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 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 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

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

A Commitment Taxonomy Strategic Substitutes Complements Type of Commitment SoftTough Situations in which strategic commitment should be undertaken Situations in which strategic commitment should be undertaken Top Dog Fat Cat Situations in which strategic commitment should be refused Situations in which strategic commitment should be refused Lean & Hungry Puppy 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 millionProfit $250 million Probability 0.5 Probability 0.5 Expected profit =0.5x x = $375 million Suppose that one period’s delay removes the uncertainty Suppose that one period’s delay removes the uncertainty If acceptance is low then choose an alternative “normal” investment If acceptance is low then choose an alternative “normal” investment This changes the expected profit of the investment This changes the expected profit of the investment (0.5( ) + 0.5(0))/1.1 (0.5( ) + 0.5(0))/1.1 = $455 million Assuming a 10% discount rate Assuming a 10% discount rate The option value of delay in 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