Summarized by Sam Mishra, MBA (MIT Sloan)This framework can be best explained using the figure below, which represents a negotiating arena between two companies, who are trying to extract maximum value from a negotiable agreement.
Points Y and Z represent outcomes which are superior for both parties compared to outcome F, in terms of creating and claiming value. If both companies resort to an integrative bargaining approach as opposed to a distributive one, they can agree on either Y or Z, for example, as opposed to settling for outcome F.
The maximum value extraction for either party can improve with multiple rounds of negotiation. However, the exercise of creating and claiming value has limitations, represented in the above figure by the Pareto Frontier. The Frontier represents what is ultimately possible by joint action after the negotiators from both companies have tried their best to maximize value for themselves and for each other. This requires creativity, unlocking hidden value, etc., which are all ingredients of integrative bargaining, as opposed to a distributive approach.
Pareto Frontier is a heuristic, and exists only theoretically. Neither company may know the exact location of this frontier. However, awareness that this best possibilities frontier exists will help the negotiators create and claim more value than they otherwise could. On this frontier, company A cannot find another negotiated agreement that makes it better off without making company B worse off. For example, if company A is aware of this frontier but company B is not, company A can negotiate for outcome X, which represents the same value for company B as outcome F, but which represents a higher value for company A compared to outcome F.
So, Pareto Frontier, even though an abstraction, is nonetheless an important tool which can be used in business negotiations. For an application of this framework in a real business case, please check our Special Book Offers section, and our article on vacant U.S. homes in our Global Economy Portal.To get a deeper insight on this important framework, please listen to the corresponding MP3 podcast. Thank you.