Post on 30-Dec-2015
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Strategic Commitment
Introduction
Firms make at least two sets of decisions strategic commitments
long-term and difficult/expensive to reverse tactical decisions
short-term and easily reversed
Strategic commitments can significantly affect competition Schelling: Constrain an adversary by binding your hands
Firms must be foresighted in the commitments they make anticipate rivals’ reactions
An example
Commitment and Value
Simple example of capacity choice by two firms
Firm 1
Aggressive
Passive
Firm 2
Aggressive Passive
12.5, 4.5
15, 6.5 18, 6
16.5, 5
Firm 2 hasno dominant
strategy
Firm 2 hasno dominant
strategy
Dominantstrategy
for Firm 1
Dominantstrategy
for Firm 1
15, 6.515, 6.5
SimultaneousNash
Equilibrium
Suppose thatcapacities are chosen
simultaneously
Suppose thatcapacities are chosen
simultaneously
Can Firm 1 dobetter than this?
Can Firm 1 dobetter than this?
Suppose Firm 1 cancommit to being
aggressive
Suppose Firm 1 cancommit to being
aggressive
AggressiveAggressive
Firm 2 willchoose tobe passive
Firm 2 willchoose tobe passive
16.5, 516.5, 5
Inflexibility canhave value by
influencing behavior
PassivePassive
SequentialNash
Equilibrium
Commitment
Commitment needs to exhibit three properties visibility
must be observable by those it is intended to influence
understandability must be comprehensible by those it is intended to
influence irreversibility
must be expensive to reverse:• “talk is cheap”• only irreversible actions really affect outcomes
How to Commit
Install capacity particularly if this is in the form of specialized
assets
Sign contracts to install capacity on advertising expenditures clauses that weaken willingness to cut prices
Commit to new product introduction if non-introduction adversely affects reputation
Strategic Commitment and CompetitionA commitment need not be tough to be
effective need to consider the strategic context
when to be tough and when to be soft?
Depends upon relationship between strategies strategic substitutes
aggressive action induces passive response strategic complements
aggressive action induces an aggressive response
Strategic Substitutes and ComplementsCompare Cournot and Bertrand competition
q2
q1
p2
p1
R1
R2
Cournot Bertrand
R1
R2
The reaction functionsslope downwards
The reaction functionsslope downwards Quantities are strategic
substitutes
Quantities are strategicsubstitutes
The reaction functionsslope upwards
The reaction functionsslope upwards
Prices are strategiccomplements
Prices are strategiccomplements
Strategic Incentives to Commit
Strategic relationship between firms is important indicates how rivals will react determines whether a firm should make a tough or soft
commitment
Strategic commitment has two effects direct
impact on profitability if rivals do nothing strategic
impact on competitive responses of rivals
Both are important
Tough and Soft Commitments
Some commitments make a firm tougher invest in new capacity R&D to reduce costs potentially bad for competitors
Others makes a firm softer offer most favored customer clauses open new markets that increase current costs potentially good for competitors
Both can increase profitability
An Illustration
Two firms Firm 1 contemplates making a strategic commitment
might make firm 1 tougher new process innovation
might make firm 1 softer entry to a new market that increases production costs in the
existing market
Once the commitment is chosen the firms compete in quantities if Cournot or prices if Bertrand
Cournot competition
q2
R1
R2
q1
Original Cournotequilibrium
Original Cournotequilibrium
Suppose that the commitment makes firm
1 tougher
Suppose that the commitment makes firm
1 tougher Firm 1’s reaction functionmoves to the right
Firm 1’s reaction functionmoves to the right
R1after
New Cournotequilibrium
New Cournotequilibrium
The commitment has abeneficial strategic effect
The commitment has abeneficial strategic effect
Firm 2 is induced to produceless output, increasing firm
1’s market share
Firm 2 is induced to produceless output, increasing firm
1’s market share
Firm 1 may wellchoose to make this
commitment:become “Top Dog”
Cournot competition
q2
R1
R2
q1
Original Cournotequilibrium
Original Cournotequilibrium
Suppose that the commitment makes firm
1 softer
Suppose that the commitment makes firm
1 softer Firm 1’s reaction functionmoves to the left
Firm 1’s reaction functionmoves to the left
R1after
New Cournotequilibrium
New Cournotequilibrium
The commitment has adetrimental strategic effect
The commitment has adetrimental strategic effect
Firm 2 is induced to producemore output, reducing firm
1’s market share
Firm 2 is induced to producemore output, reducing firm
1’s market share
Firm 1 may wellchoose not to make this
commitment: stay“Lean and Hungry”
Bertrand competition
p2
R1
R2
p1
Original Bertrandequilibrium
Original Bertrandequilibrium
Suppose that the commitment makes firm
1 tougher
Suppose that the commitment makes firm
1 tougher
Firm 1’s reaction functionmoves to the left
Firm 1’s reaction functionmoves to the left
R1after
The commitment has adetrimental strategic effect
The commitment has adetrimental strategic effect
Firm 2 is induced to reduceits price harming the profits
of firm 1
Firm 2 is induced to reduceits price harming the profits
of firm 1
Firm 1 may wellchoose not to make this
commitment: the“Puppy Dog Ploy”
New Bertrandequilibrium
New Bertrandequilibrium
Bertrand competition
p2
R1
R2
p1Original Bertrand
equilibrium
Original Bertrandequilibrium
Suppose that the commitment makes firm
1 softer
Suppose that the commitment makes firm
1 softer Firm 1’s reaction function
moves to the right
Firm 1’s reaction functionmoves to the right
R1after
The commitment has abeneficial strategic effect
The commitment has abeneficial strategic effect
Firm 2 is induced to increaseits price helping the profits
of firm 1
Firm 2 is induced to increaseits price helping the profits
of firm 1
Firm 1 may wellchoose to make this
commitment: the“Fat-Cat Effect”New Bertrand
equilibrium
New Bertrandequilibrium
A Commitment Taxonomy
Strategic
Substitutes
Complements
Type of Commitment
Soft Tough
Situations in whichstrategic commitmentshould be undertaken
Situations in whichstrategic commitmentshould be undertaken
Top DogTop Dog
Fat CatFat Cat
Situations in whichstrategic commitment
should be refused
Situations in whichstrategic commitment
should be refused
Lean & HungryLean & Hungry
Puppy Dog PloyPuppy Dog Ploy
Interpreting the Taxonomy
Commitment is beneficial if: makes rivals behave less aggressively
detrimental if makes rivals behave more aggressively
Distinguish existing rivals
soften price competition to increase profits potential rivals
toughen price competition to deter entry
Commitment
The failure to commit is itself a commitment Pepsi’s failure to commit to its Venezuelan bottler
Commitment’s effects also depend upon capacity utilization
excess capacity is more likely to induce aggressive response
product differentiation high degrees of product differentiation weaken price
competition
Flexibility and Option Value
Commitment may be less valuable if there is uncertainty about future events
Flexibility gives the firm options and so has option value
An example
Option value example
Invest $500 million in a market with uncertain
demand
High Acceptance
Low Acceptance
Profit $1500 million Profit $250 million
Probability 0.5 Probability 0.5
Expected profit = 0.5x1500 + 0.5x250 - 500
= $375 million
Suppose that one period’sdelay removes the
uncertainty
Suppose that one period’sdelay removes the
uncertainty If acceptance is low then
choose an alternative“normal” investment
If acceptance is low thenchoose an alternative“normal” investment
This changes theexpected profit of the
investment
This changes theexpected profit of the
investment
(0.5(1500 - 500) + 0.5(0))/1.1(0.5(1500 - 500) + 0.5(0))/1.1
= $455 million= $455 million
Assuming a 10%discount rate
Assuming a 10%discount rate
The option value of delayin this case is $80 Million
Flexibility and option value (cont.)
There are exceptions delay leads to possibility of preemption by a
competitor particularly if competitors are as well informed
Commitment usually involves irreversible investment durable, specialized assets that are untradeable once committed cannot easily redeploy involves risk
Need a framework to analyze commitment
A Framework for Commitment
Suggests four elements positioning analysis
direct effects of the commitment sustainability analysis
strategic effects of the investment: • potential responses, analysis of competitive advantage
created
these generate a financial analysis of the commitment
impact on revenues and likely time horizon
Framework (cont.)
flexibility analysis incorporates uncertainty identifies option value
• determined by speed with which the firm learns and the rate at which it must invest: the “learn-to-burn” ratio
• high learn-to-burn ratio creates flexibility
• option value of delay is low because the firm is learning rapidly about the true situation
judgement analysis assessing managerial and organizational factors that
distort decision-making• Type I error: reject good investments
• Type II error: accept bad investments
Framework (cont.)
Errors in judgement are related to organizational structure
hierarchical firms tend to make Type I errors• tend to screen out more investment projects
decentralized firms tend to make Type II errors• tend to accept more investment projects
Thus how to make decisions is important be aware of incentives created by organizational
architecture