Strategic Commitment
Besanko, Dranove, Shanley, and
Schaefer
Chapters 7
1
Agenda




Importance of Commitment
Strategic Commitment and Competition
Flexibility and Option Value
Framework for Analyzing Commitment
2
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.
3
Motivational Game for
Strategic Commitment
Farmer B
Aggressive
Passive
(125, 45)
(165, 50)
(150, 65)
(180, 60)
Aggressive
Farmer A
Passive
4
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
5
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.
6
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.
7
Sources of Commitment


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Capacity expansions with significant upfront resource allocation
Binding contracts
Public statements
8
Strategic Commitment and
Complements

Needed terminology:




Strategic Complements
Strategic Substitutes
Tough Commitments
Soft Commitments
9
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.
10
Reaction Functions for Strategic
Complements
P2
R1
R2
P1
11
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.
12
Reaction Functions for Strategic
Substitutes
Q2
R2
R1
Q1
13
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.
14
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.
15
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.
16
Reaction Functions, Tough
Commitments, and Cournot
Q2
q2 O
q2n
R2
R1original
q1o
q1n
R1new
Q1
17
Reaction Functions, Tough
Commitments, and Bertrand
P2
R1new
R1original
R2
p2O
p2n
P1n
P1O
P1
18
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.
19
Reaction Functions, Soft
Commitments, and Cournot
Q2
q2 n
q2O
R2
R1new
q1n
q1O
R1original
Q1
20
Reaction Functions, Soft
Commitments, and Bertrand
P2
R1original R1new
R2
p2n
p2O
P1O
P1n
P1
21
Examining Commitment

When making the commitment decision,
you can view this as a two stage game.


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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.
22
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.
23
Taxonomy of Commitment Strategies Taken
From Besanko’s Economics of Strategy: Table
8.2
Nature of Stage 2
Commitment
Posture
Commitment
Action
Strategy
Strategic Substitutes
Tough
Make
Top-Dog StrategyFT
Strategic Substitutes
Tough
Refrain
Submissive Underdog
Strategic Substitutes
Soft
Make
Suicidal Siberian
Strategic Substitutes
Soft
Refrain
Lean and Hungry LookFT
Strategic Complements
Tough
Make
Mad Dog
Strategic Complements
Tough
Refrain
Puppy-Dog PloyFT
Strategic Complements
Soft
Make
Fat-Cat EffectFT
Strategic Complements
Soft
Refrain
Weak Kitten
24
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.
25
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 (NPVc)
with the net present value of a decision with an
outcome that occurs with uncertainty (NPVu).
Option Value = NPVc - NPVu
26
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.
27
Option Value Example Cont.

Assume the following:


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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
28
Option Value Example Cont.

Option Value = NPVc – NPVu



NPVc = [0.5*(420-200) + 0.5*(0)] / 1.1
NPVu = (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.
29
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:



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Positioning Analysis
Sustainability Analysis
Flexibility Analysis
Judgment Analysis
30
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.
31
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.
32