Think twice before trying to get the upper hand in a business deal

15 October 2018

  • New Macquarie University research suggests trying to get the upper hand in a business deal isn’t as attractive as it may seem
  • Experimental economists’ findings contradict standard economic theory
  • Businesses should consider impacts of trying to extort a bigger slice of the pie in a deal

“Traditional economic theory suggests, in a bi-lateral trade relationship, one should establish an outside option whenever it is profitable,” says one of the authors, Professor of Economics at Macquarie Graduate School of Management Maroš Servátka.

“Simply put, when negotiating a business deal, if you have an external alternative, the party you’re negotiating with will have to make the trade more favourable to you to secure your interest.”

Common ways to address this type of opportunistic behaviour of looking for outside options includes vertical integration (for instance, if a publishing company acquires its own printing press rather than dealing with a separate printing press), or complex contracts outlining the arrangement and associated penalties.

“In practice, protecting your position against opportunistic behaviour through, for instance, vertical integration is very costly. That’s why we wanted to know whether the incentives to invest in outside options are as strong as commonly believed,” added Professor Servátka.

Through an experiment, Professor Servátka, alongside Professor Hodaka Morita of Hitotsubashi University and UNSW, investigated this question – and also took into account that the two parties may not necessarily behave purely selfishly, but that their behaviour may take others into account.

The decisions of experiment participants were financially incentivised, a crucial aspect of the experimental economics methodology, as their final dollar earnings depended on whether or not to create an outside option and how to split the profits with their trading partner. The results supported the researchers’ speculation that incentives to behave opportunistically and invest in an outside option are not as large as predicted by standard theory.

“Take the well-known example of a printing press company and a publisher who decides to hold its own standby press facilities to extort a larger share of the surplus, even though investment in press facilities is financially costly,” added Professor Morita.

“Standard economic theory predicts the publisher should establish this outside option and incur the costs to do so. But this doesn’t factor in that the printing press company might be open to splitting the gain in a fair way, and so such investment is not necessary. Conversely, the fact that the publisher established an outside option might upset the printing press company and they may be less open to a fair deal.”

This finding has important implications for the governance structure of firms – namely that costly remedies to prevent or resolving inefficiencies stemming from opportunistic behavior, such as vertical integration of the transacting parties or expensive contracts, may not always be necessary.

“Our findings suggest businesses should think carefully before investing in vertical integration – as those you’re negotiating with may not act as selfishly as you think,” said Professor Servátka. “For companies it is crucial to accurately estimate the seriousness of potential threats of lost profits due to opportunism of the other party.”

“At the same time, it is important to recognise that procurement managers negotiating on behalf of their companies might themselves face incentives to strengthen their bargaining position, as larger company profits could lead to higher individual compensation.

“But if the improvement is only minor, trying to extort a larger share of the joint surplus can damage the relationship without leading to increased profits. There is a fine line between taking advantage of competition and behaving opportunistically when dealing with a trade partner, so businesses should be careful not to do more harm than good.”

 

Hodaka Morita and Maroš Servátka, “Investment in Outside Options as Opportunistic Behavior: An Experimental Investigation,” Southern Economic Journal, 2018. https://doi.org/10.1002/soej.12285

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