This document summarizes key points from Chapter 9 of the textbook "Economics of Strategy" regarding strategic commitment. It discusses how strategic commitments can impact competition by altering rivals' expectations. Commitments are most effective when they are visible, understandable, and credible. Firms must consider whether their actions and those of competitors are strategic substitutes or complements. The value of commitments depends on their direct effects and strategic effects, and commitments can create flexibility or preserve future options depending on the context.

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.

2. 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

3. 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

4. Payoffs in the Simple Strategy Selection Game
Firm 2
Aggressive Passive
Aggressive 12.5, 4.5 16.5, 5
Firm 1
Passive 15, 6.5 18, 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

5. 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

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

7. 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

8. 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

9. 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

10. 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

11. Strategic Substitutes and Complements

12. 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

13. 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

14. 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

15. 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

16. 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.

17. “Tough” in a Cournot Market

18. 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

19. “Soft” in a Cournot Market

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

21. 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

22. “Tough” in a Bertrand Market

23. 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

24. “Soft” in a Bertrand Market

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

26. 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?

27. 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

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

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

30. 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

31. 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

32. Strategic Effects & Product Differentiation

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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”

41. 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

42. 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

43. 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

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