Bargaining and Search with Recall: A Two-Period Model with Complete Information Author(s): Ching Chyi Lee Source:

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AND SEARCH WITH RECALL:A TWO-PERIOD BARGAINING MODELWITHCOMPLETEINFORMATION

CHINGCHYILEE
The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong (Received September 1991; revisions received December 1992, January 1994; accepted May 1994) Two standard results of previous bargaining models state that delay is generally not expected to occur under complete information, and bargaining outcome depends crucially on the bargainers' intrinsic characteristics that determine their reservation prices, and, in general, bargainers with "better" reservation prices tend to get better outcomes. This paper considers a bilateral bargaining problem with complete information in which one of the bargainers, the buyer, is allowed to search while bargaining. More importantly, we assume that the buyer is allowed to recall past outside offers. We find that, quite contrary to the standard results of previous complete information bargaining models, complete information renders no guarantee for immediate resolution of bargaining, and the effect of changing the buyer's search cost on each player's bargaining outcome is unpredictable. The major driving force of these two results is the assumption that the buyer can recall past outside offers.

TJ'wostandardresults of previous bargainingmode s state that delay is generally not expected to occur under complete information, and bargaining outcome depends crucially on the bargainers' intrinsic characteristics that determine their reservation prices, and, in general, bargainerswith "better" reservation prices tend to get better outcomes. The first result can be seen, for instance, in the bargainingmodel of Rubinstein (1982);in the bargaining with outside option models of Shaked and Sutton (1984), Shaked (1987), and Binmore, Shaked and Sutton (1989); and in the bargainingand search models of Wolinsky (1987), Chikte and Deshmukh (1987), and Muthoo (1991). All of these complete information models predict immediate resolution of bargaining.In particular,in bargainingmodels with a search option, the ability to search enables a bargainer to improve his bargainingoutcome, but search never takes place. The intuition for the no-delay result is straightforward. If everything is known to every player, there is no need for players to spend time in exploring each other's bargainingstrength. Since delay is costly for both players, it is then to both players' advantage to resolve bargaining immediately. Under this argument, delay can occur when the players have incomplete information. (There are exceptions for different reasons; see Rubinstein 1982 and Chatterjee et al. 1990.) There is a long list of incomplete information bargaining models that try to make this point clear (see, for example, Fudenberg and Tirole 1983, Sobel

and Takahashi 1983, Grossman and Perry 1986, and Chatterjee and Samuelson 1987, 1988). The "intrinsic" characteristic of a player mentioned in the second result can be a player's time preference (e.g., the discount factor and bargaining cost in Rubinstein), his freedom to switch bargainingpartners (e.g., fixed time interval T within which players cannot switch in Shaked and Sutton), or his search cost (e.g., Chikte and Deshmukh). In particular, Chikte and Deshmukh found that search costs are closely related to players' reservation prices, that is, a smaller search cost leads to a higher reservationprice for the seller and a lower reservation price for the buyer. In addition, they concluded that a decrease in a player's search cost can increase his payoff without increasing the other player's payoff. This paper considers a bilateralbargainingproblem with complete information in which one of the bargainers, the buyer, is allowed to search while bargaining. The main feature that distinguishes this model from other bargaining and search models is that the buyer is allowed to hold onto the outside offers he receives through search in the entire bargainingprocess. We find that, quite contrary to the standard results of previous complete information bargaining models that complete informationrenders no guarantee for immediate resolution of bargaining, and the effect of changing the buyer's search cost on each player's bargaining outcome is unpredictable. The

Subject classifications: Games/group decisions, bargaining: bargaining and search with recall. Area of review: DECISIONANALYsIs,BARGAININGAND NEGOTIATION. Operations Research Vol. 42, No. 6, November-December 1994

1100

0030-364X194142061100 $01.25 ? 1994 Operations Research Society of America

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major driving force of these results is the assumption that the buyer can recall past outside offers. The basic intuition for the first result of this paper is that when the buyer's search cost is small, it may be too costly for the seller to deter search. Hence, instead of making a "low" offer to deter search, the

seller chooses to charge the buyer a "high" price knowing that the buyer will search and hoping that this "high" offer will be accepted later if the buyer's search turns out to be unfruitful.The second result is in contrast to the result of Chikte and Deshmukh mentioned earlier. The detail of this result will be provided in the sequel. The organization of this paper is as follows: Section 1 describes the bargaining and search model, Section 2 derives the equilibrium,and finally, Section 3 provides detailed discussions for the major results of this paper along with an example.

1. THE MODEL Consider a bilateral bargainingproblem in which one seller and one buyer are bargainingover the price of an indivisible good. For convenience, the buyer will sometimes be referred to as "he" and the seller as "she" in the later discussions. The seller's and the buyer's valuations of the good are 0 and 1, respectively. The seller initiates the game by making an offer,p1, to the buyer. The buyer can either accept or reject pl. Acceptance of Pi by the buyer ends the game and the good is then exchanged at the agreedupon price. If Pi is rejected, the buyer can choose either "to search" or "to ask the seller for a second offer." The latter option, however, would move the game to its second period. If the buyer chooses to search, he pays a cost c (c > 0) and then draws an outside offer x1 from the unit interval. Once x1 is observed, the buyer can either accept xl, Pi (which is still open) or neither. If he decides to accept an offer (x1 or P1), the game is over; otherwise, the game moves to its second period. The bargaining and search process in the second period is basically a replica of that in the first period. What should be most noted is that the buyer is allowed to recall x1, but not p1, in the second period. Furthermore, players' payoffs in the second period are discounted by the common discount factor 8 (8 S 1). The second period starts with the seller making an offerp2. The buyer can then accept eitherp2 orx1 to end the game, or he can search. If he chooses to search, he draws an outside offer x2 from the unit interval at cost c. After observing x2, the buyer

accepts one of the available offers, P2, x1, orx2, and the game ends. Outside offers, xl and x2, are governed by the same probabilitydistributionfunction F(x) with support on [0, 1]. The density function of F(x) isf(x). If the seller and the buyer agree to exchange the good at price p in the ith period, the seller's payoff is 5'-'p and the buyer's is 51-1(1 - p). On the other hand, if the buyer accepts an outside offerx in the ith period, his payoff is 51-1(1 - x) and the seller's is zero. Finally, we assume everything is known to both players-the structureof the game, the preferences of the players, the values of 8 and c, the realized values of outside offers, and the probability distribution function F(x) and its support. The game tree of this model is depicted in Figure 1. Examples of this type of bargainingare abundantin real life. For instance, in the car market, a buyer will normally search around while bargainingwith a particular dealer. Car dealers generally do not make take-it-or-leave-it offers. Instead, they often allow buyers to retain their offers for at least a given amount of time. The employee-employer relationship is another example. The employer makes an offer initially. If the employee is satisfied with the offer, he will not search. Otherwise, verifiable alternative offers must be generated to improve his salary. Sometimes the

Figure 1. The game tree of the bargainingand search game.

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1102 / LEE alternatives are sufficient for the employee to convince his employer of a promotion; sometimes the alternatives are simply too good to be given up and the employee ends up taking the new job. We now introduce the following two tie-breaking assumptions. These assumptions will enable us to characterize a unique equilibriumfor each given value of c in the next section. Al: If a player is indifferentbetween taking an action A to get a sure payoff a and taking an action B to get a probabilistic payoff with an expectation of a, he takes action A. A2: If the buyer is to accept a price among several prices of the same magnitude, he accepts the one that he received most recently. One way to interpretAl is to consider players of the game as being "slightly" risk averse. A2 can be justified in at least two ways. First, we can imagine that there is a very small cost for the buyer to recall past offers, and, additionally, the older an offer becomes, the more expensive it becomes to recall that offer. Second, by making his or her offer slightly smaller, the finalperson can always make his or her offer more attractive than any of the previous. 2. THE ANALYSIS 2.1. The Second Period Behavior The solution concept used in this model is that of Subgame Perfect Equilibrium.The key to the solution of this game is by backward induction starting from the second period. Let pi and xi be as defined previously and s = min [x1, P2j. Then, in the second period, the buyer's expected payoff from a search given that he has searched in the first period is
S

our later analysis, establishes that p * is the seller's largest possible search-deterringoffer in the second period. Lemma 1. Lets E [0, 1]. Then, 1 - s < F(s) for all s >p*, andl1 -s > (D(s)for alls <p*. Proof. Integration by parts yields that (1 - s) 4D(s) = c - fl F(x2) dx2. Since c = fP* F(x2) dx2, (1 - s) - &D(s)= fP* F(x2) dX2 - 0f F(x2) dx2. Clearly, (1 - s) - ((s) is positive if, and only if, s < p*. The reverse case can be proven similarly. To interpretLemma 1, consider the s as the buyer's best available offer in the second period before search (i.e., s = min[xl, P2]). Then, Lemma 2 says that the buyer will not search in the second period unless min[xl, P2] > P* Given the buyer's strategy, the seller's problem is to choose a price, P2, to maximize her second-period expected payoff, denoted as S(p2),
I

Max S(p2)

p2[
<x-l

P2

- F(p2)] .

if P2 >p

if P2 <P*

(3)

subject to P2

To simplify the analysis, the set of probability distribution functions such thatp[l - F(p)] is strictly quasiconcave will be focused upon. This is stated formally as an assumption. A3: Here p[1 - F(p)] is strictly quasiconcave. Among commonly used distributionfunctions, the family of power functions, F(x) = xm (m > 0), satisfies this assumption. This assumption guarantees thatp[1 - F(p)] is single-peaked and contains no flat portion in the interior of [0, 1]. Letp be the unique maximizer of p2[1 - F(p2)] over [0, 1]. Then, the solution to (3) depends on the values of x1, p *, and p[1 - F(p)] . If p * > p[1 F(p-)], the seller will offerp2 = min[x1, p ] and the buyer will accept. If p * < p [1 - F(fp)], the seller's optimal strategy is slightly more complicated. Define p" = inf{p2 Jp2[1 - F(p2)] - p*}(4)

-c

(1 -X2)f(X2)

dX2

+ I(1
Js

- S)f(X2)

dJC2 -

?(S)(l

We assume that ?F(s)is nonnegative throughout,so c cannot be "too large." Let p* be the price which makes the buyer indifferent between searching and not searching in the second period. Then, p* must satisfy the condition: 1 - p* = ('(P*). (2) Since (2) is equivalent to c = fPO*F(x2) dx2, there must exist a unique p* for each c, andp* is increasing in c. The following lemma, which will be useful for

The seller's offers and the buyer's accompanying responses in this case are summarizedin Table I. The optimal behavior described in the table can be checked by referringto Figure 2. The above analysis of each player's behavior in the second period is based on the presumption that the buyer has searched and obtained an outside offerx1 in the first period. If the buyer did not search in the first period, the seller's problem in the second

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Table I The Seller's Offer and the Buyer's Response in the Second Period Given That the Buyer has Searched in the First Period andp* < p[1 - F(p)]
Range ofx,

[O,p*]
x1

(p*,p"] p*

(p", p)
xi

[pI 1]

Seller's Offer(P2) Buyer's Response

Accept

Accept

Search

Search

period is similar to the one given in (3), except there is no constraintp2 < x1. The seller will offer eitherp * orfp in the second period depending on which of p* and p[1 - F(p)] is larger. The buyer will accept immediately all prices less than or equal top* and search otherwise. Since the seller will never offer any P2 less than min[x1, p*], the most the buyer can get by going to the second period is 8(1 - min[x1, p*]) regardless of the value of c. In fact, when c is sufficiently large (i.e.,p * 3 p[1 - F(p)]), the buyer's payoff for going to the second period is exactly 8(1 - min[x1, p*]). When c is small (i.e.,p* < p[1 - F(fp)]), because the seller will never offer any P2 greater thanp, the buyer's expected payoff for going to the second period is at least 8'F(p) (which is greater than 8(1 because,p > p*). Having completed the analysis of the second period behavior, let us now consider the players' behavior in the first period. 2.2. The First-Period Behavior There are at least two, possibly three, "moves" in the first period of the game, the first pertains to the seller, and the second and the third pertain to the buyer. First, the seller has to make an offer. Second, after receiving the seller's offer, the buyer must decide whether to accept, to search, or to ask the seller for a second offer. The third move may or may not be

necessary depending on the buyer's choice made in the first move. If the buyer chooses to search previously, he will then have to move againonce an outside offer is received. In his second move, the buyer must make a decision regardingwhether to accept a price (p, orxl) at the end of the first period or to go to the second period and ask the seller for a second offer. Following the procedure of backward induction, our analysis of the first-period behavior starts from the buyer's second move, then his first move, and then, the seller's first move. 2.2.1. The Buyer's Behavior After First-Period Search After receiving an outside offer x1 from the first period search, the buyer can take one of the following two actions. First, he can accept the lower price of x1 andp1 to get 1 - min [x1,p1]. Second, he can ask the seller for a new offer P2, in which case, his payoff will be either 8(1 - min[xl, P2]) or 5I?(min[xl, P2]), depending on whether or not he will search in the second period. Hence, his decision regardingwhich action to take at the end of the firstperiod depends not only on the values of x1 and Pi, but also on the projected value of P2. Since the seller's second period offer depends on the values of p* and p-[1 F(p)], the following discussions are separated into two cases: i) whenp* p-[1 - F(p)], and ii) when p* < p[l - F(p-)]Before proceeding, a new notation will be introduced. Let p0 be the price such that the buyer is indifferent between accepting p0 in the first period and accepting p* in the second period. In other words, p0 satisfies the equation: 1 -po = 8(1 -p*). (5)

Figure 2. Illustration of the players' behavior described in Table I.

Note that the value of p0 is crucial in determining the buyer's optimal strategy in the first period. Recall in the previous discussion of the second-period behavior that, in equilibrium, the most the buyer can obtain by going to the second period is 8(1 - min[x1, p *]). If x1 S p *, however, the buyer certainly will not go to the second period because he can simply accept x1 at the end of the first period. Hence, if the second period is reached, it must be the case that

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x1 > p*, and this, in turn, means that the most the

buyer can obtain by going to the second period is actually 8(1 - p*). Knowing this, the buyer will accept any offer,p1 orx1, less than or equal topo at the end of the first period. Since the actual value of p0 depends not only on p *, but also on 8 (p0 is close top* when 8 is close to 1 and is close to 1 when a is close to 0), the computation of the equilibriumof this game can become quite complicatedwithout knowing the actualvalue of 8. Hence, to keep things simple, the following assumption is made. A4: Assume that 8 is close enough to one such that the following is true: i. p* <p 0 <p", and ii. 1 -x < 8'(x) for allx >p". Two remarks must be made. For part i of A4, we know that p" is always greater than p* for c strictly greater than 0 (for c = 0, p* = p"). Since p0 can be smaller (for large 8) or larger (for small 8) than p" depending on the value of 8, part i of A4 ensures that 8 is large enough. Similarly, part ii of A4 makes sure that 8 is not "too small." By Lemma 1, 1 - x < ?F(x) for allx > p*. Hence, 1 - x < ?F(x) for allx > p" because p" > p*. However, 5'F(x) can be smaller than 1 - x even if x > p" for 8 sufficiently small. Part ii of A4 ensures that such cases are ruled out. Assumption A4 enables us to focus on a particular class of games whose equilibria can be derived in a similarmanner. It is worth mentioning, however, that

althoughA4 affects the ways that the equilibriaof the game are computed, it does not affect the major results of this model. In other words, allowing 8 to take other values will not lead to qualitatively different results. The buyer's optimal strategies at the end of the first period are described in Table II for the cases ofp * ? p[l - F(p)] andp* < p[1 - F(p)]. It is easy to verify the information given in these two tables. If min[x1, P2] S p*, then, by Lemma 1, there will be no search in the second period and the buyer's payoff for going to the second period will be 8(1 - min[x1, P2])- If min[xl, P2] > p*, search will take place in the second period and the buyer's expected payoff for Comparing going to the second period will be 5&F(P2). these to the buyer's payoff, 1 - min[x1, Pl], if he accepts min [P1, x1] at the end of the first period, the buyer will accept min[xl, Pl] at the end of the first max[8(1 - min[xl, period if 1 - min[x1, Pl] P2]), 5F(P2)] and otherwise will go to the second period. 2.2.2. The Buyer's Behavior Before First-Period Search Earlier in the analysis of the second-period behavior, p* is defined as the seller's highest possible searchdeterring price in the second period. The following lemma shows thatp* also plays the same role in the first period. That is, the buyer will acceptpi immediately if, and only if,p 1 p*, and otherwisewill search.

Table II The Buyer's Optimal Strategy at the End of the First Period Whenp* > p[1 - F(p)]
Range ofx1

[O,p*]
x Accept min[pl, xl] at the end of the first period
(P*, p?]

(P*,P

(po, 1] p*

The resultingsecond period seller's offer Buyer's optimalstrategyat the end of the first period
Range ofx1

p Accept min[p1, x1] at the end of the first period

(P, P"]

Acceptp1 at the end of the first period ifp1 < p0; acceptp * in the second periodotherwise
(p", P]
(p,

Whenp* <fp[1 -F(p)]

[0, p*] 1]

The resulting xp p* x1 P second period seller's offer Buyer's optimal Accept min[xl, Pl] Accept min[xl, p1] Acceptp1 at the Acceptp1 at the Acceptp1 at the at the end of the at the end of the strategyat the end of the first end of the first end of the first end of the first period first period period if P1 < period if 1 period if 1 first period p0; acceptp* Pi > 8&D(x1); P i > &D(P); in the second search in the search in the period second period second period otherwise otherwise otherwise

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Lemma 2. In the first period, the buyer will accept immediately any seller offer less than or equal to p *, and will search if the seller's first period offer is greater than p *. Proof. Consider first the case when the seller offers Pi < p *. In this case, we know that the second period will not be reached because, as discussed previously, the buyer's payoff for going to the second period is at most b(1 - p *). Hence, the buyer will either accept Pi immediately or accept min[p1, x1] after search. By Lemma 1, sincep1 p *, the buyer will acceptp immediately. Now, consider the case when the seller offersp1 > p*. Since the buyer can always recallp1 after search, the expected payoff from search will be at least 'F(p1), which is greaterthan 1 -P1 becausep1 >p*. Obviously, the buyer will not acceptp1 immediately. Hence, we need only to consider the buyer's payoff if he searches and his payoff if he goes directly to the second period. We consider two cases: i) when p* p[1 - F(Q)], and ii) whenp* < p-[1 - F(F)]. 5 - F(p)], the buyer's payoff for F[1 Whenp* going directly to the second period is 8(1 - p*) (= 1 - po), whereas his expected payoff from search is at least
1

Clearly,p' > p* because b8(3P) < 1 - p* and, by Lemma 1, 1(p') > 1 - p'. In other words, the buyer will search. 2.2.3. The Seller's Behavior in the First Period Lemma 2 greatly simplifies the analysis for the seller's equilibrium offer in the first period. Lemma 2 also p * will be suggests that, because all seller offersp1 p accepted immediately by the buyer, the seller can guarantee herself a payoff of p * by offeringp1 = p* in the first period. One may then suspect that, ifp * is sufficientlylarge (i.e., c is sufficientlylarge), the seller will then have incentive to end the game immediately. This is indeed the case. The following proposition gives the sufficient condition for the immediate resolution of bargaining. Proposition 1. Whenp* ? p[1 - F(p)], this game has a unique subgame perfect equilibrium in which the seller offers p * in the first period and the buyer accepts immediately. Proof. Since, by Lemma 2, the buyer will accept all seller offers less than or equal top * in the first period, the seller will never offer any price less thanp . Now, consider the case when the seller's first period offer is strictly greater thanp *. In particular,let us consider first ifp1 E (p *, p?0].Then, by Lemma 3, the buyer will search and the post-search behavior (see the first part of Table II) is to accept the outside offerx1 if x1 S P1, and otherwise to acceptp1 at the end of the firstperiod. The seller's expected payoff for makingsuch an offer isp1[1 - F(p1)] becausep1 will be accepted at the end of the first period with probability 1 - F(p1) and the second period will never be reached. Sincep* > p[1 - F(p)] by our assumption, p* ? p1[1 - F(p1)] for allp1. Hence, it is clearly not optimal for the seller to offerp1 E (p*, P?]Next, consider the case ifp1 > p0. Then, again by Lemma 3, the buyer will search, and the buyer's post-search behavior, according to Table II, is to accept the outside offerx1 if x1 < po, and otherwise to accept the seller's second offer p * in the second period. Hence, the second period will be reached with probability 1 - F(p?), and once reached, the seller will offerp2 = p* and the buyer will accept. Therefore, the seller's expected payoff for offeringp1 > p0 is 8p*[l - F(p?)], which is clearly less thanp* . Therefore, the unique equilibriumis for the seller to offerp * in the first period and for the buyer to accept p * immediately. The equilibriumdescribed in Proposition 1 requires the buyer's search cost to be sufficiently high. As c

-c +
0

max[1 -x1,

8(1 -p*)]f(xl)

dx1

-c + +

J
0

(1 -xl)f(xl)

dx1

(1 -p0)f(xl)

dxl =-?(po)

where po = 1 - 8(1 - p*), as defined in (5). By Lemma 1, since po > p*, 1 - po < FD(p0). Clearly, the buyer will search. When p * < p [ 1 - F(P) ], the buyer's payoff for going directly to the second period is 8C(p), whereas his expected payoff from search is at least -c +
f
0 PI

max[1 -xl,

5'F(p)]f(xi)

dx1

-c +

(1 -xl)f(xl)

dxl

(1 -p')f(xi)

dxl = 'D(p'),

wherep' = 1 -

SFD(p).

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becomes smaller, the value of p* decreases and the seller's payoff in this equilibrium also decreases. Eventually, when c becomes sufficiently small (i.e., p* < F[1 - F(F)]), the seller may no longer have an incentive to end bargaining immediately. We now turn our attention to this case. To characterize the seller's optimal offer in the first period whenp* < p[1 - F(p)], let us first identify certain prices which cannot be the seller's equilibrium first period offer. First of all, since the seller can get p * by offering p1 = p*, it is obvious that she will not offer any price strictly less thanp* in the first period in equilibrium. Hence, the seller's equilibriumfirst period offer must be greater than or equal top*. In the following discussion, we will argue that no price in the following intervals can be the seller's equilibrium first period offer: (p*, p?], (po, 1 3&F(p")), and (1 - 8F(p), 1]. Notice that 1 - 8F(p") < 1 - as'(p) because '(FQ) is a decreasing function and p" < p. Also, 1 - 8F(p") > p0 because 1 - po = 8(1 - p*) = S8D(p*) > S(D(p"). Furthermore, forp1 in these ranges, the buyer's best response is always "to search" according to Lemma 2. Hence, the informationgiven in the second part of Table II will be useful for computing the seller's expected payoffs in these cases. First note that no price in (p *, po] can be the seller's equilibrium first-period offer. If the seller were to make such an offer, then, by Lemma 2 and the second part of Table II, the buyer would search and accept min[xl, Pi] after search. The seller's expected payoff for making such an offer is therefore pl[l - F(p1)]. Since Pi E (p*, p?], Pi < P". Also, p[l - F(p)] being strictly quasiconcave implies thatp[l - F(p)] is increasing inp forp < p. Hence, p 1[1 - F(p 1)] S p"[l - F(p")] because p 1 and p" are both less than p and p" > P1. However, since p * = p"[1 - F(p")], the seller is better off offering p * directly instead of offering a price in (p*, p0]. Any price in the open interval (p?, 1 - S?(p")) can also be ruled out as the seller's equilibriumfirstperiod offer. Suppose that the seller offers a price in the half-open interval (p?, 1 - S8F(p")]. Then, the buyer will search and, based on the buyer's postsearch behavior described in Table II, the seller's expected payoff can be shown to be equal to:
p", 1

Since (6) is clearly increasing in pl, the maximum

of (6) is achieved atp1 = 1 - &F(p"). Hence, any

seller strategy which chooses a price in (p?, 1 8F(p")) as her first-period offer cannot be an equilibrium strategy. Note, however, that Pi = 1 8FD(p")is not ruled out as a possible equilibrium first-periodoffer. Finally, there is one more price range to be ruled out. Consider the case if the seller offers p1 > 1 8(D(p). Then, again based on Table II, the seller's expected payoff will be
P" Sp*f(X ) dx + p

8x1[1

-F(xl)]f(xl)

dxl

+ |

P[l -F(p)]f(xj)

dx1.

(7)

However, if the seller offersp1 = 1 - &FD(p), her expected payoff will be

pp*f(X ) dx1 +

x 8x[1

-F(xl)]f(xl)

dx

(1 -

FD(pf))f(xj) dxl.

(8)

Since
1 - asD(p) ? 1 - ?(p)
p

=c + jxf(x)
> 8p-[l - F(p)],

dx + p-[1 - F(p)]

the value of (8) is greater than that of (7). Hence, offering P1 strictly greater than 1 - (D(p) in the first period cannot be optimal for the seller. Two possible candidates for the seller's equilibrium first-periodoffer now exist-one is p* and the other is a price in the closed interval [1 - S&D(p"), 1 S(D (p)]-

S 8*f(x

) dx1 +

plf(x1) dxl.

(6)

If the seller offers a price p1 in the interval [1 8F(p`), 1 - 8F(p)], then there must exist a price, call it x*(p1), in [p", p] such that Pi = 1 8D(x*(p1)). We can interpret x*(p1) as follows: x*(p1) is the outside offer which makes the buyer, after search in the first period, indifferent between accepting Pi immediately and going to the second period to search. Note that if x1 E (p", F], it is never optimal for the buyer to accept x1 at the end of the first period (see Table II). Hence, if x1 E (p", p], the buyer's payoff for acceptingpl at the end of the
first period is 1 - Pi, while his expected payoff for

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going to the second period and searching is &1(x1). (This is because, if the buyer goes to the second period with an outside offer x1 E [p", pl], the seller will offer P2 = x1 and the buyer will search. Again, see Table II.) Therefore, at the end of the first period, the buyer will acceptp 1 if x 1 > x *(p 1); otherwise, he will go to the second period and search if x1 < x*(pl). Hence, the seller's expected payoff for offering such ap1 in the first period will be
P,,

S p*f(xl)
x*(pI)

dx

+
p,, 1

xfl[1 - F(xl)]f(xl)

dxl

+
x*(pO)

p1f(x1)dx1

P(p1).

(9)

uniformly distributed on [0, 1], the two conditions required by the first type of equilibrium, p* < p[l - F(p-)] and p* > T(fl), cannot be satisfied simultaneously. Regardless of the form of F(.), the second type of equilibriumis always possible, given a sufficiently small c. To see this, consider again expression (9) and letpi = 1 - 8'F(p). Since p is the unique optimal offer in this equilibrium, T(P) _ T(1 - 8(p)). Now, consider the last term of T(1 - 8(p)), fp1 (1 - 81?(fP))f(x1)dxl, which can be shown by simple computation to be greater than p[1 - F(p)]2. Notice thatp[1 - F(p)]2 is a positive constant. However, p * depends on c. In fact, as c approaches zero,p * approaches zero as well. Hence, there must exist some c (which are small enough) such that p * < p [ 1 - F(fp)]2. Consequently, there must exist some c such that p* < T

1Let P E [1 - SF(p"), (p)] be the maximizer (assumed unique) and T(fl) be the maximumvalue of (9); then the seller will offer eitherp* or p5in the first period dependingon the value of p* and T(fl). Proposition 2. Whenp* < p-[1 - F(p)], one of the following will be the unique equilibriumof the game: i. If p* > P(13), the unique equilibrium is for the seller to offer P1 = p * in the first period and the buyer to accept immediately. The seller's and the buyer's payoffs in this equilibrium are p* and 1 - p*, respectively. ii. If p* < T((p), then the unique equilibriumis for the seller to offer p1 = p and the buyer to search in the first period. The seller's (ex ante) expected payoff in this equilibriumis T(p) and the buyer's is -c+ (1-xj)f(xi) dxl + J (1-p*)f(xj) dxl

3. DISCUSSION 3.1. The Main Results Propositions 1 and 2 suggest that this game has two types of equilibria. When c is large, the first type of equilibrium arises, in which the seller makes an acceptable offerp* and the buyer accepts immediately in the beginning of the first period. When c is sufficiently small, the second type of equilibriumarises, in which the seller offers a relatively high pricefl in the first period and the buyer searches. The bargaining outcome in the first type of equilibrium is efficient because bargainingends immediately without delay. In the second type of equilibrium, however, since agreement cannot be reached immediately by both players, efficiency loss is inevitable. This efficiency loss is due to the search cost paid by the buyer and the delay in reaching agreement. Intuitively, what happens is the following. In the first period, the seller has two options. First, she can charge the buyer a reasonable price p * to deter search. Second, she can make a high offer, knowing that the buyer will search and hoping that this high offer will eventually be accepted due to an unfruitful search. Note that, for the seller's second option to be a viable strategy, it is necessary to allow the buyer to hold onto the seller's offer for a given amountof time. Otherwise, there is no reason for the seller to make an offer that will be rejected in the first place and will never be accepted in the future. Since the search-deterringpricep * is increasing in c, the larger c is, the more attractiveis the first option to the seller. As c becomes smaller, the seller's incentive to deter

+ I
1

6(X1j)f(xj)

dx

+
x*(ff)

(1 -)f(xj)

dx1.

(10)

Proof. See the previous discussion. Proposition 2 delineates two types of equilibriathat may arise under the condition p* < p[1 - F(F)]. Yet, it is not clear whether both types of equilibriaare always possible. In fact, examples can be found so that the first type of equilibrium cannot arise. For instance, it can be shown that, if outside offers are

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1108 / LEE search decreases. Eventually, when c becomes sufficiently small, the second option becomes the better one. When the second type of equilibrium arises, the second period may or may not be reached depending on the outcome of the buyer's first period search. The probability that the second period will be reached is F(x*(f)) - F(p). In other words, there are two situations underwhich the game ends at the end of the first period. The first situationis when the buyer receives a satisfyingoutside offer (i.e., x1 < p?) in the firstperiod. In this case, the buyerwill be satisfiedwith what he has and will accept the outside offer. The second case arises when the buyer receives a discouragingoutside offer (i.e., x1 > x*(jp)). In this case, the buyer will become pessimistic about his bargaining situation in the second period and will accept reluctantly the seller's offerp1 = fl at the end of the first period. It is only when the buyer's first period outside offer is neither good nor bad (i.e., p0 < xi < x*(p)) that the second period will be reached. The buyer goes to the second period for one of two reasons. First, the buyer may believe that he has received a good outside offer (although not good enough to be accepted immediately)which can be used to convince the seller to make a better offer. This is the case when the buyer goes to the second period with an outside offer x1 E (p?, p"]. In this case, the seller offers p2 = p* (< x1) in the second period and the buyer accepts. Second, the buyer may feel that, considering the outside offer received in the first period, it may be worthwhile to search again in the second period. This happens when x1 E (p", x* (p)). If this occurs, the game proceeds to the end of the second period. When the buyer goes to the second period due to the second reason mentioned above, it is interesting to note that the seller's second period offer may be higher than her first period offer. To see how this can happen, recall that the seller's first period offer in the second type of equilibriumisp 1 = P. By part ii of A4, P = 1 - 6F(x* (P)) < x *(P) (because x * (P) > p ) . Now, suppose the buyer's first-periodoutside offer is slightly smaller than x*(f), say x1 = x*(ff) - E. Then, the buyer will go to the second period and the seller will offer P2 = X*(f) - E. Since x*(p) is strictly greater than fl, there must exist some E such that x*(Q) - E > 5. Two remarks should be made on how the assumption of allowing recall affects the results of this model. First, it is easy to check that the game will end immediately if the buyer cannot recall any of the past offers. Second, the more freedom the buyer has to recall past offers, the better is his equilibrium expected payoff and the worse is the seller's. In the earlierversion of this paper, two variations of this model were considered-the first variation allows the buyer to recall all past offers (includingthe seller's offers), and the second variationdoes not allow the buyer to recall any offer. Computation of the equilibriumexpected payoffs for both players in each of the three models indicates that the buyer's equilibriumexpected payoff is the highestin the "full recall"model andis the lowest in the "no recall" model, and vice versa for the seller. Since the derivation for the equilibria of these two variations is quite tedious and provides no additional insight into the problem, it will not be presented here. The detail is availableupon request. 3.2. An Example The following example is constructed by assuming outside offers to be uniformly distributedfrom 0 to 1. When F(-) is uniform, it should be easy to verify that p* = (2c) 1"2 andp = 1/2. Depending on the value of c, one of these two types of equilibriawill arise. Type 1 Equilibrium. When c ? 1/32 (i.e., whenp* ? p[l - F(p)]), the game has a unique equilibriumin which the seller offersp1 = (2c)1/2 in the first period and the buyer accepts immediately. In this equilibrium, the seller's payoff is (2c)1/2 and the buyer's is 1 - (2c) . Type 2 Equilibrium. When c < 1/32 (i.e., whenp* < p[l - F(p)]), the game has a unique equilibriumin which the seller offersp1 = 1 - 8(5/8 - c) in the first period and the buyer searches. The seller's and the buyer's (ex-ante) expected payoffs in this equilibrium are the same as those defined in (9) and (10) withp 1 = 5= 1 - 8(5/8 - c), x*(j) = 1/2, and po = 1 - 8 (1 - (2c)12). The seller's and the buyer's equilibriumexpected payoffs when 6 = 1 are plotted in Figure 3. It is interesting to see in Figure 3 how each player's equilibriumexpected payoff depends on c. Intuitively, we may expect the buyer's equilibriumexpected payoff to be decreasing and the seller's to be increasing in c. Figure 3, however, shows that this intuition is correct only when c ? 1/32, where the first type of equilibrium is supposed to be played. Even for c < 1/32, where the same second type of equilibrium is supposed to be played, both players' expected payoffs are convex, but not monotonic, in c. Furthermore, there is a sudden jump in both players' expected payoff functions for moving from c < 1/32 to c > 1/32 due to differenttypes of equilibria in effect. The buyer's

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REFERENCES 1989. An Outside Option Experiment.Quart. J. Econ. 104, 753-770. CHATrERJEE 1987. Bargaining K., AND L. SAMUELSON. With Two-Sided IncompleteInformation: An Infinite Horizon Model With AlternatingOffers.Rev. Econ. Studies 54, 175-192.
BINMORE,K. G., A. SHAKEDAND J. SUYrON.

1988. Bargaining CHATrERJEE, K., ANDL. SAMUELSON.

Under Two-sided Incomplete Information:The UnrestrictedOffersCase. Opns. Res. 36, 605-618.

CHATTERJEE, K., B. DUTTA, D. RAY AND K. SENGUPTA.

Figure 3. Players' equilibrium expected payoffs in the uniform example.

1990.A NoncooperativeTheoryof Coalitional Bargaining. WorkingPaper No. 90-10, Departmentof ManagementSciences and InformationSystems, Pennsylvania State University, University Park, Penn.
CHIKTE, S. D., ANDS. D. DESHMUKH. 1987. The Role of

expected payoffjumps to a higherlevel and the seller's drops to a lower level. In fact, the buyer's payoff is the highest and the seller's the lowest at c = 1/32. Hence, if the buyer's search cost is any indicationat all of his bargainingpower, it is when c is in some intermediate range that his bargainingpower is the strongest, not when c is infinitesimallysmall. In short, due to the convexity and the discontinuity in each player's expected payoff function, the effect of changingthe buyer's search cost on each player's equilibriumexpected payoff is practicallyunpredictable.Increasing (or decreasing)the buyer's search cost could make both players better off or worse off, or it could make one player worse off and the other better off-all depending on where the change occurs. ACKNOWLEDGMENT I thank Kalyan Chatteree, Larry Kranich, Motty Perry, and two anonymous referees for their helpful comments. Research support from the Center for Research in Conflict and Negotiation at the Pennsylvania State University is gratefully acknowledged.

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MuTHoo,A. 1989. A Note on the Strategic Role of Outside Options in Bilateral Bargaining.Unpublished Paper, Departmentof Economics, London School of Economics, U.K.
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