1 Strategic Commitment Besanko, Dranove, Shanley, and Schaefer Chapters 7

2 Agenda Importance of Commitment Strategic Commitment and Competition Flexibility and Option Value Framework for Analyzing Commitment

3 Strategic Commitments Strategic commitments are decisions/strategies that have long-term impact and are difficult if not impossible to reverse. Strategic commitments can have a profound effect on your competitor’s decisions.

4 Motivational Game for Strategic Commitment Farmer B AggressivePassive Farmer A Aggressive (125, 45)(165, 50) Passive (150, 65)(180, 60)

5 Motivational Game for Strategic Commitment Cont. In a sequential move game, the Nash Equilibrium is Farmer A chooses Passive and Farmer B chooses Aggressive. Is there a better situation for Farmer A? How could Farmer A use strategic commitment to obtain a better solution

6 Importance of Commitment A strategic commitment can have an effect on other players’ strategies which make the firm better off. In essence this is done by making a simultaneous move game into a sequential game.

7 Characteristics of Strategic Commitment There are three essential characteristics to having a valuable strategic commitment: It must be visible It must be understandable It must be credible A key to credibility is irreversibility.

8 Sources of Commitment Capacity expansions with significant up- front resource allocation Binding contracts Public statements

9 Strategic Commitment and Complements Needed terminology: Strategic Complements Strategic Substitutes Tough Commitments Soft Commitments

10 Strategic Complements Strategic complements are actions that cause competing firms to take more of the same type of action, e.g., if I increase price, you will increase price. The reaction functions of the firms tend to slope upward.

11 Reaction Functions for Strategic Complements P2P2 P1P1 R2R2 R1R1

12 Strategic Substitutes Strategic complements are actions that cause competing firms to take more of the same type of action, e.g., if I increase quantity, you will decrease quantity. The reaction functions of the firms tend to slope downward.

13 Reaction Functions for Strategic Substitutes Q2Q2 Q1Q1 R2R2 R1R1

14 Strategic Complements and Substitute Notes A rule of thumb is that price competition (Bertrand) tend to be strategic complements, while quantity/capacity competition (Cournot) tend to be strategic substitutes. Knowing whether you are in a strategic substitute versus complement world tells you what type of competition you face.

15 Strategic Complements and Substitute Notes Cont. Strategic substitutes imply that aggressive behavior by one firm will lead to less aggressive behavior of the other firm. Strategic complements imply that aggressive behavior by one firm will lead to more aggressive behavior of the other firm.

16 Tough Commitments A tough commitment is a commitment that is going to have an adverse effect on the competitors of the firm. In the Cournot setting, a tough commitment by firm A would imply that the quantity chosen under the tough commitment is going to be greater for firm A than if it did not make a commitment at all.

17 Reaction Functions, Tough Commitments, and Cournot Q2Q2 Q1Q1 R2R2 R 1 original R 1 new q2Oq2O q1oq1o q2nq2n q1nq1n

18 Reaction Functions, Tough Commitments, and Bertrand P2P2 P1P1 R2R2 R 1 original R 1 new p2np2n p2Op2O P1OP1O P1nP1n

19 Soft Commitments A soft commitment is a commitment that is going to have a beneficial effect on the competitors of the firm. In the Cournot setting, a soft commitment by firm A would imply that the quantity chosen under the tough commitment is going to be less for firm A than if it did not make a commitment at all.

20 Reaction Functions, Soft Commitments, and Cournot Q2Q2 Q1Q1 R2R2 R 1 original R 1 new q2nq2n q1nq1n q2Oq2O q1Oq1O

21 Reaction Functions, Soft Commitments, and Bertrand P2P2 P1P1 R2R2 R 1 original R 1 new p2Op2O p2np2n P1nP1n P1OP1O

22 Examining Commitment When making the commitment decision, you can view this as a two stage game. In stage 1, you decide whether to make a commitment or not. In stage 2, you play a simultaneous move game. To solve this game, you solve for the Subgame Perfect Nash Equilibrium.

23 Making Tough Versus Soft Commitment You should make a tough commitment when the positive strategic effect outweighs the potential negative direct effect. You should make a soft commitment when the positive direct effect outweighs the negative strategic effect.

24 Taxonomy of Commitment Strategies Taken From Besanko’s Economics of Strategy: Table 8.2 Nature of Stage 2Commitment Posture Commitment Action Strategy Strategic SubstitutesToughMakeTop-Dog Strategy FT Strategic SubstitutesToughRefrainSubmissive Underdog Strategic SubstitutesSoftMakeSuicidal Siberian Strategic SubstitutesSoftRefrainLean and Hungry Look FT Strategic ComplementsToughMakeMad Dog Strategic ComplementsToughRefrainPuppy-Dog Ploy FT Strategic ComplementsSoftMakeFat-Cat Effect FT Strategic ComplementsSoftRefrainWeak Kitten

25 Flexibility and Option Value While it was shown that inflexibility can lead to a strategic advantage, there is some value in maintaining flexibility in decisions. This means that you can calculate an option value of maintaining flexibility.

26 Option Value An option value is an amount of money that you would be willing to pay up to to see the future. To calculate the option value, examine the difference in the net present value of a decision from an outcome that occurs with certainty (NPV c ) with the net present value of a decision with an outcome that occurs with uncertainty (NPV u ). Option Value = NPV c - NPV u

27 Option Value Example Suppose you are a large agribusiness company investigating whether you want to build a new plant for your product. Assume that the firm is unsure whether the product that this plant produces will be highly acceptable or not to the consumer, e.g., GMO products.

28 Option Value Example Cont. Assume the following: High acceptance implies revenues of $420 million Low acceptance implies revenues of $100 million It costs $200 million to build the plant There is a 50% chance of high acceptance Your discount rate is 10% If it is low acceptance, you would not build the plant

29 Option Value Example Cont. Option Value = NPV c – NPV u NPV c = [0.5*( ) + 0.5*(0)] / 1.1 NPV u = (0.5*(420) + 0.5*(100)) – 200 Option Value = 110 – 60 = 50 The firm would pay up to 50 million dollars to know the outcome with certainty assuming risk neutrality.

30 Framework for Analyzing Commitment A commitment-intensive decision is one such that the investments are durable, specialized, and not tradable after the firm has moved forward with them. Ghemawat developed a four-step framework for analyzing these decisions: Positioning Analysis Sustainability Analysis Flexibility Analysis Judgment Analysis

31 Framework for Analyzing Commitment Cont. Positioning analysis is where you examine the direct effects of the commitment. Sustainability analysis determines the strategic effect of the commitment.

32 Framework for Analyzing Commitment Cont. Flexibility analysis takes into consideration uncertainty when examining the sustainability and positioning analysis. Judgment analysis examines the distorting factors of the firm that affect the optimal choice of the strategy.