Strategic Commitment. Introduction Firms make at least two sets of decisions –strategic...
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Transcript of Strategic Commitment. Introduction Firms make at least two sets of decisions –strategic...
![Page 1: Strategic Commitment. Introduction Firms make at least two sets of decisions –strategic commitments long-term and difficult/expensive to reverse –tactical.](https://reader036.fdocuments.us/reader036/viewer/2022072013/56649e6b5503460f94b6a076/html5/thumbnails/1.jpg)
Strategic Commitment
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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
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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
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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
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Strategic Commitment and Competition
• A 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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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