Notes for Chapter 9: Strategic Commitment

1. Strategic commitment: If a firm makes the correct decisions that (a) entail

significant costs , and (b) have long term implications so that both (a)and (b) limit the firms options, that commitment can influence rivals expectations/moves in ways that improve the long term profitability of the firm making the commitment. /, Example: In 1518, Cortes ordered that all but one of his ships be burned. i. To have this impact, the commitment must be: i. Visible making a public announcement ii. Understandable clearly indicating the size, scope and location of the project
iii. Credible Irreversibility adds to this credibility especially with

contractual commitments . Examples from BP in 2008: (1) announcing and signing memorandum of understanding with Irving Oil for new refinery in New Brunswick, Canada (March); (2) announcing the contract for Foster Wheeler Ltd. to engineer and build a coking unit & gas plant facility at its existing Whiting refinery in Indiana (August) Example 9.1: Loblaw positioning itself in the superstore market including complex negotiations with its union - to keep Wal-Mart from expanding into Canada Example 9.2: Airbus announcing its A380 to carry more passengers (555) at lower cost per customer for long-haul high-capacity, & taking 60 early orders. Boeings attempts to position itself differently in the market to carry 175-250 passengers may have been a direct result, and Boeing wasted years on this effort before abandoning it to compete against the A380 head-to-head with the Boeing 787, which will carry 250-290 passengers. 2. Strategic complements & substitutes a. Effects of Firm As commitments
b. Direct effect impacts PVA() from As tactics that support the commitment,

ceteris paribus (assuming other firms behaviors dont change) c. Strategic effect can be positive or negative depending on whether the variables affected are strategic complements or substitutes:
i. Effect on tactical decisions of rivals

ii. Ultimately, the effect on equilibrium P and Q from both the direct effect and

the rivals decisions , P Q Example: Apple positioning itself to appeal to an even narrower segment of the workstation market in the late 1990s (product differentiation referred to here as horizontal differentiation): Apple focused on features especially important to designers, publishers, artists, graphic artists, choreographers, musicians, etc. Their small segment is quite loyal, and they have not been engaged in the price slashing that PC companies have been.
3. Fudenberg & Tirole (FT) taxonomy of strategic commitments

a. Tough v. soft commitments:

i.

Tough commitment - one that hurts the profitability of rivals

ii.

Soft commitment one that benefits rivals, and may or may not benefit the firm making the commitment

b. The firm must determine whether it is (a) better to make a commitment that

generates strategic effects that benefit that firm; or (b) to refrain from such a commitment to avoid negative strategic effects. The cells in boldface are the ones recommended by FT as beneficial moves. (See Table 9.2 on p. 252 for descriptions of the terms used. Mad Dog, the one in boldface & italics, can be recommended if the firm is willing to withstand a price war or other aggressive moves . This is especially beneficial when entry costs are low, because the lower profit margins discourage potential entrants ,, . Your credibility for using the Mad Dog commitment can depend on having built a reputation a reputation for irrationality, winning at any cost or for seeming randomness. (Remember the character Riggs played by Mel Gibson in Lethal Weapon?) Tough (hurts rivals) Make Mad Dog Top Dog Refrain Puppy Dog Submissive Underdog

Soft (benefits rivals) Make Fat Cat Suicidal Siberian Refrain Weak Kitten Lean & Hungry Look

Example: Wal-Mart Stores preemptive investment/location strategy, to deter entry of other firms into small communities. Which one of these do you think this fits into? Why? Example: HEBs preemptive investment/location strategy, to keep Walmart from locating on Staples near Lipes. Which one of these do you think this fits into? Why?

c. Implications of this taxonomy for strategic decision-making and market analysis:

i. Managers must try to anticipate how investment decisions will affect market

competition into the future . FT suggest using elaborate computer simulations to consider the long term outcomes from most likely moves of rivals.
ii. The various aspects of rivalry in that particular market are important

for estimating the likelihood that firms will make commitments that create strategic effects. iii. Commitments that make rivals less aggressive are those that are likely to be most beneficial to the firm making the commitment.
iv. Capacity utilization rates may have an important effect on the

strategic effects of commitments: With high capacity utilization, competitors are not well positioned to respond aggressively. However, with low capacity utilization, strategic effects are likely to be negative.
v. The degree of horizontal differentiation makes a big difference in strategic

effects. Products that are highly differentiated tend to not engender important effects.
vi. Having information ahead of rivals can allow a firm to make a commitment

without causing harmful strategic effects.

4. Real options: plans that are flexible, to allow opportunities for changes when new information is received a. Having real options results in higher NPV than if changes werent possible . These could take the form of changing capacity to be built, rollout dates, specifications; canceling or modifying orders; etc. b. Any commitment involves risk and uncertainty.

i.

A firm that creates simulations (as suggested in (3a) above) to crank out various potential scenarios must attach probabilities to each of those scenarios to capture the risk. But each of those probabilities is uncertain. Example 9.5, Philips delayed decision for building CD capacity in the US. Example 9.6, Cornings decisions concerning expanded fiber optic capacity after the dot.com bubble burst in 2000

ii.

5 Pankaj Ghemawats framework for analyzing commitments: Major strategic decisions involve assets with some sunk costs assets that are costly to transform or redeploy. Therefore management should follow a 4-step framework for analyzing commitment-intensive choices: a. Positioning analysis: Analyzing the direct effects of a commitment whether the commitment serve customers better and/or lower costs
b. Sustainability analysis : Analyzing (1) the strategic effects of a

commitment and (2) market imperfections that protect competitive advantages and make the firms resources scarce and immobile ,, After having undertaken (a) and (b) above, the firm should undertake a formal analysis of NPV from this and alternative strategic commitments.
c. Flexibility analysis: The firm should find out how much flexibility its

commitment would allow under other potential market conditions. It examines the burn rate: the ratio of the rate at which the firm can collect new market information relative to the rate at which it must spend on what will be the sunk costs from the commitment. If this ratio is high, the firm has the flexibility to make modifications before too much becomes sunk.
d. Judgment analysis: Analyzing issues within the firm that might keep the firm from

choosing an optimal strategy

i. Type I error: rejecting an investment that should have accepted mostly

arising from centralized decision-making

ii. Type II error: selecting an investment that should have been rejected

mostly arising from decentralized decision-making

iii. How to make such decisions? Managers must be aware of biases in decision-making that result from:
a) Incentives regarding bottom-up accurate information sharing

b) Organizational structure

c) Politics and culture within the firm