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Economics of Strategy
Fifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010 John Wiley Sons, Inc.
Chapter 9
Strategic Commitment
Besanko, Dranove, Shanley, and Schaefer
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Strategic Commitment
Strategic commitments
have long run impact and
are hard to reverse
Strategic commitments can affect choicesmade by rivals
Assessing strategic commitments involvesanticipating market rivalry
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Strategic Commitment
Inflexibility can add value
Strategic commitment limits options butalters competitors expectations
Strategic commitment can make asimultaneous move game into a sequentialmove game
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Payoffs in the Simple Strategy Selection Game
Firm 2
Aggressive Passive
Firm 1Aggressive 12.5, 4.5 16.5, 5
Passive 15, 6.5 18, 6
Unique Nash equilibrium: Firm 1 passive and Firm 2 aggressive
Net present values are in millions of dollars. First payoff listed is
firm 1s; second is firm 2s.
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Sequential Move Game
Firm 1 commits itself to be aggressive
Firm 2 finds that it is better of choosing tobe passive given firm 1s commitment
Resulting equilibrium has a bigger payoff forfirm 1 compared to what it had in thesimultaneous move game
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Strategic Commitment
To achieve the desired result, thecommitment should be
Visible
Understandable
Credible
To be credible, the commitment should be
irreversible
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Strategic Commitment
Moves that represent commitment:Capacity expansion with investment in
relationship specific assets
Contracts with clauses such as most favoredcustomer clause
Public announcements provided the reputationof the firm/management will suffer when not
backed by action The move should be difficult to stop once set
in motion
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Strategic Commitment & Competition
Concepts to describe how a firm reacts toprice/quantity change by a competitorStrategic complements
Strategic substitutes
Concepts that distinguish between actionsby a firm that puts its competitors at a
disadvantage and those that do not Tough commitments
Soft commitments
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Strategic Complements
When a firms action induces the rival totake the same action the actions are strategiccomplements
In Bertrand duopoly model prices arestrategic complements
A price cut is the profit maximizing response
to competitors price cut The reaction function is upward sloping
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Strategic Substitutes
When a firms action induces the rival totake the opposite action the actions arestrategic substitutes
In Cournot duopoly model quantities arestrategic substitutes
A quantity increase is the profit maximizing
response to competitors quantity reduction Reaction function slopes downward
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Strategic Substitutes and Complements
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Incentives to Make Commitments
Commitments affect the present value of thefirms profits Direct effect: Due entirely to its own tactical decisions
Strategic effect: Due to the effect on the tactical decisionsof the competitors
The strategic effect can be positive or
negative depending on the choice variablesbeing strategic complements or strategicsubstitutes
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Tough Commitments and Soft Commitments
A tough commitment hurts the competitorswhile a soft commitment helps them
Tough commitment conforms to the
traditional view of competition
A soft commitment may be beneficial if thestrategic effect of the commitment is
sufficiently positive
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The Value of Soft Commitments
A firm that makes a soft commitment toraise its price may experience a negativedirect effect on its profitability
If the optimal response of the rival is to raiseits price, the strategic effect can be beneficial
If the strategic effect is sufficiently large, the
net benefit from the commitment will bepositive
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An Analysis of Soft and Tough Commitments
The market has two firms and decisions aremade in two stages
In the first stage Firm 1 makes either a soft
commitment or a tough commitment
The second stage competition between therivals will be either Cournot or Bertrand
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Cournot After Tough Commitment
Firm 1 commits to a higher than previousoutput for every output choice of the rival
Firm 2s reaction function makes the
equilibrium output of Firm 1 even higher
Firm 2 produces less than what it used toproduce.
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Tough in a Cournot Market
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Cournot After Soft Commitment
Firm 1 shifts its reaction function to the left,committing to produce less (than pre-commitment level) for every level of rivals
output Rivals reaction hurts Firm 1 by making its
output fall further
Firm 2 produces more than what it producedwithout Firm 1s soft commitment
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Soft in a Cournot Market
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Scenarios to be Analyzed
First Stage Second Stage
Soft CournotSoft Bertrand
Tough Cournot
Tough Bertrand
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Bertrand After Tough Commitment
Firm 1 commits to a lower price by shiftingits reaction function to the left
Firm 2s reaction further lowers the
equilibrium price
Both firms end up being hurt by Firm 1stough commitment
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Tough in a Bertrand Market
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Bertrand After Soft Commitment
Firm 1 commits to charge a higher (than thepre-commitment level) price for every pricelevel picked by the rival
Firm 2s reaction provides a even higherprice (for both firms)
Both firms benefit from Firm 1s soft
commitment
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Soft in a Bertrand Market
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Strategic Effects of the Commitments
Firm 1s
Commitment
Second Stage
Competition
Strategic Effect
on Firm 1
Soft Cournot Negative
Soft Bertrand Positive
Tough Cournot Positive
Tough Bertrand Negative
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Flexibility and Options
The value of commitments lies in creatinginflexibility
However, when there is uncertainty,
flexibility is valuable since future options arekept open
Commitments can sacrifice the value of the
options
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Commitment-Flexibility Tradeoff
By waiting, a firm preserves its option values
By waiting, the firm also may allow itscompetitors to make preemptive
investments
Example: Philips decides to delay its CDmanufacturing plant in the U.S., allowing
Sony to build its plant first
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Preserving Flexibility
Modify the commitment as conditionsevolve
Delay commitment until better information
is available on profitability
Make unprofitable commitments today topreserve valuable options in the future
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Flexibility and Real Options
A real option exists if future information canbe used to tailor decisions
Better information about demand can be
utilized by delaying implementation ofprojects
Value of real options may be limited by the
risk of preemption Key managerial skill in spotting valuable real
options
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