterpart.
26. UG & waste negotiation. (40 points). Two …rms, A (proposer, she) and B (re-
sponder, he), must decide whether to participate or not in a joint venture. This joint
venture involves a productive process that generates two outputs: pro…ts equal to
> 0 and industrial waste equal to > 0 (both outputs are expressed in the same
monetary units). In case that the joint venture takes place, pro…ts will be distributed
…fty-…fty between the …rms. However, the distribution of waste between the …rms is
yet unresolved. This dispute is relevant because the decision to participate or not in
the joint venture depends on whether the …rms are able to attain an agreement on that
issue. The bargaining procedure to distribute the industrial waste adopts the rules of
an ultimatum game. If the proposal x 2 [0; ] made by A is accepted by B, there is
an agreement and their payo¤s are given, respectively, by
1
uA = + ;
2 x
1
uB = + :
2 x
Otherwise, there is a disagreement, case in which the joint venture fails and …rm i
receives its outside option U i > 1 + 2 for all i = A; B.
(c) Compute the equilibrium payo¤ of the two …rms (10 points)
SOLUTION
…rm B accepts …rm A’s o¤er if
1
+ UB (205)
2 x
,
2
x
2U B
75
1
max +
x 2 x
subject to
0 x (206)
1
+ UA (207)
2 x
2
x (208)
2U B
and (208) represents the agreement condition above derived.
Notice that (208) implies the l.h.s. of (206) since
2
> 0
2U B
,
1
UB > + ;
2
which is true by assumption. In addition, from (207) we obtain
1
+ UA
2 x
,
2
x ;
2U A
where
2
<
2U A
,
1
UA > + ;
2
which is true by assumption. Thus, (207) implies the r.h.s. of (206).
Therefore, the previous program is equivalent to
1
max +
x 2 x
subject to
2 2
x (209)
2U B 2U A
2 2
2U B 2U A
,
2 2
+ (210)
2U A 2U B
76
Since the objective function is decreasing in x, we have two cases.
Case 1: Condition (210) is satis…ed. There is a unique agreement. The above problem has
a corner solution from below given by
2
x = : (211)
2U B
The SPE under this case is characterized by the following set:
2
2 accepts if x 2U B
= x = ; B :
2U B rejects otherwise
Case 2: Condition (210) is not satis…ed. There is a disagreement and the SPE is described
by the set
2
2 accepts if x 2U B
= x = "; B ;
2U B rejects otherwise
with " > 0.
(c) Case 1. Firm A’s equilibrium payo¤ is given by:

1
uA = +
2 x
1
= + 2
2 2U B
2U B
= + > U A;
2 2 UB + 2
where the last inequality is true under Case 1. Firm B’s equilibrium payo¤ is given
by:
1
uB = +
2 x
2U B
= +
2 2
= UB
Case 2. Firms receive their outside options (U A ; U B ):
27. OCG, risk averse countero¤erer & growing surplus (60 points). Two parties,
A (o¤erer, she) and B (countero¤erer, he), want to split a cake of an initial size equal
to 1. The negotiation mechanism is a potentially two-stage process with the following
schedule.
In the latter case, the cake under division increases to a size > 1.
77
The discount factors of player i is i 2 (0; 1) with i = A; B. Outside options are risky
such that, in case of disagreement, player i receives a wealth Wi > 0 with probability
p > 0 and zero wealth with the remaining probability for i = A; B. More speci…cally,
assume that WA = 52 and WB = 51 .
Assume also that whereas player A is risk neutral, player B is risk averse. Speci…cally,
B’s utility function is, in case of agreement or disagreement, given by
u(W ) = W 1 ;
degree.
erate. (30 points)
(c) Describe the role played by the parameters ’s, and in the likelihood of a delay in
the agreement. Justify formally your answer and provide an economic intuition. (10
points)
(d) Based on your answer in part (b), discuss the role played by B and as sources of
bargaining strength/weakness. (10 points)
SOLUTION
Period t = 2.
2
x2 p;
5
max ( x2 ) 1
x2
subject to
0 x2 (212)
1
1
( x2 )1 p (213)
5
2
x2 p; (214)
5
78
max ( x2 ) 1
x2
subject to
2 1 11
p x2 p (215)
5 5
Notice that h i
1
@ ( x2 )
= (1 )( x2 ) < 0
@x2
because < 1 and x2 < according to interval (215). Thus, the solution candidate is a
corner solution from below. Notice however that the interval for x2 described by (215) is
always nonempty since
2 1 11
p> p
5 5
,
2 1 1
p + p1 < ;
5 5
which is always true because ; p < 1 < ). Thus, the optimal strategy for B is x2 = 52 p,
which would be accepted by A. The outcome of the second-period negotiation is therefore a
potential agreement.
Period t = 1.
(1 x1 )1 B ( x2 )1
()
1
1 2
(1 x1 ) B p
5
()
1
1
2
x1 1 B p x1 ;
5
maxx1
x1
s:t:
0 x1 1 (216)
x1 A x2 (217)
x1 x1 (218)
79
From (217) we obtain
2
x1
Ap > 0 (219)
5
given that by assumption A ; p > 0. Thus, (217) implies the l.h.s. of (216), and thereby, we
can omit the last constraint from the problem. Moreover, notice that since x1 < 1, condition
program to be solved.
maxx1
x1
s:t:
2
Ap x1 x1 (220)
5
The solution candidate is thus a corner solution from above, but only as long as (220) is
nonempty. That is, if
2 1
1
2
Ap x1 = 1 B p
5 5
,
2 1
1
2
Ap + B p 1
5 5
,
1
1
2
B 1 + p(1 A) ; (221)
5
which can be true or not because, according to the assumptions of the model, it is veri…ed
that
>1
as
2 1
1
1 + p(1 A) > 1 > B :
5
Thus, the optimal strategy for A is described by
x1 if (221) holds true
x1 =
x1 + " otherwise
with " > 0. Therefore, this game has two possible negotiation outcomes:
1. If (221) is veri…ed, there will be an agreement without delay characterized by the sharing
rule (x1 ; 1 x1 ) = (x1 ; 1 x1 ):
2. If (221) is not veri…ed, there will be an agreement with delay (temporary disagreement)
characterized by the sharing rule (x2 ; x2 ) = ( 25 p; 2
5
p):
(c) The condition for an agreement with delay is given by

1
1
2
> B 1 + p(1 A) : (222)
5
Then, a permanent disagreement is more likely if:
80
(i) The gross growth rate of the cake is su¢ ciently high (i.e., > ). In that case, the
two players prefer wait for an agreement in t = 2 rather than an agreement in t = 1 because
the delayed agreement gives a higher wealth to each other. In fact:
For player A:
x2 > x1
()
2 1
1
2
p > 1 B p
5 5
()
1
1
2 1
1
e;
> B 1 p(1 B )
5
where the last inequality holds true because > e. Similarly, for player B:
x2 > 1 x1
()
2 1
1
2
p > 1 1+ B p
5 5
()
2
> p;
5
which is always true since > 1 and p < 1.
(ii) Players are less impatient. In that case either A or B or both increase, which implies
that the r.h.s. of (222) decreases. This property highlights the idea that impatience is a
friction that facilitates to reach an agreement without delay because it makes haggling more
costly.
(iii) Player B is less risk averse. If decreases then 1 1 decreases as well. Since 1 1 > 1
1
and B < 1, this implies that B 1 decreases and, thereby, the r.h.s. of (222) decreases. The
intuition of this result is that when player B becomes less risk averse, his marginal utility of
wealth increases. Thus, since player B always obtains a higher wealth in agreement at t = 2
than in the agreement at t = 2, this wealth gap becomes more valuable as long as B is less
risk averse.
(d) (i) The …rst-responder’s patience is a source of bargaining power for player B in the
negotiation of the agreement without delay since
@x1 1 1 2
= B p < 0:
@ B 1 5
Given that B has a pivotal position in the game, he enjoys from a bargaining advantage
coming from a lower impatience rate (larger B ) because he will be more willing to reject
a low o¤er in the …rst period and wait for a larger payo¤ in the second period.
(ii) The growth rate of the cake constitutes a source of bargaining power for player B in the
negotiation of the agreement without delay. In fact:
@x1 1
1
= B < 0:
@
81
This occurs because the alternative scenario is an agreement at t = 2 where player B can
obtain a higher wealth as long as is larger because
2
x2 = p:
5
28. OCG and asymmetric inside options (50 points). A songwriter called Billy the
Rebel (B, he) has self-produced a new album. He can sell independently the album
and remain as an ‘indie’ artist, or alternatively, he can sign a distribution contract
with the multinational Applerecords (A, she) and become a more ‘commercial’artist.
Under the umbrella of Applerecords, all the market is covered and the bene…ts from
total sales are estimated to be > 0.
The negotiation mechanism is a potentially two-stage process with the following sched-
ule.
At t = 1, there is a negotiation to distribute total bene…ts in which Applerecords
makes a sharing o¤er x1 . Billy can accept or reject that o¤er. If he accepts it, Applere-
cords receives x1 and Billy the remaining fraction of the total bene…ts. If Billy rejects
the o¤er, he sells independently his album receiving at the end of period t = 1 bene…ts
equal to with 2 (0; 1=2). In the latter case, negotiation moves to a second stage.
At t = 2, there is a negotiation to distribute the bene…ts from the yet uncovered
market equal to (1 ) . In that negotiation, Billy makes a sharing countero¤er x2
and Applerecords can accept or reject such a countero¤er. If she accepts it, Applere-
cords receives x2 and Billy the remaining fraction of the bene…ts under negotiation.
If Applerecords rejects the countero¤er, she receives nothing and Billy receives again
bene…ts of size coming from the independent distribution of his album.
Assume that the two players are risk neutral and share the same discount factor
2 (0; 1).
(b) Find the SPE of this game and characterize all the possible outcomes of this negotiation
process. (30 points)
(c) Discuss the role played by the parameter in this bargaining model. (10 points)
SOLUTION
Period t = 2.
x2 0;
which by feasibility will always be true.
82
max(1 ) x2
x2
subject to
0 x2 (1 ) (223)
(1 ) x2 (224)
x2 0; (225)
o¤erer and (273) represents the agreement condition in the second-period negotiation. From
(272) we obtain that
x2 (1 2 ) < (1 ) ;
and thus the r.h.s. of (271) becomes redundant. This problem is thus equivalent to the
following program:
minx2
x2
subject to
0 x2 (1 2 ) (226)
Notice that the interval (274) is always nonempty because < 1=2. The above problem has
then a corner solution from below; hence, the optimal strategy for B is
x2 = 0:
agreement in t = 2.
Period t = 1.
x1 + ((1 ) x2 )
()
x1 (1 ) (1 ) x1 ;
maxx1
x1
subject to
0 x1 (227)
x1 x2 (228)
x1 x1 ; (229)
83
x2 = 0, and since x1 < (because ; > 0), the previous program becomes then equivalent
to
maxx1
x1
subject to
0 x1 x1 : (230)
Interval (278) is always nonempty because x1 > 0 as ; < 1. The problem has then a
corner solution from above and the optimal strategy for A is x1 = x1 . Since this o¤er is
accepted by player B, the only bargaining outcome in equilibrium is an agreement without
delay.
(c) The parameter is a source of bargaining strength for player B since

@x1
= (1 ) < 0.
@
This a very intuitive result because it means that the higher the capacity of Billy to
sell independently his album, the better agreement he can obtain with the recording
company. Notice that can be thought of as how much known is already Billy in
limited circles as an indie artist and without the boost a marketing campaign can give
to his career. Technically, is related to both Billy’s inside option (at t = 1) and
outside option (at t = 2).
29. OCG & waste negotiation. (40 points). Two …rms, A (she) and B (he), must
decide whether to participate or not in a joint venture. This joint venture involves a
productive process that generates two outputs: pro…ts equal to = 2 and industrial
waste equal to = 1 (both outputs are expressed in the same monetary units). In
case that the joint venture takes place, pro…ts will be distributed …fty-…fty between
the …rms. However, the distribution of waste between the …rms is yet unresolved.
This dispute is relevant because the decision to participate or not in the joint venture
depends on whether the …rms are able to attain an agreement on that issue. The
bargaining procedure to distribute the industrial waste adopts the rules of the two-
period o¤er-countero¤er game in which A is the o¤erer and B is the countero¤erer.
If the proposal xt 2 [0; ] made by a …rm in period t = 1; 2 is accepted by his/her
counterpart, there is an agreement and their payo¤s are given by:
1
uA
t = + ;
2 xt
1
uB
t = + :
2 xt
Otherwise, there is a disagreement. If this disagreement takes place at t = 1, nego-
tiation moves to the second period. However, if this disagreement occurs at t = 2
the joint venture fails and …rm i receives his/her outside option U i = 3 for i = A; B.
Assume that the two …rms share the same discount factor 2 32 ; 1 .
84
(c) Compute the equilibrium payo¤ of the two …rms and indicate whether this payo¤ is
greater, smaller or equal to their outside options (10 points)
SOLUTION
(a) See Figure 29.
Period t = 2.
In this period, player A accepts B’s o¤er if and only if9
1
1+ 3
x2
,
1
x2 ;
2
1
max1 +
x2 1 x2
subject to
0 x2 1 (231)
1
1+ 3 (232)
1 x2
1
x2 ; (233)
2
1
max1 +
x2 1 x2
subject to
1 1
x2 (234)
2 2
Thus, the optimal strategy for B is x2 = 1=2. That countero¤er would be accepted by …rm
Period t = 1.
9
Recall that = 2, = 1, and U i = 3 for i = A; B.
85
In this stage player B accepts what player A o¤ers if10
1 1
1+ 1+
1 x1 1 x2
()
1
1+ 3
1 x1
()
3 2
x1 x1 ;
3 1
On his part, …rm A chooses x1 so that
1
max1 +
x1 x1
subject to
0 x1 1 (235)
1 1
1+ 1+ (236)
x1 x2
x 1 x1 (237)
where (235) is the feasibility constraint, (236) is the participation constraint of …rm A, and
(237) represents the agreement condition at t = 1 above derived.
Notice that (237) implies the l.h.s. of (235) since
x1 > 0
,
2
> ;
3
which is true by assumption. In addition, after substituting x2 = 1=2 from (236) we obtain
1
3 1
x1
,
1
x1 x1 ;
3 1
where
x1 < 1
,
2
> ;
3
which is true by assumption. Thus, (236) implies the r.h.s. of (235).
10
The sign of the inequality doesn’t change because > 3=2 by assumption.
86
Therefore, the previous program is equivalent to
1
max1 +
x1 x1
subject to
x1 x x1 : (238)
Interval (238) is nonempty because
3 2 1
3 1 3 1
,
1; (239)
which is true by assumption. Since the objective function is strictly decreasing in x1 , the
optimization problem has a corner solution from below given by
3 2
x1 = : (240)
3 1
This is the optimal strategy for …rm A, and thus, the unique equilibrium outcome of the
complete bargaining game is an agreement during period t = 1 (no delay). That agreement
implies a sharing rule (x1 ; 1 x1 ) = (x1 ; 1 x1 ).
(c) Firm A’s equilibrium payo¤ is given by:

1
uA = 1 +
x1
3 1
= 1+
3 2
6 3
= > 3 = U A;
3 2
where the last inequality is true because < 1. Firm B’s equilibrium payo¤ is given
by:
1
uB = 1 +
1 x1
= 3 < 3 = UB
where the last inequality is true because < 1.
30. Invasion, war, annexation, and bargaining. (60 points). Consider the following
model of a potentially two-stage bargaining process between two countries, Akraine
(A, she) and Brussia (B, he). Brussia has an historical aspiration for the sovereign of
the territory of Akraine, which can be thought of as a surplus of size > 0.
Peacekeeping negotiation. At t = 1, Akraine makes a sharing o¤er, (x1 ; x1 ), so
that if there is an agreement, x1 is the fraction of the territory that this player retains
under her control and sovereign, and x1 the fraction of the territory going to the
87
control of her counterpart by means of an annexation process. Brussia can accept or
reject that o¤er. If he accepts it, the annexation takes place and each country controls
his/her respective fraction of the territory. If Brussia rejects it, this country invades
militarily Akraine. This military operation unleashes a war, which produces in the …rst
period, costs (losses) of mA < 0 and mB < 0 to each country. In addition, negotiation
moves to a second stage.
Pacemaking negotiation. At t = 2, Brussia makes a sharing countero¤er (x2 ; x2 ); so
that if there is an agreement, x2 is the territory fraction this player gets and x2 is the
fraction retained by his opponent. Akraine can accept or reject such a countero¤er. If
she accepts it, each party retains or obtains the sovereign of his/her respective fraction
of the territory. If she rejects it, Brussia makes a …nal military o¤ensive which allows
him to get the sovereign of a fraction 2 (0; 1) of the territory under dispute.
Assume that countries A and B share the same discount factor 2 (0; 1). Both
players are risk-neutral with objective functions, if there exists an agreement in period
t, described by:
uA
t = xt
B
ut = xt :

generate. (30 points)
determining what type of agreement is attained in the negotiation process. (10 points)
(d) Based on your answer in part (b), discuss which are the sources of bargaining power/weakness
in this game. (10 points)
SOLUTIONS
Period t = 2.
x2 (1 ) ,
max x2
x2
subject to
0 x2 (241)
x2 (242)
x2 (1 ) ; (243)
88
2 (0; 1), this problem is equivalent to the following program:
minx2
x2
subject to
(1 ) x2 (1 ) (244)
This problem has a unique feasible solution, and thus, the optimal strategy for B is x2 =
(1 ) . That countero¤er would be accepted by player A, and thereby, it would be always
a potential agreement in t = 2. This implies that a scenario with a …nal military o¤ensive
can be ruled out as the potential pacemaking process would be always successful.
Period t = 1.
x1 mB + ( x2 )
()
x1 mB ( x2 )
()
x1 (1 ) mB x1 ;
maxx1
x1
subject to
0 x1 (245)
x1 m A + x 2 (246)
x1 x1 ; (247)
After substituting x2 = (1 ) , the previous problem is equivalent to
maxx1
x1
subject to
max f0; mA + (1 ) g x1 min fx1 ; g (248)
Interval (270) is always nonempty because

(i) x1 ; > 0,
(ii)
mA + (1 ) x1
()
mA + (1 ) (1 ) mB
()
mA + mB (1 ) ;
89
which is true because mA + mB < 0, < 1 and > 0.
(iii)
mA + (1 )
()
mA (1 (1 )) : (249)
which is true because mA + mB < 0, < 1, < 1 and > 0.
We have then to analyze two cases given by the condition:
x1
()
mB :
Case 1 (Annexation): mB . In this case, the optimal strategy for A is x1 = x1 ;

and there will be an agreement during period t = 1 (no delay). That agreement implies a
sharing rule (x1 ; x1 ) = (x1 ; x1 ).
Case 2 (No annexation): mB > . In this case, the optimal strategy for A is x1 = ,
and there will be an agreement during period t = 1 (no delay). That agreement implies a
sharing rule (x2 ; x2 ) = ( ; 0).
Since the two possible agreements are reached without delay, this model predicts that the
peacekeeping process will be always successful, and therefore, the war scenario will never
take place.
However, a process of annexation (i.e., Case 1 when x1 = x1 < ) will only occur as long as,
from the invader country’s standpoint, the losses from the invasion mB are lower (in absolute
value terms) than , i.e., the the present value of the fraction of the territory obtained
thanks to a potential agreement in the pacemaking process.
(c) The condition for an annexation process is given by

mB :
This condition suggests that the game will end with an annexation in t = 1 if the
military capacity of the invader is su¢ ciently high such that the potential agreement
reached at t = 2 o¤ers him (in present value terms) a bene…t larger than the invasion
costs mB .
Therefore, from the invader’s perspective, lower invasion costs, lower impatience, and
more powerful military capacity increase the probability of attaining an annexation
agreement.
(d) Annexation agreement
@x1
< 0;
@
@x1
< 0;
@
@x1
< 0:
@mB
90
Thus, on the one hand, the military capacity and the patience rate are sources of
bargaining power for the invader country. On the other hand, the invasion costs are a
source of bargaining weakness for the invader country: recall that mB < 0, and thus,
if losses are higher (i.e., mB decreases), x1 (the fraction going to the invaded country)
increases.
31. OCG, asymmetric risk aversion & deadline (50 points). Two parties, A (o¤erer,
she) and B (countero¤erer, he), want to split a cake of an initial size equal to . The
in case of disagreement, player i receives a wealth W > 0 with probability p > 0 and
Assume that whereas player A is risk neutral, player B is risk averse. Speci…cally, B’s
u(W ) = W 1 ;
degree.
1
pW + p 1 W : (A2)
erate. (30 points)
(c) Based on your answer in part (b), discuss the role of parameters , and as sources
of bargaining power in the agreement(s) found in this game.11 (10 points)
SOLUTIONS

11
Recall that
@af (y) @f (y)
= ln(a)af (y) .
@y @y
91
Period t = 2.
x2 pW ,
max( x2 )1
x2
subject to
0 x2 (250)
1 1
( x2 ) pW (251)
x2 pW ; (252)
max( x2 )1
x2
subject to
1
pW x2 p1 W (253)
(1 )( x2 ) 0
because x2 < by the r.h.s. of (253) and < 1. Thus, the solution candidate is a corner
solution from below. Note that the interval for x2 described by (253) is nonempty since
1
pW p1 W
,
1
pW + p 1 W ; (254)
which is true by assumption (A2). Thus, the optimal strategy for B is x2 = pW , which would
be accepted by A. The outcome of the second-period negotiation is therefore a potential
agreement.
Period t = 1.
( x1 )1 ( x2 ) 1
()
1
x1 1 ( x2 )
()
1
x1 1 ( pW ) x1 ;
92
maxx1
x1
s:t:
0 x1 (255)
x1 x2 (256)
x1 x1 (257)
After substituting x2 = pW , from (256) we obtain that
x1 pW > 0: (258)
Thus, (256) implies the l.h.s. of (255), and thereby, we can omit the last constraint from
the problem. Moreover, notice that x1 < since under assumption (A2), pW < . Thus,
problem.
maxx1
x1
s:t:
pW x1 x1 (259)
as (259) is nonempty. That is, if
1
pW x1 = 1 ( pW )
,
1 1
pW 1 (1 1 ) ; (260)
1
which is true because assumption (A2) implies that pW < ; and also because 1 <
1
1 1 as ; < 1.
Thus, the optimal strategy for A is x1 = x1 ; and hence, there is an agreement at t = 1 (no
delay). That agreement implies a sharing rule given by (x1 ; x1 ) = (x1 ; x1 ).
Therefore, the unique bargaining outcome of this game is an agreement without delay.
(c) (i) Patience is a source of bargaining power for player B since

@x1 1
= ( pW ) < 0
@ 1 ( 1)
Since B has a pivotal position in the game, he enjoys from a bargaining advantage
coming from a lower impatience rate (larger ) because he will be more willing to
reject a low o¤er in the …rst period and wait for a larger payo¤ from a potential
93
agreement in the second period.
(ii) The severity of the deadline is a source of bargaining power for player A and a
source of bargaining weakness for player B because
@x1
= 1 < 0:
@ 1
Thus, if the e¤ect of the deadline is more severe over the cake under division (lower ), it
is a source of bargaining power for A, but a source of weakness for B. This phenomenon
comes from the fact that the alternative scenario for a …rst-period agreement is a
potential agreement at t = 2 in which B plays the role of proposer, and thus, the
horizon of a smaller surplus in the second period makes him a softer negotiator in the
…rst period.
(iii) Risk aversion is a source of bargaining weakness for player B since
@x1 1 ln
= ( pW ) > 0
1)2
1
@ 1 (
because ln < 0 as < 1:

If player B is more risk averse, he will be more willing to accept a lower fraction of
the cake obtained with certainty in case of agreement rather than a higher but risky
outside option in case of disagreement.
32. UG & nonlinear externalities. (40 points). Two parties, A and B, want to divide
an asset resembling a cake of size 3. The negotiating mechanism is as follows. A makes
a sharing-rule o¤er, (x; 3 x); where x is the fraction going to A, and 3 x is the
fraction gotten by her counterpart in case of agreement. Player B can accept or reject
that o¤er. If he rejects, each player receives his/her outside option. Since the two
parties are greedy, their utility functions in case of agreement are given by:
uA = x (3 x)2
uB = (3 x) x2 :
Outside options are U A = 3 and U B = 1.
(a) Represent this game using a decision tree (10 points).
(b) Find the set of SPE of this game and identify the negotiation outcome(s) of this
bargaining model (20 points).12
(c) Compute the equilibrium payo¤ for each player (10 points).
SOLUTION
12
Recall that the roots of the quadratic equation ax2 + bx + c = 0 are given by the formula:
p
b b2 4ac
x= :
2a
94
(a) See Figure 32.
(b) Applying backward induction, we begin with the last subgame. In this subgame, player
B accepts player A’s o¤er i¤:
(3 x) x2 1,
In the …rst subgame, player A chooses x such that
maxx (3 x)2
x
subject to
0 x 3 (FC)
x (3 x)2 3 (PC)
2
(3 x) x 1: (AC)
(i) (PC) is equivalent to:

x2 7x + 6 0;
which, with equality, has roots given by
p
7 49 24
x= ;
2
that is,
1 x 6;
which, since o¤ers cannot be larger than the cake by the feasibility constraint, becomes
the following condition:
1 x 3 (261)
(ii) (AC) is equivalent to:
x2 + x 2 0;
which, with equality, has roots given by
p
1 1+8
x= ;
2
that is,
2 x 1;
which, since o¤ers cannot be negative by the feasibility constraint, becomes the follow-
ing condition:
0 x 1 (262)
The previous analysis implies that player A solves the program
max x2 + 7x 9
x
subject to
1 x 3 (C1)
0 x 1: (C2)
95
It is easy to see that the only value for x satisfying both conditions (C1) and (C2) is
1. Hence, x = 1. Thus, the SPE of the game is described by:
accepts if 3 x x2 1
= x = 1; B =
rejects otherwise
Therefore, the unique negotiation outcome of this model is an agreement characterized

by the sharing rule (x ; 3 x ) = (1; 2).
(c) The equilibrium payo¤s are given by
uA = x (3 x )2
= 1 (3 1)2
= 3
= UA
and
2
uB = (3 x ) x
= (3 1) 12
= 1
= U B:
Therefore, the agreement is such that each player obtains just his/her outside option.
33. OCG with loss aversion under suit threat. (40 points). Two high-tech …rms, A
(she) and B (he) face the following dispute. Today, …rm A has the exclusive property
rights of a new technology that will give her a surplus, in present value terms, equal to
> 0. Firm B claims that …rm A should share these property rights with him because
he simultaneously developed a similar technology. Accordingly, …rm B argues that
he also deserves to enjoy a part of the surplus . To resolve this dispute, they have
designed the following potentially two-stage procedure to bargain over this surplus.
At t = 1, …rm A makes a sharing o¤er, (x1 ; x1 ), so that if there is an agreement,
x1 is the surplus fraction that this player retains, and x1 the fraction obtained
by her counterpart. Firm B can accept or reject that o¤er. If he accepts it, there is
an agreement and each party receives his/her respective fraction of the surplus. If B
rejects it, the negotiation moves to a second stage.
At t = 2, …rm B makes a sharing countero¤er (x2 ; x2 ); so that if there is an
agreement, x2 is the surplus fraction this player gets and x2 is the fraction retained
by his opponent. Firm A can accept or reject such a countero¤er. If she accepts
it, there is an agreement and each party receives his/her respective fraction of the
surplus. If she rejects it, …rm B sues …rm A and a legal litigation takes place. In this
legal process, …rm B estimates that he can obtain a fraction 2 (0; 1) of the total
surplus under dispute.
Assume that …rms A and B share the same discount factor 2 (0; 1).
Players do not evaluate these utility functions in …nal wealth, but in gains and losses.
96
For example, in case of an agreement in period t, their objective functions are described
by:
uA
t = ( xt ) ;
and
uB
t = xt ;
where > 1 represents the degree of loss aversion of …rm A.
(b) Find the set of SPE and characterize the negotiation outcome(s) this negotiation
process can generate. (20 points)
(c) Based on your answer in part (b), discuss the role played by parameters , , and .
(10 points)
SOLUTION
Period t = 2.
( x2 ) , x2 (1 ) ,

max x2
x2
subject to
0 x2 (263)
x2 (264)
x2 (1 ) ; (265)
2 (0; 1), this problem is equivalent to the following program:
minx2
x2
subject to
(1 ) x2 (1 ) (266)
This problem has a unique feasible solution, and thus, the optimal strategy for B is x2 =
(1 ) . That countero¤er would be accepted by player A, and thereby, it would be always
97
a potential agreement in t = 2. This implies that a scenario with a legal litigation can be
ruled out as the potential second-stage negotiation would be always successful.
Period t = 1.
x1 ( x2 )
()
x1 ( x2 )
()
x1 (1 ) x1 ;
max ( x1 )
x1
subject to
0 x1 (267)
( x1 ) ( x2 ) (268)
x1 x1 ; (269)
Notice that x1 < because ; > 0, and thus, (AC) is a su¢ cient condition for the r.h.s. of
(FC). Moreover, after substituting x2 = (1 ) , we can check that since ; < 1, (PC) is
a su¢ cient condition for the l.h.s. of (FC). The previous problem is thus equivalent to
max x1
x1
subject to
(1 ) x1 x1 (270)
Given the de…nition of x1 , the only feasible solution of this problem is x1 = x1 . Therefore,
the unique negotiation outcome of this game is an agreement without delay characterized by
the sharing rule (x1 ; x1 ).
(c) Comparative statics:
@x1
< 0;
@
@x1
< 0:
@
Thus, the litigation capacity and the patience rate are sources of bargaining power for …rm
B. However, the loss aversion degree plays no role at all in the negotiation because x1 does
not depend on .
34. OCG, asymmetric inside options & risk aversion (Billy revisited) (50 points).
A songwriter called Billy the Rebel (B, he) has self-produced a new album. He can
98
sell independently the album and remain as an ‘indie’artist, or alternatively, he can
sign a distribution contract with the multinational Applerecords (A, she) and become
a ‘mainstream’ artist. Under the umbrella of Applerecords, the bene…ts from total
sales are estimated to be > 0.
The negotiation mechanism is a potentially two-stage process with the following sched-
ule.
At t = 1, there is a negotiation to distribute total bene…ts in which Applerecords
makes a sharing o¤er x1 . Billy has three options: accept, opt-out or di¤er. If he
accepts it, Applerecords receives x1 and Billy the remaining fraction of the total bene-
…ts. If Billy decides to opt-out, he accepts the o¤er made by other recording company
(Sonyrecords), which gives him in advance at t = 1 total bene…ts equal to V . If Billy
defers, he sells independently his album receiving at the end of period t = 1 bene…ts
equal to m1 < . In the latter case, negotiation moves to a second stage.
At t = 2, Billy makes a sharing countero¤er x2 and Applerecords can accept or reject
such a countero¤er. If she accepts it, Applerecords receives x2 and Billy the remaining
fraction of the bene…ts under negotiation. If Applerecords rejects the countero¤er, she
receives nothing and Billy receives bene…ts of size m2 < coming from the indepen-
dent distribution of his album at period t = 2.
In case of agreement or disagreement, preferences of players are represented by the
utility functions
uA (W ) = W
uB (W ) = W
where W represents wealth and ; 2 (0; 1). Assume that the two players share the
same discount factor 2 (0; 1) and that V < m1 .
(b) Find the SPE of this game and characterize all the possible outcome(s) of this negoti-
ation process. (30 points)
(c) Discuss the role played by the parameters m1 and m2 in this bargaining model. (10
points)
SOLUTION
Period t = 2.
x2 0 , x2 0;
which by feasibility will always be true.
99
max ( x2 )
x2
subject to
0 x2 (271)
( x2 ) m2 (272)
x2 0; (273)
o¤erer and (273) represents the agreement condition in the second-period negotiation. From
(272) we obtain that
x2 m2 < ;
and thus the r.h.s. of (271) becomes redundant. This problem is thus equivalent to the
following program:
max ( x2 )
x2
subject to
0 x2 m2 (274)
Notice that the interval (274) is always nonempty because m2 < by assumption. Since the
objective function is decreasing in x2 , the above problem has a corner solution from below;
hence, the optimal strategy for B is
x2 = 0:
agreement in t = 2.
Period t = 1.
In this stage player B compares the payo¤ coming from three alternatives:
(i) Opt-out: V
(ii) Accept: ( x1 )
(iii) Defer: m1 + ( x2 ) = m1 +
Since V < m1 by assumption, the strategy Opt-out is strictly dominated by the strategy
Defer. Thus, the …rst strategy will never be adopted by player B:
Then, player B accepts what player A o¤ers if
( x1 ) m1 +
()
1=
x1 m1 + x1 ;
and defers otherwise. On his part, player A chooses x1 solving
maxx1
x1
subject to
0 x1 (275)
x1 (x2 ) (276)
x1 x1 ; (277)
100
x2 = 0, and since x1 < (because m1 ; > 0), the previous program becomes then equivalent
to
maxx1
x1
subject to
0 x1 x1 : (278)
Interval (278) is nonempty i¤
x1 0
,
1=
m1 + 0
,
m1 (1 )1= m (279)
We have two cases:

Case 1. m1 m. The optimal strategy for A is x1 = x1 . There is an agreement at t = 1.
Case 2. m1 > m. The optimal strategy for A is x1 = x1 + "A . There is a disagreement at
t = 1.
Therefore, the bargaining game has two possible negotiation outcomes:
1. If m1 m, there is an agreement without delay characterized by the sharing rule
(x1 ; x1 ).
2. If m1 > m, there is an agreement with delay characterized by the sharing rule (0; ).
(c) Whereas parameter m2 plays no role at all in the outcomes of the model, parameter
m1 plays a dual role.
First, m1 in‡uences the possibility of reaching the agreement with or without delay. Accord-
ing to condition (279), the larger m1 , the more likely it is an agreement with delay. The
intuition of this result is that player B will be less tolerant with low o¤ers, and will prefer
to wait for an agreement at t = 2 where he is the proposer, as long as his inside option is
higher.
Second, parameter m1 represents a source of bargaining strength for player B in the agreement
without delay since
1
@x1 1
= m1 + m1 1 < 0.
@m1
This a very intuitive result because it means that the higher the capacity of Billy to sell
independently his album at t = 1, the better agreement he can obtain with the recording
company in the negotiation held in this period. Notice that m1 can be thought of as how
much known is already Billy in limited circles as an indie artist and without the boost a
marketing campaign can give to his career. Technically, m1 is the Billy’s inside option.
101
35. OCG with generalized agreement valuing (50 points). Two parties, A (o¤erer,
she) and B (countero¤erer, he), want to split a cake of size . The negotiation mech-
anism is a potentially two-stage process with the following schedule.
At t = 1, party A makes a sharing o¤er so that if there is an agreement, this player
gets a fraction x1 of the cake and her counterpart the remaining fraction. Party B
At t = 2, party B makes a sharing countero¤er so that if there is an agreement, his
counterpart gets x2 and he receives the remaining fraction of the cake under dispute.
Party A can accept or reject such a countero¤er. If she accepts it, each party receives
his/her respective fraction of the cake. If she rejects it, each party receives his/her
respective outside option.
Players are impatient with discount factors A ; B 2 (0; 1) and have the same outside
options such that U A = U B = 0.
In case of agreement at period t = 1; 2, the payo¤s of players are given by
utA = + xt ;
utB = +( xt );
where ; > 0.
(b) Find the SPE of this game and characterize the outcome(s) of this negotiation process.
(30 points)
(c) Find the equilibrium payo¤s for each possible negotiation outcome. (5 points)
(d) Discuss the role played by parameter . (5 points)
SOLUTION
Period t = 2.
+ x2 0 , x2 ,
max + x2
x2
subject to
0 x2 (280)
+ x2 0 (281)
x2 ; (282)
102
> 0, it is clear that the l.h.s. of (FC) implies (AC). Also, notice that (PC) generates an
upper bound such that x2 + , and thus, we conclude that the r.h.s. of (FC) implies
(PC) as > 0. As a result, the previous program becomes equivalent to
minx2
x2
subject to
0 x2 (283)
This problem has a corner solution from below, and hence, the optimal strategy for B is
x2 = 0. That countero¤er would be accepted by player A, and thereby, it would be always
a potential agreement in t = 2.
Period t = 1.
+ x1 B ( + x2 )
()
x1 (1 B )( + ) x1 ;
and rejects it otherwise. On her part, player A chooses x1 solving
max + x1
x1
subject to
0 x1 (284)
+ x1 A ( + x2 ) (285)
x1 x1 ; (286)
(286) represents the agreement condition in the …rst-period negotiation.
After substituting x2 = 0; from (PC) we get
x1 ( A 1):
Since A < 1 and > 0, it follows that the l.h.s. of (FC) is a su¢ cient condition for (PC).
Therefore, the above problem is equivalent to
maxx1
x1
subject to
0 x1 min fx1 ; g (287)
Interval (209) is always nonempty because x1 > 0 (as ; > 0 and B < 1) and > 0. We
thus have two possible corner solutions from above depending on the condition
x1
,
B
: (288)
1 B
103
Case 1: . The optimal strategy for A is x1 = x1 . There is an agreement without delay
(Type I agreement) characterized by the sharing rule (x1 ; 1 x1 ) = (x1 ; 1 x1 ).
Case 2: > . The optimal strategy for A is x1 = . There is an agreement without delay
(Type II agreement) characterized by the sharing rule (x1 ; 1 x1 ) = ( ; 0).
(c) Type I agreement. The equilibrium payo¤s are given by
uA = + x1 > 0 = U A
uB = + x1 > 0 = U B
Type II agreement. The equilibrium payo¤s are given by
uA = + > 0 = UA
uB = > 0 = UB
(d) Parameter plays a dual role in this bargaining model.
First, according to condition (288), when increases, it is more likely a very inequitable
agreement (Type II agreement) in which player A gets all the surplus under division.
Second, conditional on reaching a Type I agreement (more equitable), represents a source
of bargaining weakness for player B because
@x1
=1 B > 0:
@
The intuition of these two results is as follows. Parameter can be interpreted as the value
that B assigns to the fact of reaching an agreement irrespective of how much this player
obtains from this agreement (the reaching-agreement value). Then, when the reaching-
agreement value to B is larger (i.e., increases), he is more tolerant with low o¤ers made by
his counterpart. Player A anticipates this phenomenon, and as result, she becomes a tough
negotiator in the agreement reached in the …rst stage. In particular, when is too large
( > .), player A extracts all the surplus under division.
36. UG, risk aversion, and numerical regret. (40 points) Two parties, A (she) and
B (he), must split a cake of size 1. If W represents …nal wealth, the utility functions
of these two parties are given by
1
uA (W ) = W 1 W;
3
uB (W ) = W 1 ;
where 2 32 ; 1 and 2 (0; 1) are parameters related to the risk aversion degree
of A and B, respectively. In case of agreement, party A receives x 2 [0; 1] and her
counterpart receives 1 x. Otherwise, in case of disagreement, each party gets her/his
outside option. Outside option of player A is risky: with probability p 2 (0; 1) she
obtains a …nal wealth of 2, and with probability 1 p she gets zero …nal wealth. In
contrast, outside option of B is certain as this player obtains a zero …nal wealth with
probability 1:
104
The bargaining procedure is conducted in accordance with the ultimatum game in
which A plays the role of proposer and B the role of responder.
1
[3(1 )]1=
[3(1 )] 3
p 2
: (A1)
21 3
(a) Represent this game using a decision tree diagram (10 points).
(b) Characterize the set of equilibria (SPE), all the possible negotiation outcomes and the
pair of equilibrium shares if an agreement is reached (20 points).
(c) Indicate the equilibrium payo¤s in each possible negotiation outcome. (5 points)
(d) What is the role played by parameter ? (Hint: Once you …nd the equilibrium share
x , see what happens with this share if takes values 0:7, 0:8 and 0:9.) (5 points)
SOLUTION
(b) The equilibrium notion to be applied is the subgame perfect equilibrium (SPE). Con-
sequently, by backward induction, we begin with the stage in which player B accepts
player A’s o¤er if:
(1 x)1 0,x 1
In the …rst stage, player A chooses x so that:
1
maxx1 x
x 3
subject to
0 x 1 (FC)
1 2
x1 x p 21 (PC)
3 3
x 1 (AC)
It is clear that we can drop (AC) because redundancy. The …rst-order condition of the
unrestricted problem is
1
(1 )x = 0;
3
from wich we obtain the solution canditate
e = [3(1
x )]1=
Let us check that xe satis…es all the constraints of the problem.

First, notice that
e>0
x
105
as < 1, and
e<1
x
since > 2=3 by assumption, and therefore, x e satis…es (FC).
e into (PC) yields
Second, the substitution of x
1 [3(1 )]1= 2
[3(1 )] p 21
3 3
,
1
[3(1 )]1=
[3(1 )] 3
p 2
21 3
e satis…es (PC) as well. Therefore, there is an

which is true by assumption (A1), and thus x
e.
interior solution such that x = x
The SPE of the game is thus described by:
accepts if x 1
= x = [3(1 )]1= ; B =
rejects otherwise
Therefore, there a unique agreement in which the equilibrium shares are given by ([3(1 )]1= ; 1
[3(1 )]1= ).
(c) The equilibrium payo¤s are given by
1 1
uA = x x;
3
uB = (1 x )1 ;
which after substituting x generates the payo¤ combination13
1 [3(1 )]1=
UA = [3(1 )] ;
3
UB = (1 [3(1 )]1= )1 >0
(d) Parameter is related to the risk aversion degree of player A. Notice that by simple
inspection it is not possible to conclude that
@x
< 0;
@
because as increases, [3(1 )] (which is smaller than 1) decreases and 1= decreases.
1=
De…ne x g( ) = [3(1 )] .
Numerically, we obtain
g(0:7) = 0:860 26
g(0:8) = 0:528 07
g(0:9) = 0:262 44
13
Notice that in this UG model the responder obtains an equilibrium payo¤ that is larger than his outside
option, i.e., UB > 0 = UB .
106
This numercial analysis suggests that parameter represents a source of bargaining weak-
ness for player A, as this parameter is related to her level of risk aversion. Thus, when the
proposer is more risk averse, she will be willing to obtain a smaller but certain fraction of the
surplus in case of agreement rather than a larger but risky wealth in case of disagreement.14
37. OCG, impatience, and inside option. (50 points). Two parties, A (o¤erer, she)
and B (countero¤erer, he), want to split a surplus of size 1. The negotiation mecha-
nism is a potentially two-stage process with the following schedule.
is the fraction gotten by this player, and 1 x1 the fraction of her counterpart. Party
B can accept or reject that o¤er. If he accepts it, each party receives his/her respective
fraction of the surplus. If he rejects it, each party receives in the …rst period his/her
agreement, 1 x2 is the fraction this player gets and x2 is the fraction obtained by
his opponent. Party A can accept or reject such a countero¤er. If she accepts it, each
party receives his/her respective fraction of the surplus. If she rejects it, each party
Assume that the two players are risk-neutral with discount factors A = 1 and B 2
(0; 1). The outside options are U A = 1=4 and U B = 2=3, and inside options are
mA ; mB 0.
generate. (20 points)
determining what type of agreement is attained in the negotiation process. (10 points)
(d) Based on your answer in part (b), discuss which is the role played by discount factor
and inside options as sources of bargaining power in this game. (10 points)
SOLUTION
Period t = 2.
1
x2 ,
4
14 @g( )
This numerical insight can be formally shown to be true by stating analytically that @ < 0.
107
max1 x2
x2
subject to
0 x2 1 (289)
2
1 x2 (290)
3
1
x2 ; (291)
4
minx2
x2
subject to
1 1
x2 (292)
4 3
Note that the interval for x2 described by (292) is never empty. Thus, the optimal strategy
for B is x2 = 1=4. That countero¤er would be accepted by player A, and thereby, it would
be always a potential agreement in t = 2.
Period t = 1.
1 x1 mB + B (1 x2 )
()
x1 1 mB B (1 x2 )
()
3
x1 1 mBB x1 ;
4
maxx1
x1
subject to
0 x1 1 (293)
x1 mA + x2 (294)
x1 x1 ; (295)
After substituting x2 = 1=4, and since x1 1 and mA 0, the previous problem is equivalent
to
maxx1
x1
subject to
1
mA + x1 x1 (296)
4
108
1 3
mA + 1 mB B
4 4
()
3
mA + mB (1 B ). (297)
4
After de…ning m 34 (1 B ), we can characterize two possible subcases.
Subcase 1.1: mA + mB m. In this case, the optimal strategy for A is x1 = x1 ; and thus,
there will be an agreement during period t = 1 (no delay). That agreement implies a sharing
rule (x1 ; x1 ) = (x1 ; 1 x1 ).
Subcase 1.2: mA + mB > m. In this case, the optimal strategy for A is x1 = x1 + "A (with
implies a sharing rule (x2 ; 1 x2 ) = (1=4; 3=4).
(c) The condition for an agreement with delay can be rewritten as

1 3
mA + mB + 1 + B > 1
|{z} .
| {z } 4 {z 4}
Inside options
| Surplus at t=1
PV of the surplus at t=2
overall bene…ts from a delay (the sum of inside options and the present value of the
pie distributed in t = 2) exceeds the bene…ts from a no delay (the value of the pie
distributed in t = 1). Therefore, higher inside options and lower impatience increase
the probability of attaining an agreement with delay.
(d) We can only analyze the role of impatience and inside options in the agreement with
no delay.
@x1
< 0;
@mB
@x1
< 0:
@ B
Thus, whereas the inside option is a source of bargaining power for B, the impatience
rate ( B ) is a source of bargaining weakness for this player.15
38. UG, risk aversion, and risky surplus. (50 points). Two parties, A (proposer, she)
and B (responder, he), want to split a risky cake of size e. This cake takes value H
with probability p and value L with the remaining probability such that H > L 0.
The negotiation mechanism is an ultimatum game in which player A makes a sharing
o¤er ( ; 1 ) with 2 [0; 1]. Player B can accept or reject that o¤er. If B accepts
it, there is an agreement in which this player obtains (1 ) i and his counterpart
15
Recall that
1
B = ;
1+ B
where B is the B’s impatience rate.
109
gets i with i = L; H. If B rejects the o¤er, each party receives an amount of money
equal to V > 0. If W represents …nal wealth, the utility functions of the two parties
are given by
uA (W ) = W 1 ;
uB (W ) = W 1 ;
where ; 2 (0; 1) measure the risk aversion degree of A and B, respectively.
(a) Depict the extensive form of this game. (10 points)
(b) Find the SPE set and characterize all the possible outcomes that this negotiation
process generates. (20 points)
(c) Compute the equilibrium payo¤s in case of agreement. (5 points)
in this game excluding from your analysis the levels of risk aversion. (5 points)
(e) What is the role played by the risk aversion levels and ? For your analysis perform
a numerical simulation exercise assuming that V = 1, p = 0:7, H = 5 and L = 0 and
that the risk aversion levels increase from 0:3 to 0:4. (10 points)
SOLUTION
(a) See Figure 2.

1 1
p ((1 ) H) + (1 p) ((1 ) L) V1
h i 1
1
1 1
1 V p H + (1 p) L
()
h i 1
1
1 1
1 V p H + (1 p) L ;
and rejects it otherwise. On his part, player A chooses so that

1 1
max p ( H) + (1 p) ( L)
subject to
0 1
1 1
p( H) + (1 p) ( L) V1
110
From (PC) we obtain
1 1 1
p H + (1 p) L V1
,
1
1 1
V p H + (1 p) L
1
;
Since > 0 because V; p; H > 0, (PC) is su¢ cient for the l.h.s. of (FC). Moreover, since
< 1, (AC) is su¢ cient for the r.h.s. of (FC). The previous problem is equivalent to
1 1
max p ( H) + (1 p) ( L)
subject to
. (298)
Note that the derivative of the objective function with respect to yields
1 1
(1 ) p H + (1 p) L > 0;
and thus our natural candidate is a corner solution from above. This is true if the interval
for described by (298) is nonempty. That is, as long as
,
1
h i 1
1
1 1 1 1
V p H + (1 p) L
1
1 V p H + (1 p) L
,
1
h i 1
1
1 1 1 1
V p H + (1 p) L
1
+V p H + (1 p) L 1 (299)
| {z } | {z }
min
A min
B
There are thus two cases.

Case 1. Condition (299) is veri…ed. In this case, the optimal strategy for A is = , and
thus, there is an agreement. That agreement implies a sharing rule ( ; 1 ) = ( ;1 ).
Case 2. Condition (299) is not veri…ed. In this case, the optimal strategy for A is = + "
with " > 0, and thus, there is a disagreement.
(c) The equilibrium payo¤s in case of agreement are

1 1
E (uA ) = p( H) + (1 p)( L)
1 1 1
= p H + (1 p) L
and
1 1
E (uB ) = p( 1 H) + (1 p)( 1 L)
= (1 )1 p H
1
+ (1 p) L
1
= V1
111
(i) Proposer moving advantage: Player A can extract all the surplus after giving B just a
fraction of the cake equal to
1 = min
B
which is sconsistent with her outside option, as formally shown in part (c).
(ii) Responder’s outside option (bargaining strength for player B). In particular:
@ h i 11
1 1
= p H + (1 p) L <0
@V
(e) The role of risk aversion is dual. First, as risk aversion is lower, the likelihood of an
agreement is larger. The intuition behind this property is that su¢ ciently low risk
averse players may prefer the fraction of a risky surplus in case of agreement rather
than an income received with certainty in case of disagreement.
More formally, the condition for an agreement is
V V
1 + 1 1: (C1)
1 1
p H + (1 p) L 1
p 1H + (1 p) 1 1
L
Evaluated at V = 1, p = 0:7, H = 5 and = 0, this condition becomes

L
1 1
1 + 1 1:
0:7 1 5 0:7 1 5
The l.h.s. of this condition when = = 0:3 is equal to
1 1
1
+ 1
= 0:665 81
0:7 1 0:3 5 0:7 1 0:3 5
1
1 0:4
and when = = 0:4 it is equal to
1 1
1 + 1 = 0:724 82
0:7
1 0:4 5 0:7 5
1 0:4
which suggests that an agreement is more likely when risk aversion levels are lower.
Second, the risk aversion level is a source of bargaining power for the responder. The
intuition of this result is as follows. If B is more risk-averse, he will be more willing to avoid
an agreement since he may prefer a riskless outside option rather than the fraction of a risky
surplus in case of agreement. This makes more credible his threat to reject and thus makes
him a tougher negotiator that is less tolerant to accept low o¤ers. As a result, the proposer
becomes more generous with him.
This result is also suggested by the following numerical simulation. Let ( ) be the agreement
share obtained by player A evaluated at the risk aversion level . Then, assuming V = 1,
p = 0:7, H = 5 and L = 0, we have
1
(0:3) = 1 1 0:7 51 0:3 1 0:3
= 0:667 10
and 1
(0:4) = 1 1 0:7 51 0:4 1 0:4
= 0:637 59
which suggests that 1 increases when increases.
112

Problem Set Barg PAUTA Fall 2024

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Problem Set Barg PAUTA Fall 2024

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Problem Set on Sequential Bargaining

Games & Strategies - Fall 2024

(a) Find the set of SPE of this game.

and rejects it otherwise.

and, therefore, the SPE of the game is described by:

Optimal strategy for B

2. Ultimatum Game with explicit asymmetric outside options. Two parties, A

In case of disagreement, players A and B receive a payo¤ uA = 0 and uB = 0:1,

This problem has a corner solution such that

where 2 (0; 1) is the coe¢ cient of relative risk aversion of player A.

and rejects it otherwise.

with " > 0: The equilibrium payo¤s are given by:

(a) Draw the extensive form of this game.

and rejects it otherwise.

(a) Draw a tree representing this negotiation game.

Hence, there exist two possible subcases.

(d) Sources of bargaining power.

(a) Draw a tree representing this negotiation game.

and opts out otherwise.

Hence, there exist two possible cases.

(d) Sources of bargaining power.

(a) Draw a tree representing this bargaining game.

The SPE of this ultimatum game is then characterized by

9. Collective Bargaining, Floor & Strike. Two parties, A (a company’s manage-

(a) Draw a tree representing this negotiation game.

and opts out otherwise.

Thus, the relevant upper bound is x1 , and (47) is nonempty if

and empty, otherwise.

Case II: min fx1 ; g= , or equivalently,

Thus, the relevant upper bound is , and (47) is nonempty if

(d) Sources of bargaining power.

and rejects it otherwise.

Hence, two cases arise from condition (56).

with " > 0: The equilibrium payo¤s are given by:

(a) Depict the extensive form of this game.

and rejects it otherwise.

(c) Sources of bargaining power

is true as p 2 (0; 1) and thereby, ln p < 0, and

hInsert Figure 12i

and rejects it otherwise.

and rejects it otherwise. On his part, player A chooses x1 such that

After substituting x2 = WA , and since x1 and mA ; ; WA 0, the previous problem

We can therefore characterize two possible subcases.

(a) See Figure 13.

and rejects it otherwise.

Hence, two cases arise from condition (79).

with " > 0: The equilibrium payo¤s are given by:

for t = 1; 2, where B is a non-negative constant that represents the marginal disutility

(a) Draw the extensive form of this game.

Interval (86) is nonempty if

15. O¤er-Countero¤er, Asymmetric Externality and Inside Options. Two par-

for t = 1; 2, where B is a non-negative constant that represents the marginal disutility

(a) Draw the extensive form of this game.

and rejects it otherwise.

Interval (92) is nonempty if

Therefore, there are two possible negotiation outcomes:

(c) Identify the sources of bargaining strength/weakness in this negotiation game.

Simple inspection reveals the following signs:

16. O¤er-Countero¤er, Negative Externalities and Inside Options. Two parties,

(a) Draw the extensive form of this game.

(a) Draw the extensive form of this game.

and rejects it otherwise.