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Economics of Strategy
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Economics of StrategyFifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010 John Wiley Sons, Inc.
Chapter 9
Strategic Commitment
Besanko, Dranove, Shanley, and Schaefer
Strategic Commitment
Strategic commitments
have long run impact and
are hard to reverse
Strategic commitments can affect choices made by rivals
Assessing strategic commitments involves anticipating market rivalry
Strategic Commitment
Inflexibility can add value
Strategic commitment limits options but alters competitors’ expectations
Strategic commitment can make a simultaneous move game into a sequential move game
Payoffs in the Simple Strategy Selection Game
Firm 2
Aggressive Passive
Firm 1
Aggressive 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 1’s; second is firm 2’s.
Sequential Move Game
Firm 1 commits itself to be aggressive
Firm 2 finds that it is better of choosing to be passive given firm 1’s commitment
Resulting equilibrium has a bigger payoff for firm 1 compared to what it had in the simultaneous move game
Strategic Commitment
To achieve the desired result, the commitment should be
Visible
Understandable
Credible
To be credible, the commitment should be irreversible
Strategic Commitment
Moves that represent commitment:Capacity expansion with investment in
relationship specific assets
Contracts with clauses such as most favored customer clause
Public announcements provided the reputation of the firm/management will suffer when not backed by action
The move should be difficult to stop once set in motion
Strategic Commitment & Competition
Concepts to describe how a firm reacts to price/quantity change by a competitor Strategic complements
Strategic substitutes
Concepts that distinguish between actions by a firm that puts its competitors at a disadvantage and those that do not Tough commitments
Soft commitments
Strategic Complements
When a firm’s action induces the rival to take the same action the actions are strategic complements
In Bertrand duopoly model prices are strategic complements
A price cut is the profit maximizing response to competitor’s price cut
The reaction function is upward sloping
Strategic Substitutes
When a firm’s action induces the rival to take the opposite action the actions are strategic substitutes
In Cournot duopoly model quantities are strategic substitutes
A quantity increase is the profit maximizing response to competitor’s quantity reduction
Reaction function slopes downward
Strategic Substitutes and Complements
Incentives to Make Commitments
Commitments affect the present value of the firm’s profits Direct effect: Due entirely to its own tactical decisions
Strategic effect: Due to the effect on the tactical decisions of the competitors
The strategic effect can be positive or negative depending on the choice variables being strategic complements or strategic substitutes
Tough Commitments and Soft Commitments
A tough commitment hurts the competitors while a soft commitment helps them
Tough commitment conforms to the traditional view of competition
A soft commitment may be beneficial if the strategic effect of the commitment is sufficiently positive
The Value of Soft Commitments
A firm that makes a soft commitment to raise its price may experience a negative direct effect on its profitability
If the optimal response of the rival is to raise its price, the strategic effect can be beneficial
If the strategic effect is sufficiently large, the net benefit from the commitment will be positive
An Analysis of Soft and Tough Commitments
The market has two firms and decisions are made in two stages
In the first stage Firm 1 makes either a soft commitment or a tough commitment
The second stage competition between the rivals will be either Cournot or Bertrand
Cournot After Tough Commitment
Firm 1 commits to a higher than previous output for every output choice of the rival
Firm 2’s reaction function makes the equilibrium output of Firm 1 even higher
Firm 2 produces less than what it used to produce.
“Tough” in a Cournot Market
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 rival’s output
Rival’s reaction hurts Firm 1 by making its output fall further
Firm 2 produces more than what it produced without Firm 1’s soft commitment
“Soft” in a Cournot Market
Scenarios to be Analyzed
First Stage Second Stage
Soft Cournot
Soft Bertrand
Tough Cournot
Tough Bertrand
Bertrand After Tough Commitment
Firm 1 commits to a lower price by shifting its reaction function to the left
Firm 2’s reaction further lowers the equilibrium price
Both firms end up being hurt by Firm 1’s tough commitment
“Tough” in a Bertrand Market
Bertrand After Soft Commitment
Firm 1 commits to charge a higher (than the pre-commitment level) price for every price level picked by the rival
Firm 2’s reaction provides a even higher price (for both firms)
Both firms benefit from Firm 1’s soft commitment
“Soft” in a Bertrand Market
Strategic Effects of the Commitments
Firm 1’s
Commitment
Second Stage
Competition
Strategic Effect
on Firm 1
Soft Cournot Negative
Soft Bertrand Positive
Tough Cournot Positive
Tough Bertrand Negative
Can the Negative Strategic Effect be Forestalled?
If the direct effect is positive and the strategic effect negative, can the firm forestall the latter?
Example: The net present value of cost reducing commitment is positive. Can the negative strategic effect be avoided by refusing to lower the price?
Can the Negative Strategic Effect be Forestalled?
If the profit maximizing strategy (after the commitment) is to lower the price, rival will assume that the firm will do so
It is difficult to convince a rival that your firm will act against its own interest in the second stage
A Taxonomy of Strategic Commitments
Firm 1’s Strategy
Commitment Posture
Commitment Action
Top-Dog Strategy
Tough Make
Submissive Underdog
Tough Refrain
Suicidal Siberian
Soft Make
Lean and Hungry Look
Soft Refrain
When Second Stage Actions are Strategic Substitutes
A Taxonomy of Strategic Commitments
Firm 1’s
Strategy
Commitment
Posture
Commitment
Action
Mad Dog Tough Make
Puppy-Dog
Play
Tough Refrain
Fat-Cat Effect Soft Make
Weak Kitten Soft Refrain
When Second Stage Actions are Strategic Complements
Factors that Influence the Strategic Effect
In general, commitments that lead to less aggressive behavior from the rivals will have beneficial strategic effect
If the rival is a potential entrant rather than an existing firm, a tough commitment to price aggressively may deter entry
Factors that Influence the Strategic Effect
If the rivals is an existing firm and there is excess capacity in the industry, aggressive pricing may invite retaliation
If the products are horizontally differentiated, the strategic effect may be relatively less important since the rival does not have the incentive to react
Strategic Effects & Product Differentiation
Flexibility and Options
The value of commitments lies in creating inflexibility
However, when there is uncertainty, flexibility is valuable since future options are kept open
Commitments can sacrifice the value of the options
Commitment-Flexibility Tradeoff
By waiting, a firm preserves its option values
By waiting, the firm also may allow its competitors to make preemptive investments
Example: Philips decides to delay its CD manufacturing plant in the U.S., allowing Sony to build its plant first
Preserving Flexibility
Modify the commitment as conditions evolve
Delay commitment until better information is available on profitability
Make unprofitable commitments today to preserve valuable options in the future
Flexibility and Real Options
A real option exists if future information can be used to tailor decisions
Better information about demand can be utilized by delaying implementation of projects
Value of real options may be limited by the risk of preemption
Key managerial skill in spotting valuable real options
A Framework for Analyzing Commitments
Pankaj Ghemawat has developed a four step process for analyzing commitment intensive decisions
Positioning Analysis
Sustainability Analysis
Flexibility Analysis
Judgment Analysis
Positioning Analysis
Positioning analysis is akin to the determination of the direct effect of commitment
The focus is on whether the firm operates with lower costs than its competitors or offers superior benefits to its customers
Sustainability Analysis
Sustainability analysis resembles the determination of the strategic effect
It analyzes the response by competitors and potential entrants
It also looks at the market imperfections that protect the firm’s competitive advantage
Flexibility Analysis
Flexibility analysis incorporates uncertainty and option value
A key determinant of the option value is the ratio of the “learn rate” to the “burn rate” of the firm
The rate at which a firm receives new information that allows it adjust its strategy is termed the “learn rate”
Flexibility Analysis
The rate at which the firm makes irreversible investments in support of its strategy is the “burn rate”
A high learn to burn ratio indicates that the option value of delay is low
Firms can increase their learn to burn ratios through experimentation and pilot programs
Judgment Analysis
Judgment analysis involves looking at the organizational and managerial factors to ensure that incentives exist to support the optimal strategy
Hierarchical decision making may create a bias towards Type I errors - rejecting good projects
Judgment Analysis
Decentralized decision making may result in higher incidence of Type II errors -accepting unprofitable projects
Managers should be cognizant of the biases imparted by the structure of the organization and its politics and culture
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