Home > Mobile, Technology, Uncategorized > Contract Negotiation: Case Study in Contingent Thinking, Behavioral Economics

Contract Negotiation: Case Study in Contingent Thinking, Behavioral Economics

Whether in sales or strategic partnerships, a deal closes once a contract has been agreed upon. As expected, both sides are going to haggle over the nuances surrounding some of the greater business terms. At this point in time, negotiators are brought in to hammer out the final terms. Many would argue that agreeing on the final decisions is an art itself–this is indeed the opinion of many a “closer,” those always-in-high-demand negotiators who are able to harangue the best terms all while tying off the sales cycle quickly. Just as it is very difficult to quantify the distinction between mediocre and great salespeople, it is very difficult to pinpoint a great closer. Most people will say the distinction is intuitive–you just know when you see one.

From experience, I can say that the secret to negotiations is simple (but difficult to practice). The secret sauce of successful contract negotiation lies in understanding your opposing negotiator’s opposing point of view. In other words, the person who most completely understands their equivalent’s point of view–or to paraphrase Jerry Weissman, their WIIFY (what’s in it for you) – will best be able to broker acceptable compromise. Understanding one’s opponents’ WIIFY is difficult to do, but not impossible. What “closers” call intuitive is simply an organized plan of attack in haggling over terms.  In fact, a systematic framework for contract negotiation can be established by understanding the opposite negotiator’s key business goals; once one has understood the other side’s best alternative to a negotiated agreement, one can be in a better position to ink favorable business terms that seems acceptable to the other side.

The framework one applies in optimizing the best terms resulting from contract negotiation can be exemplified in a light case study of behavioral game theory, especially one that draws from the realm of contingent thinking. According to the main tenets of behavioral economics, people’s actions under certain time constrains can be categorized. Behavioral game theory details what people do when playing games (i.e. puzzles, prisoner’s dilemma scenarios, etc.). Normative analysis postulates what people should do (i.e. what people should do to maximize positive externalities). In contrast, positive analysis predicts what people actually do. So in scenarios where two parties are faced with two alternative decisions (in the trite prisoner’s dilemma scenario, “rat on partner” or “stay silent”), the best decision to take can usually be summed up by the Nash Equilibrium. In this situation, the negotiator, having fully understood his choices and those of his opposing party, has no incentive to deviate from the decision he ultimately chooses.  Nash Equilibriums are possible in certain situations, but they are rare, especially if the game is not zero-sum.  For instance, it may be difficult to pinpoint Nash Equilibrium if one plays the game over multiple rounds; in this new case, one’s choice can instead turn into a strategy.  As a matter of fact, a dominant strategy is dominant if it is the best response to any feasible strategy that others might play. In mathematical terms, displaying the utility function of dominant strategy is as follows:

If si = dominant strategy, then Ui(si*, s-i) > ui(si’, s-i) for all s-i, si’ si*

In a game where you can do multiple iterations, your choice of action providing the best result can be difficult to pinpoint unless one keeps in mind what one’s opponent decides. This is contingent thinking in its full form: one has to make a decision based on what one thinks one’s opponent will do. This is exactly what contract negotiation is: one has to hedge one’s bets by understanding what is valuable to the person one is in negotiation with, consequently choosing what to give in to and what to fight over.

The p-beauty game repeatedly tried in behavioral economic case studies best exemplifies the applications of contingent thinking to contract negotiation.  In the p-beauty game (Moulin 1986), all participants are asked to simultaneously pick a number between 0 and 100. The winner of the contest is the person(s) whose number is closest to 2/3 (an arbitrary p value usually picked by the mediator that falls between 0 and 1*) times the average of all numbers submitted. How do you win this game? By choosing a number contingent of what one thinks other people will choose. In this case, one knows that the highest possible mean is 100, so choosing below (2/3)* 100 is a dominated strategy (best strategy one can take considering what you think other people will do). One can do better by choosing as low as (2/3)* (2/3)* 100–in this case one assumes that everybody else had the same reasoning as you and picked (2/3)*100 as the average, so one has to pick (2/3) * (2/3) * 100 to win the game. The same logic applies when one considers if other people think of the aforementioned strategy a step further (as you just did), so one decides to take one’s iterated decision a step further and choose between (2/3)*(2/3)*(2/3)*100 and (2/3)*(2/3)*100. Extending this process N steps results in the following conclusion: the highest possible valuation of the mean is 100*(2/3)^N, so one can do better by choosing at least as low as 100*(2/3)^(N+1). If everyone practices this sort of contingent thinking, then the best possible number to choose is 0. However, we know in the real world, not everybody will be practicing this sort of contingent thinking (I sure didn’t when I played this game for the first time). So one has to take that in consideration, and hedge one’s bets by choosing a number a little more than 0 rather than exactly 0. That gives one the highest realistic probability that one’s chosen number will win.

In the p-beauty game, one has to make a realistic decision by contingently thinking of what one’s opponent(s) may decide to do.  This happens every day when one negotiates contracts. As Roger Fisher and William Ury explain in their book Getting to Yes, arriving at the best business terms comes from negotiating on merits rather than on positions. They argued that negotiators need to focus on the issues and not the people, generate a variety of creative possibilities that can be mutually agreed to, and insist that final decisions be made on a rational basis rather than arbitrary or emotional ones. Ultimately, when one understands the opposing side’s best alternative to a negotiated agreement–BATNA as Fisher and Ury write–then one can avoid negotiating from a bottom line, allowing for flexibility in negotiated terms that are favorable to both sides. Just as in the p-beauty game where one has to make decisions based on what other people will decide, the contract negotiator has to ask for terms that they think can be agreed to by both sides.

Ultimately a contract is a formal approval for a relationship to progress between two sides. The one lesson that I’ve taken away from my own experiences is the following: sometimes it’s worth losing some battles for the sake of preserving the relationship with your business partner. Especially if you are inking the beginning of a partnership, whether distribution or channel, the potential upsell will be more expedient if the relationship begins on good terms. One must  understand what your partner’s BATNA is for the contract negotiation to be fruitful.

Sadly, sometimes each side’s BATNAs is more attractive than any compromise, and one side walks. Sometimes preserving the relationships means discounting the potential utility from future endeavors in hope that the future discounted utility is greater than the present BATNA’s. The relationship is the most important factor to keep in consideration when contracts are being negotiation–sometimes not having that relationship in place is an unacceptable BATNA. This is a card that needs to be played close to the chest when dealing in hostile conversations.

The truly skillful negotiator will prepare for his séances with the other side by meticulously researching what the partner’s BATNA is, and strategize his thinking so that the resulting compromises is better than his own BATNA. Indeed, planning one step ahead–or multiple steps, as exemplified by the p-beauty game–separates the best “closers” from the mediocre.

[*if p=1 then there are many possible Nash equilibria, as there are multiple dominant strategies. ]

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