ch9 strategy

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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 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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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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To achieve the desired result, thecommitment should be

Visible

Understandable

Credible

To be credible, the commitment should be

irreversible


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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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