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Strategic commitment

Strategic commitment. September 3, 2008. Where we are. We learned that the nature of the market a firm competes in impacts its profit margin Equilibrium profit margin is zero when Homogeneous goods, compete on price Equilibrium profit margin is positive when

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Strategic commitment

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  1. Strategic commitment September 3, 2008

  2. Where we are • We learned that the nature of the market a firm competes in impacts its profit margin • Equilibrium profit margin is zero when • Homogeneous goods, compete on price • Equilibrium profit margin is positive when • Homogeneous goods, compete on output • Differentiated products, compete on price • A firm’s equilibrium profit margin is higher when its profit is insulated from its rivals’ actions Strategic commitment

  3. Question of the day • Are there actions that a firm can commit to that improves its competitive position? Strategic commitment

  4. We need more game theory • The games we have looked at so far are static • All players move simultaneously • No time passes • We can’t talk about commitment without talking about the future • Make a commitment now to restrict future behavior • Need a type of game that allows for a future Strategic commitment

  5. Dynamic games Player 1 moves first, and chooses either A or B Player 2 sees player 1’s move and then chooses either X or Y Player 1 B A Player 2 X Y X Y 1’s payoff: 2’s payoff: 6 0 2 2 -2 5 3 3 Strategic commitment

  6. Dynamic games Player 1 Decision nodes B A Player 2 X Y X Y 1’s payoff: 2’s payoff: 6 0 2 2 -2 5 3 3 Strategic commitment

  7. Dynamic games In equilibrium, player 1 must correctly anticipate player 2’s response Otherwise 1 would like to change Solve the game using the concept of backward induction Begin the analysis at the last nodes of the game and work back to the beginning Player 1 B A Player 2 X Y X Y 6 0 2 2 -2 5 3 3 Strategic commitment

  8. Dynamic games Player 2 plays Y if 1 played A X if 1 played B Player 1 B A Player 2 X Y X Y 6 0 2 2 -2 5 3 3 Strategic commitment

  9. Dynamic games Player 2 plays Y if 1 played A X if 1 played B Player 1 plays A This is called the subgame perfect equilibrium Player 1 B A Player 2 X Y X Y 6 0 2 2 -2 5 3 3 Strategic commitment

  10. Interpreting subgame perfection Dad has tickets to the circus, but the kid is whining and driving Dad crazy Dad tells the kid that if the kid doesn’t stop whining Dad will not take him to the circus Is Dad’s threat credible? Kid Whine Good Dad Home Circus Circus Home 4 2 2 1 3 4 1 3 Strategic commitment

  11. Interpreting subgame perfection Dad’s threat makes the kid choose between two branches, so the kid should choose to be good Right? Kid Whine Good Dad Home Circus Circus Home 4 2 2 1 3 4 1 3 Strategic commitment

  12. Interpreting subgame perfection Find the subgame perfect equilibrium Dad chooses Circus if Kid whines Circus if Kid is good Kid chooses to whine Kid Whine Good Dad Home Circus Circus Home 4 2 2 1 3 4 1 3 Strategic commitment

  13. Interpreting subgame perfection Find the subgame perfect equilibrium Dad chooses Circus if Kid whines Circus if Kid is good Kid chooses to whine Dad takes him to the circus anyway Dad’s threat was non-credible Kid Whine Good Dad Home Circus Circus Home 4 2 2 1 3 4 1 3 Strategic commitment

  14. Strategic commitment • Suppose that a firm can take some action now to improve its competitive position in the future • That commitment must be credible • Otherwise it is not consistent with subgame perfect equilibrium • Credibility is enhanced by irreversibility • Contracts • Public statements • The commitment should also be visible and understandable Strategic commitment

  15. Commitment vs. strategic commitment • Suppose that a firm decides to invest in a new manufacturing process that reduces its cost • After the new process is in place, it saves on every unit it produces • This increases profit • Standard financial analysis will tell if this investment is worthwhile • But, this also changes its competitive position against its rivals • Goal: determine strategic advantages of commitment Strategic commitment

  16. Terminology – strategic substitutes vs. strategic complements • Strategic substitutes • When firm A does more of an activity, firm B’s best response is to do less • Cournot (quantity) competition • Downward-sloping reaction functions • Strategic complements • When firm A does more of an activity, firm B’s best response is to do more • Bertrand (price) competition • Upward-sloping reaction functions Strategic commitment

  17. Terminology – tough vs. soft commitments • Tough commitments • Commitments that hurt rivals’ profit • Commitment to produce more in Cournot competition • Commitment to charge a lower price in Bertrand competition • Soft commitments • Commitments that help rivals’ profit • Commitment to produce less in Cournot competition • Commitment to charge a higher price in Bertrand competition Strategic commitment

  18. Cournot competition Reaction curves are downward-sloping, so strategic substitutes qB A’s reaction curve B’s reaction curve qA When A produces zero, B produces this much This is monopoly output When A produces this much, B’s optimal output is zero This is where both PCMs are zero Strategic commitment

  19. Cournot competition Arrow shows direction of increasing profit for firm B along its own reaction curve A tough commitment for firm A moves A’s reaction curve to the right This lowers B’s profit A soft commitment for firm A moves A’s reaction curve to the left This raises B’s profit qB A’s reaction curve B’s reaction curve qA Strategic commitment

  20. Cournot competition Arrows show direction of increasing profit for firm A along firm B’s reaction curve The black dot is firm A’s favorite (i.e. highest profit) point on firm B’s reaction curve qB A’s reaction curve B’s reaction curve qA Strategic commitment

  21. Strategic commitment Firm A would like to commit to producing more output, shifting its reaction curve to the right This is a tough commitment Reduces B’s profit The tough commitment allows A to earn its highest possible profit given how B will respond qB A’s reaction curves B’s reaction curve qA Strategic commitment

  22. Bertrand competition The reaction curves are upward-sloping, so strategic complements A’s reaction curve pB B’s reaction curve pA Strategic commitment

  23. Bertrand competition Arrow shows direction of increasing profit for firm B along its own reaction curve A tough commitment for firm A moves A’s reaction curve to the left This lowers B’s profit A soft commitment for firm A moves A’s reaction curve to the right This raises B’s profit A’s reaction curve pB B’s reaction curve pA Strategic commitment

  24. Bertrand competition Arrows show direction of increasing profit for firm A along B’sreaction curve The black dot is firm A’s favorite (i.e. highest profit) point on firm B’s reaction curve A’s reaction curve pB B’s reaction curve pA Strategic commitment

  25. Strategic commitment Firm A would like to commit to charging a higher price, shifting its reaction curve to the right This is a soft commitment Increases B’s profit The soft commitment allows A to earn its highest possible profit given how B will respond A’s reaction curves pB B’s reaction curve pA Strategic commitment

  26. Learning from the two cases - tough Cournot – tough commitment leads to higher profit Tough commitment corresponds to more output Shift reaction curve right Rival responds with less output Response to tough commitment is less-aggressive behavior Bertrand – tough commitment leads to lower profit Tough commitment corresponds to lower prices Shift reaction curve left Rival responds with lower prices Response to tough commitment is more-aggressive behavior Strategic commitment

  27. Learning from the two cases - soft Cournot – soft commitment leads to lower profit Soft commitment corresponds to less output Shift reaction curve left Rival responds with more output Response to soft commitment is more-aggressive behavior Bertrand – soft commitment leads to higher profit Soft commitment corresponds to higher prices Shift reaction curve right Rival responds with higher prices Response to soft commitment is less-aggressive behavior Strategic commitment

  28. Learning from the two cases • Commitment has two effects on profit • Direct effect • Strategic effect • Strategic effect is positive if commitment makes rival compete less aggressively • Tough commitment in Cournot • Soft commitment in Bertrand • Strategic effect is negative if commitment makes rival compete more aggressively • Soft commitment in Cournot • Tough commitment in Bertrand Strategic commitment

  29. Example – Reducing marginal cost • Firm A can undertake costly innovation to reduce marginal cost • This adds a large up-front fixed cost • Reduces cost on every unit produced • Should firm A undertake the innovation? • Traditional analysis • Compute NPV • Strategic analysis • Look at impact on competitive behavior • This is a tough commitment • Strategic effect positive if Cournot, negative if Bertrand Strategic commitment

  30. Example – Commitment to quality • Is quality a strategic complement or a strategic substitute? • Want tough commitment if strategic substitute • Want soft commitment if strategic complement • If A increases quality, how will B respond? • B increases quality - strategic complements • “Quality war” • Compete away profits • B decreases quality – strategic substitutes • Tough commitment • A becomes the high-quality firm Strategic commitment

  31. Example – Airline baggage policies • Airline A adds a fee for checked baggage • Commitment or reversible? • What are the strategic implications? Strategic commitment

  32. Back to irreversibility • Commitments must be credible • Irreversible • Irreversible commitments are risky • Important to consider the strategic impacts beforehand Strategic commitment

  33. Strategic commitment September 3, 2008

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