Transcript Chapter 9

Economics of Strategy

Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 9

Strategic Commitment

Slides by: Richard Ponarul,

California State University, Chico

Copyright  2010 John Wiley  Sons, Inc.

Strategic Commitment

 Strategic commitments  have long run impact and  are hard to reverse  Strategic commitments can affect choices made by rivals  Assessing strategic commitments involves anticipating market rivalry

Strategic Commitment

 Inflexibility can add value  Strategic commitment limits options but alters competitors’ expectations  Strategic commitment can make a simultaneous move game into a sequential

move game

Payoffs in the Simple Strategy Selection Game

Firm 2

Aggressive Passive Aggressive 12.5, 4.5 16.5, 5 Firm 1 Passive

15, 6.5

18, 6 Net present values are in millions of dollars. First payoff listed is firm 1’s; second is firm 2’s.

Unique Nash equilibrium: Firm 1 passive and Firm 2 aggressive

Sequential Move Game

 Firm 1 commits itself to be aggressive  Firm 2 finds that it is better of choosing to be passive given firm 1’s commitment  Resulting equilibrium has a bigger payoff for firm 1 compared to what it had in the simultaneous move game

Strategic Commitment

 To achieve the desired result, the commitment should be  Visible  Understandable  Credible  To be credible, the commitment should be irreversible

Strategic Commitment

  Moves that represent commitment:  Capacity expansion with investment in relationship specific assets  Contracts with clauses such as most favored customer clause  Public announcements provided the reputation of the firm/management will suffer when not backed by action The move should be difficult to stop once set in motion

Strategic Commitment & Competition

 Concepts to describe how a firm reacts to price/quantity change by a competitor 

Strategic complements

Strategic substitutes

 Concepts that distinguish between actions by a firm that puts its competitors at a disadvantage and those that do not 

Tough commitments

Soft commitments

Strategic Complements

    When a firm’s action induces the rival to take the same action the actions are strategic complements In Bertrand duopoly model prices are strategic complements A price cut is the profit maximizing response to competitor’s price cut The reaction function is upward sloping

Strategic Substitutes

    When a firm’s action induces the rival to take the opposite action the actions are strategic substitutes In Cournot duopoly model quantities are strategic substitutes A quantity increase is the profit maximizing response to competitor’s quantity reduction Reaction function slopes downward

Strategic Substitutes and Complements

Incentives to Make Commitments

 Commitments affect the present value of the firm’s profits  Direct effect: Due entirely to its own tactical decisions  Strategic effect: Due to the effect on the tactical decisions of the competitors  The strategic effect can be positive or negative depending on the choice variables being strategic complements or strategic substitutes

Tough Commitments and Soft Commitments  A tough commitment hurts the competitors while a soft commitment helps them  Tough commitment conforms to the traditional view of competition  A soft commitment may be beneficial if the strategic effect of the commitment is sufficiently positive

The Value of Soft Commitments

 A firm that makes a soft commitment to raise its price may experience a negative direct effect on its profitability  If the optimal response of the rival is to raise its price, the strategic effect can be beneficial  If the strategic effect is sufficiently large, the net benefit from the commitment will be positive

An Analysis of Soft and Tough Commitments  The market has two firms and decisions are made in two stages  In the first stage Firm 1 makes either a soft commitment or a tough commitment  The second stage competition between the rivals will be either Cournot or Bertrand

Cournot After Tough Commitment

 Firm 1 commits to a higher than previous output for every output choice of the rival  Firm 2’s reaction function makes the equilibrium output of Firm 1 even higher  Firm 2 produces less than what it used to produce.

“Tough” in a Cournot Market

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’s reaction hurts Firm 1 by making its output fall further  Firm 2 produces more than what it produced without Firm 1’s soft commitment

“Soft” in a Cournot Market

Scenarios to be Analyzed

First Stage Soft Soft Tough Tough Second Stage Cournot Bertrand Cournot Bertrand

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 being hurt by Firm 1’s tough commitment

“Tough” in a Bertrand Market

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

“Soft” in a Bertrand Market

Strategic Effects of the Commitments

Firm 1’s Commitment Soft Soft Tough Tough Second Stage Competition Cournot Bertrand Cournot Bertrand Strategic Effect on Firm 1 Negative Positive Positive Negative

Flexibility and Options

 The value of commitments lies in creating inflexibility  However, when there is uncertainty, flexibility is valuable since future options are kept open  Commitments can sacrifice the value of the options

Commitment-Flexibility Tradeoff

 By waiting, a firm preserves its option values  By waiting, the firm also may allow its competitors to make preemptive investments  Example: Philips decides to delay its CD manufacturing plant in the U.S., allowing Sony to build its plant first

Preserving Flexibility

 Modify the commitment as conditions evolve  Delay commitment until better information is available on profitability  Make unprofitable commitments today to preserve valuable options in the future

Flexibility and Real Options

 A real option exists if future information can be used to tailor decisions  Better information about demand can be utilized by delaying implementation of projects  Value of real options may be limited by the risk of preemption  Key managerial skill in spotting valuable real options