Economics of Strategy Fifth Edition

Transcription

1 Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 9 Strategic Commitment Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc. Strategic Commitment Strategic commitments have long run impact and are hard to reverse Strategic commitments can affect choices made by rivals Assessing strategic commitments involves anticipating market rivalry 1

2 Strategic Commitment Inflexibility can add value Strategic commitment limits options but alters competitors expectations Strategic commitment can make a simultaneous move game into a sequential move game Payoffs in the Simple Strategy Selection Game Firm 2 Aggressive Passive Firm 1 Aggressive 12.5, , 5 Passive 15, , 6 Net present values are in millions of dollars. First payoff listed is firm 1 s; second is firm 2 s. Unique Nash equilibrium: Firm 1 passive and Firm 2 aggressive 2

3 Sequential Move Game Firm 1 commits itself to be aggressive Firm 2 finds that it is better of choosing to be passive given firm 1 s commitment Resulting equilibrium has a bigger payoff for firm 1 compared to what it had in the simultaneous move game Strategic Commitment To achieve the desired result, the commitment should be Visible Understandable Credible To be credible, the commitment should be irreversible 3

4 Strategic Commitment Moves that represent commitment: Capacity expansion with investment in relationship specific assets Contracts with clauses such as most favored customer clause Public announcements provided the reputation of the firm/management will suffer when not backed by action The move should be difficult to stop once set in motion Strategic Commitment & Competition Concepts to describe how a firm reacts to price/quantity change by a competitor Strategic complements Strategic substitutes Concepts that distinguish between actions by a firm that puts its competitors at a disadvantage and those that do not Tough commitments Soft commitments 4

5 Strategic Complements When a firm s action induces the rival to take the same action the actions are strategic complements In Bertrand duopoly model prices are strategic complements A price cut is the profit maximizing response to competitor s price cut The reaction function is upward sloping Strategic Substitutes When a firm s action induces the rival to take the opposite action the actions are strategic substitutes In Cournot duopoly model quantities are strategic substitutes A quantity increase is the profit maximizing response to competitor s quantity reduction Reaction function slopes downward 5

6 Strategic Substitutes and Complements Incentives to Make Commitments Commitments affect the present value of the firm s profits Direct effect: Due entirely to its own tactical decisions Strategic effect: Due to the effect on the tactical decisions of the competitors The strategic effect can be positive or negative depending on the choice variables being strategic complements or strategic substitutes 6

7 Tough Commitments and Soft Commitments A tough commitment hurts the competitors while a soft commitment helps them Tough commitment conforms to the traditional view of competition A soft commitment may be beneficial if the strategic effect of the commitment is sufficiently positive The Value of Soft Commitments 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 7

8 An Analysis of Soft and Tough Commitments The market has two firms and decisions are made in two stages In the first stage Firm 1 makes either a soft commitment or a tough commitment The second stage competition between the rivals will be either Cournot or Bertrand 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 used to produce. 8

9 Tough in a Cournot Market Cournot After Soft Commitment Firm 1 shifts its reaction function to the left, committing to produce less (than precommitment 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 9

10 Soft in a Cournot Market Scenarios to be Analyzed First Stage Soft Soft Tough Tough Second Stage Cournot Bertrand Cournot Bertrand 10

11 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 being hurt by Firm 1 s tough commitment Tough in a Bertrand Market 11

12 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 Soft in a Bertrand Market 12

13 Strategic Effects of the Commitments Firm 1 s Commitment Second Stage Competition Strategic Effect on Firm 1 Soft Cournot Negative Soft Bertrand Positive Tough Cournot Positive Tough Bertrand Negative 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? 13

14 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 A Taxonomy of Strategic Commitments When Second Stage Actions are Strategic Substitutes Firm 1 s Strategy Commitment Posture Commitment Action Top-Dog Strategy Submissive Underdog Suicidal Siberian Lean and Hungry Look Tough Tough Soft Soft Make Refrain Make Refrain 14

15 A Taxonomy of Strategic Commitments When Second Stage Actions are Strategic Complements Firm 1 s Strategy Commitment Posture Commitment Action Mad Dog Tough Make Puppy-Dog Tough Refrain Play Fat-Cat Effect Soft Make Weak Kitten Soft Refrain 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 15

16 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 Strategic Effects & Product Differentiation 16

17 Flexibility and Options 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 Commitment-Flexibility Tradeoff By waiting, a firm preserves its option values By waiting, 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 17

18 Preserving Flexibility Modify the commitment as conditions evolve Delay commitment until better information is available on profitability Make unprofitable commitments today to preserve valuable options in the future Flexibility and Real Options A real option exists if future information can be used to tailor decisions Better information about demand can be utilized by delaying implementation of projects Value of real options may be limited by the risk of preemption Key managerial skill in spotting valuable real options 18

19 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 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 19

20 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 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 20

21 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 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 21

22 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 Copyright 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the1976 United States Copyright Act without express permission from the copyright owner is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. 22