BEChapter 8

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Published on April 13, 2008

Author: Jeremiah

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Strategic Commitment:  Strategic Commitment 滕曉雲 國立中央大學經濟系 When Should an Capacity Investment Be Made?:  When Should an Capacity Investment Be Made? Should Philips build a disk-pressing plant to supply compact disks to the American market in 1982? Should TSM build a foundry in the Mainland China right now? When Should an Capacity Investment Be Made?:  Dilemma to be considered: When Should an Capacity Investment Be Made? Uncertainty about the demand for the products First mover can deter further entry in the primitive market Capacity investment sinks a large amount of capital and usually has no alternative uses. Strategic Commitment:  Strategic Commitment Whether to invest in new capacity or introduce new products are examples of strategic commitments. Strategic commitments are decisions that have long-term impacts and are difficult to reverse. Tactical Decisions:  Tactical Decisions Strategic commitments should be distinguished from tactical decisions, decisions that are easily reversed and whose impact persists only in the short run. The pricing and production decisions are examples of tactical decisions. Tactical decisions can be adapted to what-ever situation the firm currently faces. Strategic Commitment:  Strategic Commitment Strategic commitments can significantly influence competition in an industry. If firms are farsighted when they make their commitments, they will anticipate the effect their decisions will have on market competition. The market rivalry can influence the commitments firms make. Strategic Commitment:  When these commitments are effective, they can often shape competitors’ expectations and change their behavior in ways that benefit the firm making the commitment. Strategic Commitment Strategic commitments are hard to reverse, they are inherently risky. Strategic Commitment:  Firms facing commitments must balance the benefits that come from preempting or altering competitors’ behavior with the loss in flexibility that comes from being unable to undo once they have been made. Strategic Commitment The purpose of this chapter is to discuss the economic considerations that underlie this balancing act. Why Commitment Is Important:  Why Commitment Is Important Two firms are competing in an oligopolistic industry. Firm 1, the dominant firm, can choose “aggressive” or “passive” strategy in increasing its capacity. Firm 2, the smaller firm, can choose “aggressive” or “passive” strategy in increasing its capacity. Why Commitment Is Important:  Payoff table for a simultaneous game Why Commitment Is Important The Nash equilibrium is that Firm 1 chooses Passive and Firm 2 choose Aggressive Why Commitment Is Important:  The Nash equilibrium where Firm 1 chooses Passive and Firm 2 chooses Aggressive will only give Firm 1 the payoff 15, rather than the highest payoff, 18. Why Commitment Is Important Firm 1’s highest payoff can be achieved when both firms choose “Passive” strategy. Why Commitment Is Important:  But as long as Firm 1 chooses “Passive” strategy, Firm 2 will always choose “aggressive” strategy for a higher payoff (6.5 < 6), and Firm 2’s “aggressive” strategy will not allow Firm 1 to get the highest payoff, 18. Why Commitment Is Important Why Commitment Is Important:  But instead of pursuing the highest payoff, 18, Firm 1 can settle for the second highest payoff, 16.5, which is still better than the equilibrium payoff, 15. Why Commitment Is Important In order for Firm 1 to achieve the second highest payoff, 16.5, it must commit itself to the “aggressive” strategy by expanding its capacity in advance. Why Commitment Is Important:  Such a capacity commitment will transform a simultaneous game to a sequential game in which Firm 2 would choose its capacity strategy only after it has seen what Firm 1 has done. Why Commitment Is Important After seeing Firm 1 choosing the “Aggressive” strategy, Firm 2 will choose the “passive” strategy, which gives Firm 1 the second highest payoff, 16.5. Why Commitment Is Important:  This simple example illustrates a profound point: Why Commitment Is Important Strategic commitments that seemingly limit options can actually make a firm better off. Why Commitment Is Important:  Inflexibility can have value because a firm’s commitments can alter its competitors’ expectations about how it will compete. Why Commitment Is Important This will lead competitors to make decisions that benefit the already committed firm. Why Commitment Is Important:  Summary of the oligopolistic game: Why Commitment Is Important Firm 1’s commitment to choose an inferior strategy, the “aggressive” one, alters Firm 2’s expectations about what Firm 1 will do. In this sense, Firm 1 first puts itself in a disadvantageous place in order to alter Firm 2’s strategy. Why Commitment Is Important:  This commitment indeed induces Firm 2 to choose a strategy that actually benefits both firms under this commitment situation. Why Commitment Is Important Strategic Commitment:  Strategic Commitment A commitment by one firm will not generate the desired response from its competitors unless it has three characteristics: It must be visible It must be understandable It must be credible Credibility:  Credibility A key to credibility is irreversibility. To be a true commitment, a competitive move must be hard or costly to stop once it is set in motion. Capacity expansion, that require significant up-front expenditures and create relationship-specific assets, have a high commitment value. Credibility:  Contracts can also facilitate commitment. Credibility Sometimes, even public statements of intentions to act can have commitment value. The credibility of public announcements is enhanced when it is clear that the reputation of the firm will suffer if the firm fails to do what it has said it will do. Case Study:  Case Study Harder-to-reverse moves are less frequently matched than easier-to-reverse moves. Price cuts are especially provocative and likely to be matched frequently and quickly. Strategic Commitment and Competition:  Strategic Commitment and Competition Strategic complements and strategic substitutes are concepts that capture how competitors react when one competitor changes a tactical variable such as price or quantity. Tough commitments and soft commitments are concepts that capture whether a commitment by one firm places its rivals at a disadvantage. Strategic Substitutes:  Strategic Substitutes When reaction functions are downward sloping, the firm’s actions are strategic substitutes. Strategic Substitutes:  Strategic Substitutes When actions are strategic substitutes, the more of the action one firm takes, the less of the action the other firm optimally chooses. In the Cournot model, quantities are strategic substitutes because a quantity increase is the profit-maximizing response to a competitor’s quantity reduction. Strategic Complements:  Strategic Complements When reaction functions are upward sloping, the firm’s actions are strategic complements. Strategic Complements:  Strategic Complements When actions are strategic complements, the more of the action one firm chooses, the more of the action the other firm will also optimally choose. In the Bertrand model, prices are strategic complements because a reduction in price is the profit-maximizing response to a competitor’s price cut. Strategic Complements and Substitutes:  Strategic Complements and Substitutes One general rule is that prices are usually strategic complements, whereas quantity and capacity decisions are usually strategic substitutes. These concepts tell us how a firm expects its rival to react to its tactical maneuvers. Strategic Complements and Substitutes:  When actions are strategic complements, one firm’s aggressive behavior leads its competitors to behave more aggressively as well. Strategic Complements and Substitutes When actions are strategic substitutes, one firm’s aggressive behavior leads its competitors to behave less aggressively. Strategic Incentives to Make Commitments:  Strategic Incentives to Make Commitments Commitments have both a direct and a strategic effect on a firm’s profitability. Strategic Incentives to Make Commitments:  The direct effect of the commitment is its impact on the present value of the firm’s profits, assuming that the firm adjusts its own tactical decisions in light of this commitment, but that its competitor’s behavior does not change. Strategic Incentives to Make Commitments Strategic Incentives to Make Commitments:  The strategic effect takes into account the competitive side effects of the commitment: How does the commitment alter the tactical decisions of the rival and, ultimately, the market equilibrium? Strategic Incentives to Make Commitments The strategic effect can be positive or negative, depending on whether the choice variables affected by the commitment are strategic complements or strategic substitutes. Strategic Substitutes in the World Market for Memory Chip:  Strategic Substitutes in the World Market for Memory Chip The timing of new investment is critical for doing business in this industry. New chip factory cost over $1 billion, but they become obsolete quickly, in some cases within three years. Strategic Substitutes in the World Market for Memory Chip:  In the early 1980s, the memory chip industry was dominated by American semiconductor firms. Strategic Substitutes in the World Market for Memory Chip In 1984, a drop in prices caused the leading American chip makers to postpone plans to build new chip factories. Japanese firms responded by increasing their investments in new capacity. Strategic Substitutes in the World Market for Memory Chip:  In the 1990s, South Korean firms are aggressively expanding capacity. Strategic Substitutes in the World Market for Memory Chip Around 1990, in the midst of an industry downturn, major Japanese firms scaled back chip production. Recession in Japan forced Japanese firms to delay investments in new chip factories. Tough versus Soft Commitments:  Tough versus Soft Commitments Firm’s tough commitment is bad for its competitors, whereas a soft commitment is good for its competitors. Tough versus Soft Commitments:  A firm making a tough commitment is certain to produce more output than it would have done without the commitment. A firm making a soft commitment is certain to produce less output than it would have done without the commitment. Tough versus Soft Commitments In Cournot competition Tough versus Soft Commitments:  Tough versus Soft Commitments In Bertrand competition A firm making a tough commitment is certain to set lower price than it would have done without the commitment. A firm making a soft commitment is certain to set higher price than it would have done without the commitment. Tough versus Soft Commitments:  Firm 1 is contemplating making a strategic commitment. Tough versus Soft Commitments Stage 1: Firm 1 decides whether to make a commitment Stage 2: Firm 1 and Firm 2 compete with each other ( quantity competition or price competition) Stage 2 Competition Is Cournot:  Stage 2 Competition Is Cournot If Firm 1 makes a tough commitment, then its reaction function will shift to the right. Stage 2 Competition Is Cournot:  Stage 2 Competition Is Cournot If Firm 1 makes a soft commitment, then its reaction function will shift to the left. Stage 2 Competition Is Cournot:  Firm 1’s tough commitment has positive strategic effect. Firm 1’s soft commitment has a negative strategic effect. Stage 2 Competition Is Cournot As long as the beneficial strategic effect could outweigh the negative direct effect, the tough commitment may be valuable even though its direct effect is unfavorable. Stage 2 Competition is Bertrand:  Stage 2 Competition is Bertrand If Firm 1 makes a tough commitment, then its reaction function will shift to the left. Stage 2 Competition is Bertrand:  Stage 2 Competition is Bertrand If Firm 1 makes a soft commitment, then its reaction function will shift to the right. Stage 2 Competition is Bertrand:  Firm 1’s soft commitment has a positive effect and Firm 1’s tough commitment has a negative effect. Stage 2 Competition is Bertrand As long as the beneficial strategic effect could outweigh the negative direct effect, the soft commitment may be valuable even though its direct effect is unfavorable. Two Dimensions in the Two-stage Commitment Models:  Two Dimensions in the Two-stage Commitment Models Whether commitments are tough or soft, Whether the stage 2 tactical variables are strategic substitutes or strategic complements. Two Dimensions in the Two-stage Commitment Models:  If the stage 2 tactical variables are strategic substitutes (Cournot competition and the reaction curves slope downward), a tough commitment has a beneficial strategic effect. A soft commitment has a negative strategic effect. Two Dimensions in the Two-stage Commitment Models Two Dimensions in the Two-stage Commitment Models:  If the stage 2 tactical variables are strategic complements (Bertrand competition and the reaction curves slope upward), a soft commitment has a beneficial strategic effect. A tough commitment has a harmful strategic effect. Two Dimensions in the Two-stage Commitment Models Two Important Implications for Strategic Commitment:  Two Important Implications for Strategic Commitment When making hard-to-reverse investment decisions, managers ought to anticipate how the decisions will affect the evolution of market competition in the future. The details of market rivalry can profoundly influence the willingness of firms to make commitments. The Effect of Strategic Commitment:  The Effect of Strategic Commitment Sometimes the effect of the strategic commitment on a competitor may depend on whether the competitor is an existing competitor (in the market) or a potential competitor (outside the market). An aggressive move may result in an aggressive response by an existing competitor, but a passive response by a potential competitor. The Effect of Strategic Commitment:  The strategic effect of the commitment may depend on capacity utilization rates in the industry. The Effect of Strategic Commitment When capacity utilization rate is high, an aggressive commitment may result in a passive response by the rivals. When capacity utilization rate is low, an aggressive commitment may result in an aggressive response by the rivals. The Effect of Strategic Commitment:  The strategic effect of the commitment may depend on the degree of horizontal differentiation among the firm making the commitment and its competitors. The Effect of Strategic Commitment When the products are highly differentiated, the strategic effect of the commitment is small. When the products are less differentiated, the strategic effect of the commitment is large. The Case Study : Commitment at Nucor and USX:  The Case Study : Commitment at Nucor and USX Nucor was the first American firm to adopt thin slab casting. This adoption was a major commitment for Nucor, the largest minimill. This commitment was successful. The Case Study : Commitment at Nucor and USX:  USX, the largest American integrated steel producer, eventually decided not to adopt thin slab casting. The Case Study : Commitment at Nucor and USX This decision is anomalous in light of extant economic theory on process innovations. The Case Study : Commitment at Nucor and USX:  The theory suggests that if The Case Study : Commitment at Nucor and USX an innovation is nondrastic the innovation is likely to make the adopter tough in post-adoption competition. the returns from the process are not much more uncertain than returns from the existing technology, Then a large incumbent firm (USX) will have a stronger incentive to adopt the technology than a new entrant (Nucor). The Case Study : Commitment at Nucor and USX:  All the above conditions hold for thin slab casting. The Case Study : Commitment at Nucor and USX Why did USX not adopt thin slab casting? The prior commitment by USX to modernize existing facilities locked USX into a posture in which nonadoption of thin slab casting was a natural outcome. The Case Study : Commitment at Nucor and USX:  The conclusion highlights an important strategic point: The Case Study : Commitment at Nucor and USX In forecasting the likely reactions of competitors to major strategic commitments, a firm should recognize that prior commitments made by its competitors can constrain those firms’ potential responses. Flexibility and Option Value:  Flexibility and Option Value The positive strategic effects of a commitment are usually rooted in inflexibility. However, strategic commitments are almost always made under conditions of uncertainty about market conditions, costs, or competitors’ goals and resources. Flexibility and Option Value:  Flexibility gives the firm options. Flexibility and Option Value The value of options may occur when the firm can delay a commitment and await new information about its possible effects. The option value of delay is the difference between the expected net present value if the firm makes a commitment today and the expected net present value if the firm waits until uncertainty resolves itself. Flexibility and Option Value:  The option value arises when the firm leaves itself with options that allow it to tailor its decision making to the underlying circumstances it faces. Flexibility and Option Value Commitment versus Flexibility in the CD Market:  Commitment versus Flexibility in the CD Market Philips’ decision in 1983 whether to invest in a new CD pressing plant in the U.S. highlights the tension between the strategic effects of commitment and the option value of waiting. Commitment versus Flexibility in the CD Market:  By building a plain in 1983, Philips might preempt Sony and other potential competitors from building their plants. Commitment versus Flexibility in the CD Market There was an option value for Philips to wait and see whether market acceptance of CDs would be strong enough to justify an investment in U.S. Commitment versus Flexibility in the CD Market:  Anita McGahan studied Philips’ decision in detail and derive thresholds on what the probability of market acceptance would have to have been to justify Philips deciding to delay investment. Commitment versus Flexibility in the CD Market Without competitors, Philips would have been better off waiting and retaining flexibility if the probability that the popular market would accept the CD was 0.38 or lower. Commitment versus Flexibility in the CD Market:  When facing competitors that would learn about market demand at the same time it did, Philips would have been better off delaying investment if the probability of market acceptance was 0.006 or lower. Commitment versus Flexibility in the CD Market Commitment versus Flexibility in the CD Market:  But Philips has informational advantage about market acceptance of CDs from its experience in European market. Commitment versus Flexibility in the CD Market With this advantage, Philips would have been better off waiting if the probability of market acceptance was 0.13 or lower. Philips ultimately decided not to build the U.S. plant in 1983. A Framework for Analyzing Commitments:  A Framework for Analyzing Commitments Major strategic decisions usually involve investment in sticky factors: physical assets, resources, and capacities that are durable, specialized to the particular strategy that the firm follows, and untradeable. A Framework for Analyzing Commitments:  Commitment-intensive decisions are fraught with risk and require that managers look for into the future to evaluate alternative strategic actions. A Framework for Analyzing Commitments A Framework for Analyzing Commitments:  A four-step framework for analyzing commitment-intensive choices A Framework for Analyzing Commitments Positioning analysis Sustainability analysis Flexibility analysis Judgment analysis Positioning Analysis:  Positioning Analysis It is to determine the direct effect of the commitment. It involves analyzing whether the firm’s commitment is likely to result in a beneficial position in the market. Sustainability Analysis:  Sustainability Analysis It is to determine the strategic effects of the commitment. It involves analyzing potential responses to the commitment by competitors and potential entrants in light of the commitments that they have made and the impact of those responses on competition. Flexibility Analysis:  Flexibility Analysis Flexibility analysis incorporates uncertainty into positioning and sustainability analysis. Flexibility gives firms option value. The key determinant of option value is the learn-to-burn ratio. It is the ratio of the learn rate and the burn rate. The Learn-to-Burn Ratio:  The Learn-to-Burn Ratio The learn rate is the rate at which the firm receives new information that allows it to adjust its strategic choices. The burn rate is the rate at which the firm invests in the sunk assets to support the strategy. A high learn-to-burn ratio implies that a strategic choice has a high degree of flexibility. The Learn-to-Burn Ratio:  A high lean-to-burn ratio implies that the option value of delay is low because the firm can quickly accumulate information about the prospects of its strategic choice before it is too heavily committed. The Learn-to-Burn Ratio Experimentation and pilot programs are ways for firms to increase its learn-to-burn ratio and increase its flexibility in making commitment-intensive choices. Judgment Analysis:  Judgment Analysis Firms should take stock of the organizational and managerial factors that might distort the firm’s incentive to choose an optimal strategy. Two Types of Errors in Making Commitment-Intensive Choices:  Two Types of Errors in Making Commitment-Intensive Choices Type I errors: rejecting an investment that should have been made. Type II errors: accepting an investment that should not have been made. Decentralized decision making results in a relatively higher incidence of type II errors. Hierarchical decision making results in a relatively higher incidence of type I errors. Judgment Analysis:  Judgment Analysis Part of the process of making commitment-intensive decisions is a choice of how to make such decisions.

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