“Games Theory Bargaining and Auction Strategies” explains auction theory to the layperson.
Gregor Berz, the author, strips away the equation and introduces real-life examples and psychology. This “simplified” format makes the book very useful and accessible to anyone who’s interested in improving the outcomes of their negotiations.
- Bullet Summary
- Transactions & Indifference Price
- How to Appropriately Name Your First Price
- How to Negotiating In Fairness & Without Arguing
- The English Auction
- Vickrey Auction (Second Price Sealed Auction)
- Dutch Auction (Great to Sell Your House)
- Prisoner’s Dilemma
- Breaking The Prisoner’s Dilemma: Collusion Through Repetition
- Don’t Negotiate By Begging: Whoever Can’t Afford to Lose, Loses
- Rational Bidding Strategies
- Negotiation Power Games
- On eBay, bid your indifference price and that’s it
- To sell your house, consider a Dutch auction to scour the market for the highest price
- Never let people know you really need the transaction
The author says that the name “game theory” is confusing and a better name for the field would have been “strategy theory”.
But that’s not what happened, so we got stuck with “game theory”.
Just be aware that “game theory” is the study of the different strategies and outcomes of transactions and negotiations.
Transactions & Indifference Price
The indifference price is the lowest price that a seller is willing to accept and the highest price that a buyer is willing to pay.
Transactions hence only happen when the two indifference prices overlap.
Or when the stated indifference prices overlap as plenty of transactions don’t happen because one party fails to understand that an opening price was simply a gambit.
Negotiation is Sharing The Pie
Negotiations then are all about “sharing the pie” of the overlapping indifference prices.
How to Appropriately Name Your First Price
A price that is too close to your indifference price will result in you getting a smaller piece of the pie.
A price which is too far from your indifference price can result in the negotiation not even starting (there is no overlap of indifference prices) and you losing all your credibility).
As other negotiation books have stated, a good rule of thumb is to pick a price that is the highest price that you would not be embarrassed in defending and backing with data.
Research also shows that you are better off with a range that has your target price at the bottom.
And use precise numbers such as “81k to 84k” instead of “80k to 85k” as research shows that’s more effective in moving the other party towards your range.
How to Negotiating In Fairness & Without Arguing
Gregor Berz introduces and explains several forms of auctions that are better suited for reaching “fair” outcomes.
- Sealed Exchange of Bids
His example takes place between two friends in a beer garden (guess where Berz comes from? :).
In the “Sealed Exchange of Bids” both write down their idea of a fair price and give the bids to a third friend.
The third party only reveals the bids if the two prices intersect. Otherwise, there is no more talking about a deal.
If the prices intersect, they can meet halfway. This is done by sharing all available information.
- I Cut You Choose
This is especially suited for sharing or for settling a divorce.
One party divides the pie and the other party chooses. Nobody can complain because the person dividing has chosen two equally attractive packages and the party who chooses, well… He has chosen.
When it’s difficult to make precise packages, the difference is made up with debit or credit note to make up for the difference.
The English Auction
In an English auction, the bidders all compete against each other and the highest bidder wins the auction.
In an English auction, it’s the second-highest bid that determines the final price because the winner only has to bid higher than the second-highest bidder.
The English auction can result in poor outcomes for the auctioneer (or seller) if the auction ends far lower than the indifference price of the winner (which can be a sizable difference in case there was little visibility for the auction and/or very few bidders can afford the item).
Vickrey Auction (Second Price Sealed Auction)
The Vickrey auction is similar to the English auction in the sense that the final price is determined by the second-highest bid.
But contrary to English auction the bidders here don’t see the other bidders’ bids.
Dutch Auction (Great to Sell Your House)
The Dutch auction names a price, advertise the item and does not accept negotiations.
Technically, it’s an “open first-price auction”.
If no buyers are found at the first-named price, the price goes down over time, and each decremental step can even be shared in advance (for example: start price 350k; in one month 340k; in two months 330k).
As Gregor Berz says, The Dutch auction is a great way to scour the market for the right price (but you should avoid parallel Dutch auctions if you have several items on the market and there is little demand).
The author also shares the story of a house sold with a Dutch auction, and I decided that if/when I will sell my house, it will be with a Dutch auction (and I also thought on how to leverage the Dutch auction dynamics to increase the evaluation).
It’s also a great way if you don’t want to waste time with lowballers and long rounds of negotiations and it’s fantastic when the demand is strong.
The nature of the prisoner dilemma is that if everyone were to follow a “communal” course of action which is good for everyone, everyone would gain.
But defecting from the communal course of action can provide outsized advantages for a single individual.
Environmental protection is an example of a prisoner’s dilemma were if everyone contributed, it would be better for everyone. But individual defection can improve the individual’s life at the detriment of the collectivity.
The author says that the Prisoner’s Dilemma changed Adam’s Smith mistaken assumption that if everyone maximizes his own position, everyone gains.
I don’t think Adam’s Smith “Invisible Hand” has been nullified. That’s still what capitalism is based on and capitalism worked great.
What has been corrected is the extreme interpretation of the Invisible Hand upon which neo-liberism sought to eliminate all possible regulations (but that was always resting on flimsy foundations and little understanding of human psychology, albeit unluckily that’s exactly the politics Greenspan was embracing).
The Prisoner’s Dilemma did add an important theoretical layer that better captures many real-life situations and includes human sociology into economics and transactions (also read Stiglitz on-point correction of the Invisible Hand fallacy).
Repeated games tend to eliminate the Prisoner’s Dilemma because (also called “iterated prisoner’s dilemma“).
Breaking The Prisoner’s Dilemma: Collusion Through Repetition
When negotiations can be repeated in quick succession, the prisoner’s dilemma can be overcome.
But it can also be overcome in a way that is only good for the players (and sellers) and not for the whole market.
That’s what happens for example in the gas and fuel markets.
Collusion can take place without the parties even having to formally agree to collude.
The players know that by lowering prices they will elicit the exact same reaction from the other players and that they will only hurt each other.
So they all keep roughly equal prices that keep fat margins for all.
Don’t Negotiate By Begging: Whoever Can’t Afford to Lose, Loses
Whenever you plead the other players to go through with the transaction at the price you “need”, you signal the players that you need your portion of the pie (and you can plot it on a utility function).
But since the utility of each unit of the pie is higher for the person who “really needs it”, then it actually seems fair that the transaction is concluded quick and with a smaller pier for the one who needs it (he gets more value out of his small share anyway).
Writes the author:
(…) has been confirmed in experiments with students time and again. If both negotiation parties are aware of the assessment of utility of the counterparty, then they divide it “fairly” based on the utility and not the pie itself
Dividing “fairly” based on the utility means giving less to the one who needs it the most.
That’s how the human mind works, which to me is a prime example that if we want to a fair society we need to channel our selfish genes and darkest drives.
What does it all means to us?
Rational Bidding Strategies
A few applications of game theory:
- In a second-price-sealed-bidding auction (ie.: eBay) it’s a no brainer to simply bid your indifference price
- In a first-price-sealed-bidding auction (ie.: you pay what you bid), you must take into account your indifference price and mitigate it with your risk aversion and your estimate of the competition’s risk aversion
- It makes sense to increase your bids in the smallest possible increments (but if you factor in psychology, then it can make sense to go for a big increment to showcase your firepower)
- To avoid the winner’s curse the auctioneers should share the information of how many bidders dropped out (this is important when the estimate of one bidder is poorer than the cumulative estimates of all other bidders such as in oil rig bids)
- In most competition situations several auction types and several negotiation rounds deliver better results
- In TIOLI (take it or leave it) don’t make others look like a fool (The critical limit for acceptance is usually between 5 and 20 percent of the pie, says the author)
- Dealing with dictators and psychopaths you can increase the credibility of your TIOLI by adopting a randomized strategy because the negotiation position of a rational individual is otherwise much worse
Don’t waste time on eBay by bidding in smaller increments. Just bid the price you’d be happy to pay and then focus on the rest of your life.
Negotiation Power Games
- Feign a must have to sell it higher
You can pretend that something is really important to you not because it is, but because you can exchange it for higher concessions from your opponent.
- Serial TIOLIs
When you have several different suppliers or interested buyers you can approach them one after the other, serially, with TIOLIs (ie.: “take it or leave it” or “ultimatum games”) to take full advantage of your power position.
It’s best to let everyone know that you have several options because that increases the power and credibility of your TIOLI.
Ultimatum games only work if you have built a reputation of not reneging on your word (Chris Voss in “Never Split The Difference” explains how negotiators seek to let ultimatums slip in a non-aggressive environment as a way of removing power from hostage-takers without angering them).
- Collusion Games
The author tells the story of a sales auction for a repossessed home.
At the auction, there were two real estate agents.
But instead of bidding against each other which would have driven the price close to the market valuation, they spoke to each other and then they declared themselves a “bidding partnership”.
There was only one offer at that auction and they got the house at a crazy low valuation. They were then likely going to split a very big pie between each other (and I wondered why the author didn’t bid himself).
- Collusion Through Signaling Games
Whenever bids are visible highly experienced negotiators can submit bids with numbers that suggest their intention to collude (for example the last places of the non-rounded can correspond to the zip code of the bidding company and send the message that each company will only bid for the local license).
Press releases can also be used to hint about the intentions of a bidder to collude (for example the press release for a steel producer to close down a plant was the signal of reducing the offer and avoid a price-war).
- Avoiding collusion games
The better the bidders can observe each other, the easier it is for them to manipulate the auction. Thus, make it impossible for them to know where they each stand.
If you suspect cartels, avoid simultaneous negotiations like auction as it’s too easy for them to boycott it.
If you suspect a cartel, it’s best to deal with them sequentially with a TIOLI.
And if you’re dealing with an entrenched cartel, make a great offer to one of them to break the cartel (finesse power move).
Finally, avoid non-binding auctions because everyone will bid collusively far from their indifference price to keep their margins in the “real” negotiation taking place afterward.
- Dirty negotiation tricks of non-binding auction
In non-binding auctions, including online non-binding auctions, it’s easier for the auctioneer to submit a fake bid to increase the perceived competition and drive prices up.
- Games theory still seeks to do without sociology and psychology
The author poignantly asks:
The degree to which those involved in negotiations really behave rationally – a prerequisite for the application of game theory – is an especially interesting question.
When I read that “rational behavior” is a prerequisite for the application of game theory I can’t help but feel that the whole concept of game theory is undermined.
Countless research has shown beyond any reasonable doubt that humans are not rational (just as three examples check: Kahneman, Ariely and also “Fooled by Randomness“).
To really understand negotiation, sales and, well, people… You cannot do without psychology and pretend that people are perfectly rational.
- Practical, deep and helpful
Wonderful book, I learned hugely on how to better structure my negotiations and auctions.
- Negotiation power moves
You will learn a lot on the dirty tactics of negotiations here.
- Great for Psychology of negotiations
I would have never guessed that I’d learn psychology from a book on game theory negotiation, but I actually did learn on the (dark) psychology of negotiations (also see: manipulative negotiation techniques).
And it goes straight into my list of best negotiation books.
Albeit at times it wasn’t the easiest book to read, I loved “Game Theory Bargaining and Auction Strategies”.
Right from the start, you can see that Gregor Berz is not an ivory tower mathematician who embraces the homo economicus and snubs the real world of people and (irrational) psychology.
He recommends “Getting to Yes” and he peppers the book with real-life examples from his experience, which makes “Game Theory Bargaining and Auction Strategies” a gem for negotiators and life-strategists.