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 1 Aggressive Passive Firm 2 AggressivePassive 12.5, 4.5 15, 6.518, 6 16.5, 5 Firm 2 has no dominant strategy Firm 2 has no dominant strategy Dominant strategy for Firm 1 Dominant strategy for Firm 1 15, 6.5 Simultaneous Nash Equilibrium Suppose that capacities are chosen simultaneously Suppose that capacities are chosen simultaneously Can Firm 1 do better than this? Can Firm 1 do better than this? Suppose Firm 1 can commit to being aggressive Suppose Firm 1 can commit to being aggressive Aggressive Firm 2 will choose to be passive Firm 2 will choose to be passive 16.5, 5 Inflexibility can have value by influencing behavior Passive Sequential Nash Equilibrium

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 q2q2 q1q1 p2p2 p1p1 R1R1 R2R2 Cournot Bertrand R1R1 R2R2 The reaction functions slope downwards The reaction functions slope downwards Quantities are strategic substitutes Quantities are strategic substitutes The reaction functions slope upwards The reaction functions slope upwards Prices are strategic complements Prices are strategic complements

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 q2q2 R1R1 R2R2 q1q1 Original Cournot equilibrium Original Cournot equilibrium Suppose that the commitment makes firm 1 tougher Suppose that the commitment makes firm 1 tougher Firm 1’s reaction function moves to the right Firm 1’s reaction function moves to the right R 1 after New Cournot equilibrium New Cournot equilibrium The commitment has a beneficial strategic effect The commitment has a beneficial strategic effect Firm 2 is induced to produce less output, increasing firm 1’s market share Firm 2 is induced to produce less output, increasing firm 1’s market share Firm 1 may well choose to make this commitment: become “Top Dog”

12. Cournot competition q2q2 R1R1 R2R2 q1q1 Original Cournot equilibrium Original Cournot equilibrium Suppose that the commitment makes firm 1 softer Suppose that the commitment makes firm 1 softer Firm 1’s reaction function moves to the left Firm 1’s reaction function moves to the left R 1 after New Cournot equilibrium New Cournot equilibrium The commitment has a detrimental strategic effect The commitment has a detrimental strategic effect Firm 2 is induced to produce more output, reducing firm 1’s market share Firm 2 is induced to produce more output, reducing firm 1’s market share Firm 1 may well choose not to make this commitment: stay “Lean and Hungry”

13. Bertrand competition p2p2 R1R1 R2R2 p1p1 Original Bertrand equilibrium Original Bertrand equilibrium Suppose that the commitment makes firm 1 tougher Suppose that the commitment makes firm 1 tougher Firm 1’s reaction function moves to the left Firm 1’s reaction function moves to the left R 1 after The commitment has a detrimental strategic effect The commitment has a detrimental strategic effect Firm 2 is induced to reduce its price harming the profits of firm 1 Firm 2 is induced to reduce its price harming the profits of firm 1 Firm 1 may well choose not to make this commitment: the “Puppy Dog Ploy” New Bertrand equilibrium New Bertrand equilibrium

14. Bertrand competition p2p2 R1R1 R2R2 p1p1 Original Bertrand equilibrium Original Bertrand equilibrium Suppose that the commitment makes firm 1 softer Suppose that the commitment makes firm 1 softer Firm 1’s reaction function moves to the right Firm 1’s reaction function moves to the right R 1 after The commitment has a beneficial strategic effect The commitment has a beneficial strategic effect Firm 2 is induced to increase its price helping the profits of firm 1 Firm 2 is induced to increase its price helping the profits of firm 1 Firm 1 may well choose to make this commitment: the “Fat-Cat Effect” New Bertrand equilibrium New Bertrand equilibrium

15. 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

16. 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

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 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 =0.5x1500 + 0.5x250 - 500 = $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(1500 - 500) + 0.5(0))/1.1 (0.5(1500 - 500) + 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

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