Economics of StrategyBesanko, Dranove and Shanley

Slide show prepared by

Richard PonArulCalifornia State University

Modified by BK HobbsFGCU John Wiley Sons, Inc.

Chapter 8

Strategic Commitment

Strategic Commitment

• Strategic commitments are decisions that have long run impact and are hard to reverse (e.g., installation of additional production capacity a priori to actual production)

• Strategic commitments differ from tactical moves which are easy to reverse and have only a short run impact (e.g., a store cutting the price on certain items)

Strategic Commitment

• To achieve the desired result, the commitment must be– visible– understandable– credible

• To be credible, the commitment should be irreversible

Commitment Value of Announcements

• If a firm has an established reputation at stake, even an announcement of intention to act can have commitment value (they have carried through before and they will again.)

• However, if the firm fails to match actions to words, it will lose credibility and reputation as a player will suffer

• Smaller and newer firms cannot rely on reputation of past actions to indicate commitment

Reversible and Irreversible Moves

• Reversible moves are more likely to be matched by rivals than irreversible moves

• Empirical evidence from the airline industry supports this view– Airlines respond quickly to price cuts by rivals

(which are easily reversible) but slowly or not at all to irreversible moves by a competing carrier (e.g., acquisitions, set-up of hubs or maintenance facilities)

Strategic Substitutes and Complements

• How do firms react to one another’s strategic moves?

Strategic Substitutes

• When a rival firm increases their supply to market, the other firm decreases its supply

• When a rival firm decreases their supply to market, the other firm increases its supply

• Strategic substitutes move in opposite directions

Strategic Substitutes

• Passive behavior leads to an aggressive response by the rival firm

• Aggressive behavior leads to a passive response by the rival firm

• Usually, quantities and capacity moves are strategic substitutes

Strategic Substitutes

• Use the Cournot Model

• Reaction curves are upward sloping– one firm’s decision to increase output will

cause the other to reduce its output, therefore output decisions are strategic substitutes

– one firm’s decision to decrease output will cause the other to increase its output, therefore output decisions are strategic substitutes

Strategic Complements

• When a rival firm increases their price, the other firm will also increase price

• When a rival firm decreases their price, the other firm will also decrease price

• Strategic complements move in the same direction

Strategic Complements

• Aggressive Behavior leads to an aggressive response by the rival firm

• Usually, price moves are strategic complements

Strategic Complements

• Use the Bertrand Model • Reaction functions are upward sloping

– one firm’s decision to increase the price will cause the other to increase the price as well, therefore price decisions are strategic complements

– one firm’s decision to decrease the price will cause the other to decrease the price as well, therefore price decisions are strategic complements

Commitments – Strategic Effect vs. Direct Effects

• Direct Effect – Impact on NPV of the firm’s profits

• Strategic Effects– Impact on the competitive environment facing

the firm over the long term– “How does the commitment alter the tactical

decisions of the rival, and ultimately, the market equilibrium?”

Tough vs. Soft Commitments

• Tough Commitments are “bad” for competitors– Conforms to our cultural view of competition, creates

winners and losers

– Win/Lose model

– Prevalent in Cournot-type industries

• Soft Commitments are “good” for competitors– Win/Win model

– Soft commitments can produce strategically benificial effects

Timing

• One firm makes a strategic commitment and then the stage is set for it and its rival firms to compete at a tactical level

• A “two-stage” game– Stage One: The strategic decision is made– Stage Two: The tactical maneuvering begins

(given the strategic commitment made in Stage One)

Tough Commitments

• The immediate effect of a tough commitment is to produce an adverse impact on your rival – e.g., a firm invests in a new production process

that reduces unit cost so that it can lower its price, forcing rivals to lower theirs also

• Tough commitment conforms to the traditional “zero-sum game” view of competition

Soft Commitments

• The immediate effect of a soft commitment is a favorable impact on the rival

• To understand why soft commitments may make sense, we need to look at both the short term initial effects and the long term strategic effects

Two Effects of Commitments

• Commitment can have a direct effect and a strategic effect on the firm’s profitability– Direct effect is the change in the present value

of profits assuming that the rival’s tactics are unaffected by the commitment

– Strategic effect is the further change in the present value of the firm’s profits due to the rival adjusting its tactics

The Value of Soft Commitment

• Suppose a firm that makes a soft commitment to raise its price. It may experience a direct negative effect on its profitability in the short term

• However, if the optimal response of the rival is to raise its price also, the strategic effect can be beneficial (i.e., Everyone gets to raise price)

The Value of Soft Commitment

• If the strategic effect is sufficiently large, the net benefit from the commitment will be positive

• If the NPV of the Strategic Effect > NPV of the Direct Effect, then the soft commitment pays off over the long term.

An Analysis of Soft and Tough Commitments

• In the first stage Firm 1 makes either a soft commitment or a tough commitment

• The second stage of competition between the rivals will be classified as either Cournot or Bertrand

Scenarios to be Analyzed

First stage Second stage

Soft CournotSoft BertrandTough CournotTough Bertrand

Cournot After Soft Commitment

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 (Firm2) reacts by increasing their output

and Firm 2 ends up producing more than what it produced due to Firm 1’s soft commitment

Bertrand After Soft Commitment

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

Cournot After Tough Commitment

Cournot After Tough Commitment

• Firm 1 commits to a higher than previous output for every output choice of the rival– Rival’s (Firm 2) reaction function makes the

equilibrium output of Firm 1 even higher– Firm 2 produces less than what it produced

previously due to the tough commitment from Firm 1

Bertrand After Tough Commitment

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 hurt by Firm 1’s tough commitment

Strategic Effects of the Commitments

Firm 1’sCommitment

Second StageCompetition

Strategic Effecton Firm 1

Soft Cournot NegativeSoft Bertrand PositiveTough Cournot PositiveTough 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 the Commitment

Submissive Underdog

Tough Refrain from making it

Suicidal Siberian

Soft Make the commitment

Lean and Hungry Look

Soft Refrain from making it

When Second Stage Actions are Strategic Substitutes

A Taxonomy of Strategic Commitments

Firm 1’sStrategy

CommitmentPosture

CommitmentAction

Mad Dog Tough Make

Puppy-DogPlay

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 (“you take your market and I’ll take mine”)

Flexibility and Option Value

• The value of commitments lies in creating inflexibility

• However, when there is uncertainty, flexibility is valuable since future options are kept open

• Commitments cut off flexibility and thus sacrifice the value of the options

Commitment-Flexibility Tradeoff

• By waiting, a firm preserves its option values

• At the same time, the firm gives rivals the time to make preemptive investments– e.g., Philips decides to delay its CD

manufacturing plant in the U.S., allowing Sony to build its plant first

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

Strategic Commitments

• Often– durable– relationship specific– difficult to transfer or re-deploy– “sticky” or “lumpy”

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