strategic commitment

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


Suppose that the commitment makes firm

1 tougher


1 tougher Firm 1’s reaction functionmoves to the right

Firm 1’s reaction functionmoves to the right

R1after

New Cournotequilibrium


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




1 softer


1 softer Firm 1’s reaction functionmoves to the left

Firm 1’s reaction functionmoves to the left

R1after



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



1 tougher


1 tougher



R1after



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


Bertrand competition

p2

R1

R2

p1Original Bertrand

equilibrium



1 softer


1 softer Firm 1’s reaction function

moves to the right

Firm 1’s reaction functionmoves to the right

R1after



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


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

strategic commitment

Documents

firm softeroffer

chosensimultaneouslycan

firm1 tougher firm

reputationstrategic

competitiona commitment

strategic relationship

strategic commitmentmight

strategic contextwhen