Strategic Commitment

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Strategic Commitment
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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

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Commitment and Value

• Simple example of capacity choice by two firms

Firm 2 has no dominant strategy
Inflexibility can have value by influencing
behavior
Suppose that capacities are chosen simultaneously
Firm 2 will choose to be passive
Suppose Firm 1 can commit to being aggressive
Sequential Nash Equilibrium
Firm 2
Simultaneous Nash Equilibrium
Dominant strategy for Firm 1
Can Firm 1 do better than this?
Aggressive
Passive
Passive
Aggressive
12.5, 4.5
16.5, 5
Aggressive
16.5, 5
Firm 1
Passive
15, 6.5
18, 6
15, 6.5
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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

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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

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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

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Strategic Substitutes and Complements

• Compare Cournot and Bertrand competition

Cournot
Bertrand
q2
p2
The reaction functions slope upwards
The reaction functions slope downwards
Prices are strategic complements
R1
Quantities are strategic substitutes
R2
R2
R1
p1
q1
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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

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Tough and Soft Commitments

• Some commitments make a firm tougher
• invest in new capacity
• RD 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

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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

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Cournot competition
Firm 1 may well choose to make this commitment be
come Top Dog
Suppose that the commitment makes firm 1
tougher
Firm 1s reaction function moves to the
right
q2
Original Cournot equilibrium
The commitment has a beneficial strategic effect
New Cournot equilibrium
Firm 2 is induced to produce less output,
increasing firm 1s market share
R2
R1
R1after
q1
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Cournot competition
Firm 1 may well choose not to make
this commitment stay Lean and Hungry
Suppose that the commitment makes firm 1 softer
Firm 1s reaction function moves to the left
q2
New Cournot equilibrium
Original Cournot equilibrium
The commitment has a detrimental strategic effect
Firm 2 is induced to produce more output,
reducing firm 1s market share
R2
R1
R1after
q1
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Bertrand competition
Firm 1 may well choose not to make
this commitment the Puppy Dog Ploy
Suppose that the commitment makes firm 1
tougher
Firm 1s reaction function moves to the left
p2
R1after
R1
The commitment has a detrimental strategic effect
New Bertrand equilibrium
R2
Firm 2 is induced to reduce its price harming the
profits of firm 1
Original Bertrand equilibrium
p1
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Bertrand competition
Suppose that the commitment makes firm 1 softer
Firm 1 may well choose to make this commitment
the Fat-Cat Effect
Firm 1s reaction function moves to the
right
New Bertrand equilibrium
p2
R1
R1after
The commitment has a beneficial strategic effect
R2
Firm 2 is induced to increase its price helping
the profits of firm 1
Original Bertrand equilibrium
p1
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A Commitment Taxonomy
Situations in which strategic commitment should
be refused
Situations in which strategic commitment should
be undertaken
Type of Commitment
Soft
Tough
Substitutes
Lean Hungry
Top Dog
Strategic
Complements
Puppy Dog Ploy
Fat Cat
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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

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Commitment

• The failure to commit is itself a commitment
• Pepsis failure to commit to its Venezuelan
  bottler
• Commitments 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

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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

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Option value example
Suppose that one periods delay removes
the uncertainty
If acceptance is low then choose an
alternative normal investment
Invest 500 million in a market with uncertain
demand
The option value of delay in this case is 80
Million
High Acceptance
Low Acceptance
Assuming a 10 discount rate
This changes the expected profit of the investment
Profit 1500 million
Profit 250 million
Probability 0.5
Probability 0.5
Expected profit
0.5x1500 0.5x250 - 500
(0.5(1500 - 500) 0.5(0))/1.1
375 million
455 million
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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

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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

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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

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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

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