1. Strategic Commitment Economics of Strategy Chapter 8
Economics of Strategy
Besanko, Dranove and Shanley
Chapter 8
Strategic Commitment
Slide show prepared by
Richard PonArul
California State University
Modified by BK Hobbs
FGCU
 John Wiley  Sons, Inc.

2.
Strategic Commitment
Strategic commitments are decisions that have long run impact and are hard to reverse (e.g., installation of additional production capacity a priori to actual production)
Strategic commitments differ from tactical moves which are easy to reverse and have only a short run impact (e.g., a store cutting the price on certain items)
Strategic decisions differ from tactical decisions. Tactics deliver on strategy and can be reversed relatively easily. Strategic decisions are pre-cursors to tactical decisions and are difficult to retract.
Strategic commitments also influence the level and nature of competition in the industry. Commitments are a balancing act for firms: they must weight the irreversibility of their actions against the benefits of the commitment.
Great example of the actions of Hernan Cortes – lands in Mexico, unloads the ships and burns all but one ship.

3.
Strategic Commitment
To achieve the desired result, the commitment must be
visible
understandable
credible
To be credible, the commitment should be irreversible
The firm making the strategic commitment must show that it is serious. The commitment must be visible to other market competitors, understandable to them and be credible. Credibility is enhance when the commitment is irreversible.

4. Commitment Value of Announcements
Commitment Value of Announcements
If a firm has an established reputation at stake, even an announcement of intention to act can have commitment value (they have carried through before and they will again.)
However, if the firm fails to match actions to words, it will lose credibility and reputation as a player will suffer
Smaller and newer firms cannot rely on reputation of past actions to indicate commitment

5. Reversible and Irreversible Moves
Reversible and Irreversible Moves
Reversible moves are more likely to be matched by rivals than irreversible moves
Empirical evidence from the airline industry supports this view
Airlines respond quickly to price cuts by rivals (which are easily reversible) but slowly or not at all to irreversible moves by a competing carrier (e.g., acquisitions, set-up of hubs or maintenance facilities)

6. Strategic Substitutes and Complements
Strategic Substitutes and Complements
How do firms react to one another’s strategic moves?

7. Strategic Substitutes
Strategic Substitutes
When a rival firm increases their supply to market, the other firm decreases its supply
When a rival firm decreases their supply to market, the other firm increases its supply
Strategic substitutes move in opposite directions
Substitutes move in opposite directions
e.g., Exxon decreases its refinery output and Arco responds by increasing refinery output Complements move in the same direction
e.g., Ford responds to a price cut by Honda by also cutting price

8. Strategic Substitutes
Passive behavior leads to an aggressive response by the rival firm
Aggressive behavior leads to a passive response by the rival firm
Usually, quantities and capacity moves are strategic substitutes

9. Strategic Substitutes
Strategic Substitutes
Use the Cournot Model
Reaction curves are upward sloping
one firm’s decision to increase output will cause the other to reduce its output, therefore output decisions are strategic substitutes
one firm’s decision to decrease output will cause the other to increase its output, therefore output decisions are strategic substitutes
See figure 8.1

10. Strategic Complements
When a rival firm increases their price, the other firm will also increase price
When a rival firm decreases their price, the other firm will also decrease price
Strategic complements move in the same direction

11. Strategic Complements
Aggressive Behavior leads to an aggressive response by the rival firm
Usually, price moves are strategic complements

12. Strategic Complements
Use the Bertrand Model
Reaction functions are upward sloping
one firm’s decision to increase the price will cause the other to increase the price as well, therefore price decisions are strategic complements
one firm’s decision to decrease the price will cause the other to decrease the price as well, therefore price decisions are strategic complements

13. Commitments – Strategic Effect vs. Direct Effects
Commitments – Strategic Effect vs. Direct Effects
Direct Effect
Impact on NPV of the firm’s profits
Strategic Effects
Impact on the competitive environment facing the firm over the long term
“How does the commitment alter the tactical decisions of the rival, and ultimately, the market equilibrium?”

14. Tough vs. Soft Commitments
Tough vs. Soft Commitments
Tough Commitments are “bad” for competitors
Conforms to our cultural view of competition, creates winners and losers
Win/Lose model
Prevalent in Cournot-type industries
Soft Commitments are “good” for competitors
Win/Win model
Soft commitments can produce strategically benificial effects
Tough commitments conform to a win/lose model or a zero-sum game.
Soft commitments can create win/win situations, so taking a soft commitment stance may help all. Collusion is a soft commitment that produces higher prices, revenues and profits for all.

15.
Timing
One firm makes a strategic commitment and then the stage is set for it and its rival firms to compete at a tactical level
A “two-stage” game
Stage One: The strategic decision is made
Stage Two: The tactical maneuvering begins (given the strategic commitment made in Stage One)

16.
Tough Commitments
The immediate effect of a tough commitment is to produce an adverse impact on your rival
e.g., a firm invests in a new production process that reduces unit cost so that it can lower its price, forcing rivals to lower theirs also
Tough commitment conforms to the traditional “zero-sum game” view of competition

17.
Soft Commitments
The immediate effect of a soft commitment is a favorable impact on the rival
To understand why soft commitments may make sense, we need to look at both the short term initial effects and the long term strategic effects

18. Two Effects of Commitments
Two Effects of Commitments
Commitment can have a direct effect and a strategic effect on the firm’s profitability
Direct effect is the change in the present value of profits assuming that the rival’s tactics are unaffected by the commitment
Strategic effect is the further change in the present value of the firm’s profits due to the rival adjusting its tactics
In the direct effect the rival does not respond strategically. They simply accept the strategic commitment and react tactically.
Strategic effects occur when the rical responds to the strategic commitment with their own strategic commitment. The firm making the strategic commitment should ask “How will this commitment affect the competitive environment in which I operate?”

19. The Value of Soft Commitment
The Value of Soft Commitment
Suppose a firm that makes a soft commitment to raise its price. It may experience a direct negative effect on its profitability in the short term
However, if the optimal response of the rival is to raise its price also, the strategic effect can be beneficial (i.e., Everyone gets to raise price)
The net benefit from the commitment takes into account the losses from the short tern price increase (consumers buy less from you) and the gains from getting the entire industry price up by initiating the price increase.
NPV of the action as it plays out over time...

20. The Value of Soft Commitment
If the strategic effect is sufficiently large, the net benefit from the commitment will be positive
If the NPV of the Strategic Effect > NPV of the Direct Effect, then the soft commitment pays off over the long term.

21. An Analysis of Soft and Tough Commitments
An Analysis of Soft and Tough Commitments
In the first stage Firm 1 makes either a soft commitment or a tough commitment
The second stage of competition between the rivals will be classified as either Cournot or Bertrand
Remember that in a Cournot Model Firm 1 sets quantities and then competes on those quantities. In a Bertrand Model, the firms compete on prices.

22. Scenarios to be Analyzed
Scenarios to be Analyzed

23. Cournot After Soft Commitment
Cournot After Soft Commitment
Note the quantities of firm 1 on the horizontal axis and the quantities of firm 2 on the vertical axis.
R1before(before the commitment) is the initial reaction curve for firm 1. The strategic commitment is made to reduce output -- the Cournot Model sets quantities. Firm 1 shifts their reaction curve to R1after(after the commitment).
Under R1after, Firm 1 has reduced their level of output , committing to produce less, for each and every level of output by their rival. This is a soft commitment - I will reduce my quantities at every level of your output.
Note that q1 has fallen while q2 has risen. Firm 1 made a strategic commitment to reduce quantities which has allowed their rival (Firm 2) to increase their quantities. This is a soft commitment where the direct effects are negative.

24. Cournot After Soft Commitment
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 (Firm2) reacts by increasing their output and Firm 2 ends up producing more than what it produced due to Firm 1’s soft commitment
So again - in the short term, the soft commitment made by Firm 1 hurts it. In other words, the “direct effect” is clearly negative.
So why would Firm 1 ever make a soft commitment? Because the long run strategic effects make the short term losses worthwhile. The NPV of the action, in its totality, is positive so shareholder wealth is enhanced by the soft commitment.

25. Bertrand After Soft Commitment
Bertrand After Soft Commitment
Remember that the Bertrand Model focuses on prices rather than quantities. Hence the axes are prices here. Note the prices of firm 1 on the horizontal axis and the prices of firm 2 on the vertical axis.
R1before (before the commitment) is the initial reaction curve for firm 1. The strategic commitment is made to increase price so firm 1 shifts its reaction curve to R1after(after the commitment).
Under R1after, Firm 1 has increased their price for each and every level of price by their rival.
Note that p1 has risen but so has p2. Firm 1 made a strategic commitment to increase prices and it has, allowing their rival (Firm 2) to increase their prices also. This is a soft commitment!
Why do this? Even thought the direct effect is a lose in sales due to the increased prices, the net change in competition is good for firm 1.
The example used in the book is horizontal differentiation. Suppose the firm raises prices but in doing so it goes after a more distinct market relative to its rivals. By differentiating the market well, Firm 1 can end up with less competition in that higher-end market as they develop it.

26. Bertrand After Soft Commitment
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
So again - in the short term the soft commitment made by firm 1 helps it and its rival. The direct effect is to allow both firms to raise price.
So why would Firm 1 ever make a soft commitment? Because the long run strategic effects make the short term losses worthwhile. The NPV of the action, in its totality, is positive so shareholder wealth is enhanced by the soft commitment.

27. Cournot After Tough Commitment
Cournot After Tough Commitment
Note the quantities of firm 1 on the horizontal axis and the quantities of firm 2 on the vertical axis. R1before(before the commitment) is the initial reaction curve for firm 1. The strategic commitment is made to increase output so they shift their reaction curve to R1after(after the commitment).
Under R1after, Firm 1 has increased their level of output , committing to produce more, for each and every level of output by their rival.
Note that q1 has increased while q2 has fallen. Firm 1 made a strategic commitment to increase quantities, eating into the market share of their rival (Firm 2). This is a tough commitment. Firm 1 has made a commitment to increase its market share while Firm 2 loses market share. .

28. Cournot After Tough Commitment
Cournot After Tough Commitment
Firm 1 commits to a higher than previous output for every output choice of the rival
Rival’s (Firm 2) reaction function makes the equilibrium output of Firm 1 even higher
Firm 2 produces less than what it produced previously due to the tough commitment from Firm 1
This is what we traditionally think of as a competitive stance. Think of a manufacturing company that invests in new technology or new equipment designed to bring down cost curves. The two-piece can of CC&S, the Autocad and automated-plasma welders of Lowe Jon Boats, the MIS system of Walmart for inventory control, etc.

29. Bertrand After Tough Commitment
Bertrand After Tough Commitment
Firm 1 makes a tough commitment. No matter what firm 2 does, firm 1 has committed itself to lowering its price. The direct effect of the price cut is to reduce your total revenues. Strategically, price has lowered and you are hoping to offset that by increased volume.
Normally, why do firms lower their price? Either competitive pressures or attempting to gain market share. The “direct effect” - Firm 1 has cut its price which is designed to gain market share at eh expense of your rivals - so we are seeing a “tough” stance.
What about the strategic effect on the competitive environment? When Firm 1 drops it price, firm 2 will follow the price cut. Firm 1 does not gain all it thinks it will because the rational response of Firm 2 is to follow any price cut. The strategic effect for Firm 1 here is negative when we look at the competitive response by Firm 2: namely, it will lower price too..

30. Bertrand After Tough Commitment
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 hurt by Firm 1’s tough commitment
Here taking the tough commitment can hurt individual profits of both companies over the long term. In the Bertrand Model, where firms choose prices initially and then compete. The process of lowering prices eventually pushes both firms to a competitive type outcome with zero economic profit.
Again, this tough commitment is what one usually thinks about when we think of competition.

31. Strategic Effects of the Commitments
Strategic Effects of the Commitments

32. Can the Negative Strategic Effect be Forestalled?
Can the Negative Strategic Effect be Forestalled?
If the direct effect is positive and the strategic effect negative, can the firm forestall the latter?
Example: The net present value of cost reducing commitment is positive. Can the negative strategic effect be avoided by refusing to lower the price?

33. Can the Negative Strategic Effect be Forestalled?
Can the Negative Strategic Effect be Forestalled?
If the profit maximizing strategy (after the commitment) is to lower the price, rival will assume that the firm will do so
It is difficult to convince a rival that your firm will act against its own interest in the second stage

34. A Taxonomy of Strategic Commitments
A Taxonomy of Strategic Commitments
When Second Stage Actions are Strategic Substitutes
Taxonomy of Two-Stage Models
Making the commitment generates a positive strategic effect
Refraining from the commitment avoids a harmful strategic effect

35. A Taxonomy of Strategic Commitments
A Taxonomy of Strategic Commitments
When Second Stage Actions are Strategic Complements

36. Factors that Influence the Strategic Effect
Factors that Influence the Strategic Effect
In general, commitments that lead to less aggressive behavior from the rivals will have beneficial strategic effect
If the rival is a potential entrant rather than an existing firm, a tough commitment to price aggressively may deter entry

37. Factors that Influence the Strategic Effect
Factors that Influence the Strategic Effect
If the rivals is an existing firm and there is excess capacity in the industry, aggressive pricing may invite retaliation
If the products are horizontally differentiated, the strategic effect may be relatively less important since the rival does not have the incentive to react (“you take your market and I’ll take mine”)

38. Flexibility and Option Value
Flexibility and Option Value
The value of commitments lies in creating inflexibility
However, when there is uncertainty, flexibility is valuable since future options are kept open
Commitments cut off flexibility and thus sacrifice the value of the options

39. Commitment-Flexibility Tradeoff
Commitment-Flexibility Tradeoff
By waiting, a firm preserves its option values
At the same time, the firm gives rivals the time to make preemptive investments
e.g., Philips decides to delay its CD manufacturing plant in the U.S., allowing Sony to build its plant first

40. A Framework for Analyzing Commitments
A Framework for Analyzing Commitments
Pankaj Ghemawat has developed a four step process for analyzing commitment intensive decisions
Positioning Analysis
Sustainability Analysis
Flexibility Analysis
Judgment Analysis
This represents a quick introduction. These concepts are developed in future chapters.

41. Strategic Commitments
Strategic Commitments
Often
durable
relationship specific
difficult to transfer or re-deploy
“sticky” or “lumpy”

42.
Positioning Analysis
Positioning analysis is akin to the determination of the direct effect of commitment
The focus is on whether the firm operates with lower costs than its competitors or offers superior benefits to its customers

43. Sustainability Analysis
Sustainability Analysis
Sustainability analysis resembles the determination of the strategic effect
It analyzes the response by competitors and potential entrants
It also looks at the market imperfections that protect the firm’s competitive advantage

44.
Flexibility Analysis
Flexibility analysis incorporates uncertainty and option value
A key determinant of the option value is the ratio of the “learn rate” to the “burn rate” of the firm
The rate at which a firm receives new information that allows it adjust its strategy is termed the “learn rate”

45.
Flexibility Analysis
The rate at which the firm makes irreversible investments in support of its strategy is the “burn rate”
A high learn to burn ratio indicates that the option value of delay is low
Firms can increase their learn to burn ratios through experimentation and pilot programs

46.
Judgment Analysis
Judgment analysis involves looking at the organizational and managerial factors to ensure that incentives exist to support the optimal strategy
Hierarchical decision making may create a bias towards Type I errors - rejecting good projects

47.
Judgment Analysis
Decentralized decision making may result in higher incidence of Type II errors - accepting unprofitable projects
Managers should be cognizant of the biases imparted by the structure of the organization and its politics and culture