Strategic Behavior in Small Markets

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This project studies how the strategic behavior of economic agents shapes equilibrium outcomes within small markets. It has three parts. (1) The first is bilateral bargaining when the bargainers have the option to break off the bargaining and seek another bargaining partner. The project seeks to show that the presence of this outside option changes equilibrium bilateral bargaining behavior from being essentially indeterminate to being essentially determined. The efficiency of decentralized markets with bilateral bargaining is also compared to centralized markets with multilateral bargaining. (2) The second part is the study of the behavior of duopolists whose costs are declining through learning- by-doing. Each period each firm decides how aggressively it should produce so as to reduce its costs further. The goal is to characterize the variety of subgame perfect equilibria that can exist when learning is important. (3) The third part involves the use of heuristics by economic agents within dynamic games. A heuristic approximates the value function that the agent would use if he or she were perfectly rational. The goal is to understand how the presence of such boundedly rational agents changes the set of equilibria. This research is important because it addresses one of the basic limitations in bargaining theory, i.e., bilateral bargaining theory with incomplete information has been unable to narrow in an interesting way the wide range of outcomes that are compatible with at least one reasonable equilibrium. The contribution from the first part of this project comes from exploring a neglected aspect of the bargaining problem that could provide determinate solutions. Conventional models of bilateral, incomplete information bargaining neglect the option bargainers have of breaking-off bargaining with a particular partner and bargaining with a new partner from the outside. The project studies bilateral, incomplete information bargaining with the outside option explicitly modeled. Preliminary work by the investigator demonstrates that introducing the outside option in bargaining models may eliminate the indeterminacy found in standard models. The research should provide useful new analytical tools and valuable substantive insights into the many bargaining problems in economics.