Chapter 9

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
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
12.5, 4.5
16.5, 5
15, 6.5
18, 6
Firm 1
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
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
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
Strategic Complements
 When a firm’s action induces the rival to
take the same action the actions are strategic
 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
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
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
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
“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
 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
“Soft” in a Cournot Market
Scenarios to be Analyzed
First Stage
Second Stage
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
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
“Soft” in a Bertrand Market
Strategic Effects of the Commitments
Firm 1’s
Second Stage
Strategic Effect
on Firm 1
Flexibility and Options
 The value of commitments lies in creating
 However, when there is uncertainty,
flexibility is valuable since future options are
kept open
 Commitments can sacrifice the value of the
Commitment-Flexibility Tradeoff
 By waiting, a firm preserves its option values
 By waiting, the firm also may allow its
competitors to make preemptive
 Example: Philips decides to delay its CD
manufacturing plant in the U.S., allowing
Sony to build its plant first
Preserving Flexibility
 Modify the commitment as conditions
 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
 Value of real options may be limited by the
risk of preemption
 Key managerial skill in spotting valuable real

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