1. Strategic Commitment Economics of Strategy Chapter 7
Besanko, Dranove, Shanley and Schaefer, 3rd Edition
Chapter 7
Strategic Commitment
Slide show prepared by
Richard PonArul
California State University, Chico
 John Wiley  Sons, Inc.

2. Strategic Commitment
Strategic commitments are decisions that have long run impact and are hard to reverse (Example: Installation of additional production capacity)
These differ from tactical moves which are easy to reverse and have only a short run impact (Example: A store cutting the price on certain items)

3. Strategic Commitment
To achieve the desired result, the commitment should be
Visible
Understandable
Credible
To be credible, the commitment should be irreversible

4. Commitment Value of Announcements
If a firm has an established reputation at stake, even announcement of intention to act can have commitment value
If the firm fails to match actions to words, its reputation will suffer
Smaller and newer firms cannot use announcements to indicate commitment

5. Reversible and Irreversible Moves
Reversible moves are more likely to be matched by rivals than irreversible moves
Evidence from the airline industry supports this view
Airlines quickly respond to price cuts by rivals than to moves like acquisition of another carrier

6. Strategic Commitment and Competition
Strategic complements and strategic substitutes are concepts on how a firm reacts to price/quantity change by a competitor
Tough commitments and soft commitments are concepts that capture actions by a firm that puts its competitors at a disadvantage

7. Strategic Complements
When a firm’s action causes the rival to take the opposite action, then the actions are strategic complements
For example, in Cournot duopoly model one firms decision to increase output will cause the other to reduce its output
In the Cournot model, output decisions are strategic supplements

8. Strategic Substitutes
When a firm’s action causes the rival to take the same action, then the actions are strategic substitutes
For example, in Bertrand duopoly model one firms decision to increase the price will cause the other to increase the price as well
In the Bertrand model, price decisions are strategic substitutes

9. Soft Commitments and Tough Commitments
The immediate effect of a tough commitment is an adverse impact on the rival
Example: A firm invests in a new process that reduces unit cost so that it can lower its price, forcing the rival to lower its price
Tough commitment conforms to the traditional view of competition

10. Soft Commitments and Tough Commitments
The immediate effect of a soft commitment is a favorable impact on the rival
Tough commitment conforms to the traditional view of competition
To understand why soft commitments may make sense, we need to look at both the direct and the strategic effects

11. Two Effects of Commitments
A commitment may have a direct 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
The strategic effect is the further change in the present value of the firm’s profits due to the rival adjusting its tactics

12. The Value of Soft Commitment
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

13. An Analysis of Soft and Tough Commitments
In the first stage a firm makes either a soft commitment or a tough commitment
For each of the two cases, the second stage competition between the rivals will be either Cournot or Bertrand

14. Scenarios to be Analyzed
First Stage
Second Stage
Soft
Cournot
Bertrand
Tough

15. Cournot After Soft Commitment

16. 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

17. Bertrand After Soft Commitment

18. 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

19. Cournot After Tough Commitment

20. 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 produced without the tough commitment from Firm 1

21. Bertrand After Tough Commitment

22. 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

23. Strategic Effects of the Commitments

24. 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?

25. 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

26. A Taxonomy of Strategic Commitments
When Second Stage Actions are Strategic Substitutes

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

28. 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

29. 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

30. 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 can sacrifice the value of the options

31. Commitment-Flexibility Tradeoff
By waiting, a firm preserves its option values
At the same time, 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

32. 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

33. 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

34. 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

35. 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”

36. 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

37. 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

38. 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