This article has been written by Rashmi C pursuing the Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. This article has been edited by Zigishu Singh (Associate, Lawsikho) and Smriti Katiyar (Associate, Lawsikho).
Table of Contents
Introduction
In the modern economy, business decisions, including contract negotiations, stem out of interactions, discussions, and deliberations, and these are bound by rules, sequences or logic, whether express, implied or tacit. Decisions are made based on rational and logical thinking, after having conducted sufficient research and analysis on the subject matter to be decided. Game theory is a versatile tool that aids the negotiating parties to make strategic decisions based on the probability of the responses of the other party(ies) to a particular line of thought. Game theory has wide-ranging applications, not only in the field of economics, business and finance, but also in physics, chemistry, biology, medicine, psychology, mathematics, governance, and many more. Thus, the application of game theory can be found in any area where there are choices and/or likely outcomes. Contract negotiation is one such field where the application of game theory can be found.
Brief history of game theory
Game theory was first pioneered by Jon Von Neumann, when he published his paper on mixed-strategy equilibria in a two-person zero-sum game, and provided proof for the same. He used Brouwer fixed-point theorem to plot points and identified convergent convex sets in the outcomes, which later became the standard method in game theory application. This was later followed by his book Theory of Games and Economic Behavior, written in 1944, which he co-authored with Oskar Morgenstern, that dealt with multiple player games involving cooperation. Game theory was widely developed in terms of its aspects and applications during the 1950s by many scholars. Today, game theory is applied across a multitude of fields.
Game theory
Game theory deals with the modeling of strategic responses and outcomes of the interaction between two or more persons within a situation containing a set of definite rules and outcomes. It explains how people make decisions.
In the paper “Self-refuting Theories of Strategic Interaction: A Paradox of Common Knowledge”, Cristina Bicchieri defines Game Theory as “the study of mathematical models of conflict and cooperation between intelligent and rational decision-makers”.
Some of the important terms used in this theory are:
- Game – Any situation or set of situations the result of which is dependent on the actions of two or more decision-makers.
- Players – A participant; a strategic decision-maker within the game’s context.
- Strategy – A plan of action that a player will take based on the set of circumstances that would arise within the game.
- Payoff – The benefit, result or the payout that the player would obtain from a particular outcome. The payoff may be quantitative or qualitative, such as utility, sense of achievement, etc.
- Information Set – The information available to the players at a given point in time. This term is usually applied when the game has an element of sequence to it.
- Equilibrium – The point in time at which players have made their decisions and the outcome has been arrived at.
There are multiple types of “games” that are used in the domain of game theory, such as:
- Cooperative and non-cooperative games
- Normal form and extensive form games
- Simultaneous move and sequential move games
- Constant sum, zero-sum, and non-zero-sum games
- Symmetric and asymmetric games
As per this theory, each situation is termed as a “game”, since the persons involved in them make decisions based on how they value and perceive the possible outcomes of the choices, made either by them or the other person. This can be true even when a person is making decisions that only affect himself.. Each person involved in a game is called a “player”.
When you are involved in a “game”, you would make decisions taking into consideration the choices and alternatives of the other player(s). But in the process of doing so, you must also consider the fact that the other player(s) are also thinking about your choices and alternatives, and making his decisions taking into account this factor, and so on. Though it seems complex, subtle and tricky, the application is quite simple.
Application of game theory in contract negotiation
There are about 30 different games that model all sorts of scenarios in life and business. Among these, four are particularly important to contract negotiations. These are:
- Chicken;
- Trust;
- Prisoner’s Dilemma;
- Stag Hunt.
The result of the negotiations would depend significantly on the type of game we adopt in our negotiation process. During negotiation, there may also be a need to change the game to adapt to the situation. There is no one right or wrong game, as it depends on the strategy that the other party adopts. And, adopting the game theory will not guarantee success. However, understanding and implementing the concepts derived from game theory would help in identifying the other party’s strategy and allow one to adopt a suitable strategy to tilt the game in their favor.
The different models are explained below:
- CHICKEN:
Chicken is one of the most common forms of games played during negotiations. It is used when one party has a position of dominance or influence over the other. Chicken is a situation where two parties engage in a heated discussion activity that would result in serious damage or harm unless one of the parties accedes to the other. Chicken is not a collaborative effort, but rather a gameplay of dominance and coercion.
The Cuban Missile Crisis in 1962 – a 13-day standoff between the United States and The Soviet Union (along with Cuba at the center) – is one of the most popular examples of the Chicken strategy. Both nations used their influence and power to try to dominate the other, resulting in an impending nuclear war. The war was finally averted when both nations stopped using this strategy and instead reached a negotiated agreement.
Illustration:
Company A, the holding company, would like to enter into a Technology Transfer Agreement with its subsidiary, company B. During the course of negotiations, company B wants to transfer only the ownership, but not the possession of the technology, and has a hard stand on it. Company A is looking at a complete transfer of all rights, including the possession.
The negotiators for company A, upon understanding that company B does not intend to make complete transfer of all rights, uses its position as the holding company to exert influence over company B, resulting in company B’s negotiators finally relenting to a full transfer of all rights related to the technology. The negotiations result in a successful execution of the agreement.
- TRUST:
The strategy of trust involves two parties, wherein one party enjoys a position of influence or dominance over the other (called the proposer). The party having the position of dominance, due to its position, determines the distribution of benefits between the parties. The other party (the responder) has no real power or influence, and therefore, in order to obtain a better position at the completion of negotiations, decides to provide a gift or concession or benefit to the proposer at the beginning of the negotiations.. Thus, the responder adopts a strategy of gift-giving to gain the “Trust” of the proposer. However, it must be noted here that this act of gifting or concession-giving may work both ways, meaning, the proposer may consider it and provide a better end-position, or it may neglect it and decide the benefit-sharing as in the case of a Dictatorship.
Illustration:
Company A, the holding company, would like to enter into a Technology Transfer Agreement with its subsidiary, company B. During the course of negotiations, company B wants to transfer only the ownership, but not the possession of the technology, and has a hard stand on it. Company A is looking at a complete transfer of all rights, including the possession.
The negotiators for company B understand company A’s position and intention. To ensure that they do not end up losing the entire technology, they come to a solution – transfer all rights to company A, and enter into a separate agreement to be the exclusive service provider for all company A’s products using the technology. They set the proposal of handing over all rights to company A at the beginning of the negotiations itself, and as part of ongoing discussions, set the proposal for the exclusive service provider, to which Company A’s negotiators agreed. The negotiations result in a successful execution of the agreement.
- PRISONER’S DILEMMA:
This is the most widely popular game in the business domain, and also the most difficult to anticipate and prepare for. The Prisoner’s Dilemma is a game where both parties arrive at an agreement and promise each other to do their part, but when the time for implementation arises, either parties decide, at that moment, whether to honor the agreement or not to.
The name “Prisoner’s Dilemma” comes from a story that Albert Tucker, a researcher at Stanford University, reported in the Philadelphia Inquirer in 1995. The story is of two burglars who are arrested and questioned in separate interrogation rooms by the Police in an attempt to get a confession out of them. Both burglars have agreed to never reveal their crime. In the interrogation room, each of them is informed that the first person to confess would obtain a huge concession in the quantum of punishment, but if they do not agree, they would face the full force of the law. Further, each of them is instilled with a fear that the other burglar may turn against him at any moment. Now, each prisoner is stuck between whether to confess or not to.
This situation results in the following possible outcomes:
- Neither prisoner confesses. Thus, both of them may be charged with petty crimes or completely exonerated from all charges.
- Both prisoners confess and implicate each other. In such cases, both parties are charged under all applicable provisions, without any relaxation to either of them.
- One of the prisoners confess, implicating the other, but the other one does not. In such cases, the one confessing would be exonerated from all charges, while the one not confessing would face higher levels of charges, and in effect, more punishment.
This technique is widely used in international agreements, including resource utilization (water-sharing agreements, fishing quota agreements, etc.), border dispute resolution agreements, environmental protection & management agreements, and nuclear energy contracts.
- STAG HUNT:
Stag hunt, which talks about the conflict between self-sufficiency and social cooperation, is another widely-used game in contract negotiations.
The game talks about two hunters who go out into the forest, with chances of being able to hunt either for a hare or a stag. The hunter, on his own, can hunt for only a hare, since a stag is huge and difficult to hunt alone. While the hare is a smaller animal, providing lesser utility, he can enjoy it fully and safely without having to share anything with the other hunter. However, if both hunters work together, they would be able to hunt the stag and share the benefits. If one hunter hunts the stag(which is a bigger animal with more utility) with the other, he would have to share it with him, and each hunter would face the possibility of getting either lesser or greater than he had intended.
Illustration:
Company A, a manufacturer of paper, would like to enter into a Material Purchase Agreement with its subsidiary, company B, which procures and processes virgin wood. Due to the nature of the separate entities, there are inefficiencies in the process of both companies, such as delay in procurement, higher administrative and management costs, logistic challenges, and so on.
To mitigate the inefficiencies, both companies decide to merge into a single entity, and thus, enter into a Merger Agreement, which would be a win-win for both entities.
In contract negotiations, the game of stag hunt is widely attributable in the Mergers & Acquisitions domain. Enterprises enter into strategic purchase, mergers, acquisitions, joint ventures, partnerships, and associations primarily to achieve “synergy” (the “stag” in the hunter’s example) through mutual cooperation and understanding. This would enable both entities to benefit greater from the association than each of them as individual entities. Collaboration is a key element in the Stag Hunt game. Both parties should be willing to work closely with one another in the spirit of positivity, with the aim of gaining and sharing the benefits mutually. Negotiations are much more encouraging and enterprising when this strategy is adopted.
Conclusion
Thus, game theory plays a pivotal role in the process of contract negotiation. Using the concepts from game theory, negotiators can effectively anticipate the other party’s choices, alternatives, probabilities of choosing one alternative over the other, and make suitable strategic decisions to suit the needs of negotiations. Each game has its own benefits and shortcomings, and when negotiators carefully choose the right strategy, it can lead to successful negotiations.
References
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