Strategic Commitment

1. Strategic Commitment

2. 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

3. Commitment and Value • Simple example of capacity choice by two firms Firm 2 has no dominant strategy Inflexibility can have value by influencing behavior Suppose that capacities are chosen simultaneously Firm 2 will choose to be passive Suppose Firm 1 can commit to being aggressive Sequential Nash Equilibrium Firm 2 Simultaneous Nash Equilibrium Dominant strategy for Firm 1 Can Firm 1 do better than this? Aggressive Passive Passive Aggressive 12.5, 4.5 16.5, 5 Aggressive 16.5, 5 Firm 1 Passive 15, 6.5 15, 6.5 18, 6

4. 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

5. 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

6. 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

7. Strategic Substitutes and Complements • Compare Cournot and Bertrand competition Cournot Bertrand q2 p2 The reaction functions slope upwards The reaction functions slope downwards Prices are strategic complements R1 Quantities are strategic substitutes R2 R2 R1 p1 q1

8. 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

9. 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

10. 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

11. Cournot competition Firm 1 may well choose to make this commitment: become “Top Dog” Suppose that the commitment makes firm 1 tougher Firm 1’s reaction function moves to the right q2 Original Cournot equilibrium The commitment has a beneficial strategic effect New Cournot equilibrium Firm 2 is induced to produce less output, increasing firm 1’s market share R2 R1 R1after q1

12. Cournot competition Firm 1 may well choose not to make this commitment: stay “Lean and Hungry” Suppose that the commitment makes firm 1 softer Firm 1’s reaction function moves to the left q2 New Cournot equilibrium Original Cournot equilibrium The commitment has a detrimental strategic effect Firm 2 is induced to produce more output, reducing firm 1’s market share R2 R1 R1after q1

13. Bertrand competition Firm 1 may well choose not to make this commitment: the “Puppy Dog Ploy” Firm 1’s reaction function moves to the left Suppose that the commitment makes firm 1 tougher p2 R1after R1 The commitment has a detrimental strategic effect New Bertrand equilibrium R2 Firm 2 is induced to reduce its price harming the profits of firm 1 Original Bertrand equilibrium p1

14. Bertrand competition Suppose that the commitment makes firm 1 softer Firm 1 may well choose to make this commitment: the “Fat-Cat Effect” Firm 1’s reaction function moves to the right New Bertrand equilibrium p2 R1 R1after The commitment has a beneficial strategic effect R2 Firm 2 is induced to increase its price helping the profits of firm 1 Original Bertrand equilibrium p1

15. A Commitment Taxonomy Situations in which strategic commitment should be refused Situations in which strategic commitment should be undertaken Type of Commitment Soft Tough Substitutes Lean & Hungry Top Dog Strategic Complements Puppy Dog Ploy Fat Cat

16. Interpreting the Taxonomy • Commitment is beneficial if: • makes rivals behave less aggressively • detrimental if • makes rivals behave more aggressively • Distinguish • existingrivals • soften price competition to increase profits • potential rivals • toughen price competition to deter entry

17. 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

18. 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

19. Option value example Suppose that one period’s delay removes the uncertainty If acceptance is low then choose an alternative “normal” investment Invest $500 million in a market with uncertain demand The option value of delay in this case is $80 Million High Acceptance Low Acceptance Assuming a 10% discount rate This changes the expected profit of the investment Profit $1500 million Profit $250 million Probability 0.5 Probability 0.5 Expected profit = 0.5x1500 + 0.5x250 - 500 (0.5(1500 - 500) + 0.5(0))/1.1 = $375 million = $455 million

20. 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

21. 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

22. 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

23. 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