Microdynamics • 231
a soft commitment. In Bertrand competition, a commitment to reduce prices, perhaps through a well-publicized advertising campaign (so that the firm could not back down), is a tough commitment.
Tough commitments conform to the conventional view of competition as an effort to outdo one’s rivals. For example, we “understand” why firms may commit to be the largest volume producer or lowest price seller in a market. Tough commitments have a profitable strategic effect if they involve strategic substitutes and a negative strategic effect if they involve strategic complements. If Nucor’s rivals reduce investments after Nucor’s commitment to expand, then the strategic effect leads to higher prices and raises Nucor’s profits. If McDonald’s reduces advertising in the wake of Burger King’s campaign, that serves to further increase Burger King’s market share.
Managers need to be aware of whether the tactical weapons at their disposal are strategic complements or substitutes. This requires some economic insight (would ads be more or less valuable to McDonald’s when Burger King is heavily advertising?) and some experience (how has McDonald’s reacted in the past when Burger King launched an ad campaign?). The facts on the ground should probably trump the theoretical insights; if McDonald’s previously matched ad campaign for ad campaign, then advertising is a strategic complement and the tough commitment by Burger King will have a negative strategic effect.
Firms should not automatically refrain from making soft commitments. In fact, a soft commitment will have a profitable strategic effect when it involves strategic complements. If Burger King finds that McDonald’s stubbornly matches its ad dollars, it might benefit by reducing its own ad spending. Of course, Burger King must commit to this reduction or McDonald’s may not believe that ad spending will really be restrained. Sometimes it is easier to talk about a commitment than to credibly make that commitment.
A Taxonomy of Commitment Strategies
Drew Fudenberg and Jean Tirole developed a taxonomy of commitment strategies based on the two important dimensions that we have discussed—whether commitments are tough or soft and whether the tactical variables (e.g., quantity and price) are strategic substitutes or strategic complements.9 There are four ways of combining these dimensions to generate profitable strategic effects, and depending on the combination, the commitment can generate a profitable or unprofitable strategic effect. For example, if the tactical variables are strategic complements (e.g., prices) and the commitment makes the firm tough (e.g., the firm commits to lowering prices), then the commitment causes rival firms to behave more aggressively (e.g., they lower prices in response). In this case, the commitment has a harmful strategic effect, and the firm has an incentive either to forsake the commitment altogether or to underinvest in it—to make the commitment at a lower level. Fudenberg and Tirole call this the “puppy-dog ploy.”
The puppy-dog ploy as well as the three other profitable commitment strategies are shown in Table 7.1 and are marked by the superscript FT. The profitable alternative to the puppy-dog ploy is the “fat-cat effect,” in which the firm makes a soft commitment on tactical variables that are strategic complements. Robert Crandall tried this ploy in 1991 when American Airlines increased its prices through Value Pricing, although the subsequent price cuts suggests that there was little commitment involved in the Value Pricing promotion. When tactical variables are strategic substitutes (e.g.,
232 • Chapter 7 • Dynamics: Competing Across Time
TABLE 7.1
Nature of Stage 2 |
|
|
|
|
Tactical |
Commitment |
Commitment |
|
Comments/Role of Actor in |
Variable |
Posture |
Action |
Strategy |
Competitive Arena |
Strategic |
Tough |
Make |
Top DogFT |
Assert dominance; force |
substitutes |
|
|
|
rivals to back off |
Strategic |
Tough |
Refrain |
Submissive Underdog |
Accept follower role; avoid |
substitutes |
|
|
|
fighting |
Strategic |
Soft |
Make |
Suicidal Siberian |
Invite rivals to exploit you; |
substitutes |
|
|
|
may indicate exit strategy |
Strategic |
Soft |
Refrain |
Lean and Hungry |
Actively submissive; posturing |
substitutes |
|
|
LookFT |
to avoid conflict |
Strategic |
Tough |
Make |
Mad Dog |
Attack to become top dog; |
complements |
|
|
Puppy-Dog PloyFT |
invite battle heedless of costs |
Strategic |
Tough |
Refrain |
Placate top dog; enjoy |
|
complements |
|
|
Fat-Cat EffectFT |
available scraps |
Strategic |
Soft |
Make |
Confidently take care of self; |
|
complements |
|
|
|
share the wealth with rivals |
Strategic |
Soft |
Refrain |
Weak Kitten |
Accept status quo out of |
complements |
|
|
|
fear; wait to follow the leader |
|
|
|
|
|
quantities), the firm should go ahead with tough commitments (the “top-dog” strategy) and refrain from soft commitments (the “lean and hungry look”). For completeness, we include and name in Table 7.1 those commitment actions that generate harmful strategic effects.
One may occasionally see a firm pursue one of the seemingly harmful strategies. For example, a firm may pursue the “mad-dog” strategy of making a tough commitment when the tactical variables are strategic complements. Robert Crandall appeared to do this when he slashed American Airlines’ prices in 1992, though again it is not clear how committed he was to the price cuts. Such strategies, though seemingly counterintuitive, can make sense if the firm views price competition as a dynamic competitive process. If so, short-term strategic losses might be offset by long-term gains. We discuss the long-run dynamics of competition in the next section.
The Informational Benefits of Flexibility
The strategic effects of commitment are rooted in inflexibility. For example, in the Stackelberg model where marginal production costs are low, a firm that preemptively invests in capacity expansion is certain to increase output and drive down prices. In doing so, it may force rival firms to scale back their plans to expand capacity. In this way, the first firm to commit to a capacity expansion can increase its profits at the expense of its rivals. Likewise, a firm that sinks costs to enter a growing market will likely stay rooted in the face of entry, thereby deterring other firms from entering. As in the Stackelberg situation, making an early commitment has a strategic benefit.
Microdynamics • 233
EXAMPLE 7.2 COMMITMENT AT NUCOR AND USX:
THE CASE OF THIN-SLAB CASTING10
Pankaj Ghemawat’s case study of the adoption of thin-slab casting by Nucor and the nonadoption by USX (now renamed U.S. Steel) illustrates the relationship between commitment and product market competition, and how previous commitments can limit a firm’s ability to take advantage of new commitment opportunities.
In 1987, Nucor Corporation became the first American steel firm to adopt thin-slab casting, a significant improvement over the standard technology of the day, continuous casting. At that time, Nucor was looking to enter the flat-rolled sheet segment of the steel business, a segment that had been unavailable to the minimills, of which Nucor was the largest. Adoption of this thin-slab casting was a major commitment for Nucor. All told, the upfront investment in developing the process and building a facility to use it was expected to be $340 million, close to 90 percent of Nucor’s net worth at the time. Nucor’s commitment was successful. By 1992, Nucor’s thin-slab casting mill in Crawfordsville, Indiana, had become profitable, and Nucor built a second thin-slab casting plant in Arkansas.
USX, the largest American integrated steel producer, which was 60 times larger than Nucor, also showed an early interest in thinslab casting, spending over $30 million to perfect a thin-slab casting technology known as the Hazelett process. Yet USX eventually decided not to adopt thin-slab casting. Ghemawat argued that this decision was anomalous in light of extant economic theory on process innovations. So why did USX not adopt thin-slab casting? Ghemawat argues that
the decision stemmed from prior organizational and strategic commitments that constrained USX’s opportunity to profit from thin-slab casting. For example, in the mid1980s, USX had already modernized four of its five integrated steel mills. The fifth plant, located in the Monongahela River Valley in Pennsylvania, was a vast complex in which the steelmaking facility and the rolling mill were 10 miles apart. Moreover, the labor cost savings that would accrue to a nonunionized firm like Nucor would not be nearly as significant to unionized USX, which was bound by restrictive work rules. Finally, there was doubt as to whether appliance manufacturers, which were major customers of the sheet steel produced in the Monongahela Valley plant, would purchase sheet steel produced via continuous casting due to the adulteration in the surface quality of the steel that the new process might cause.
Ghemawat argues that USX’s prior commitment to modernize existing facilities—in particular the one at Monongahela Valley—as opposed to building “greenfield” plants, locked USX into a posture in which nonadoption of thin-slab casting was a natural outcome. This conclusion highlights an important strategic point: 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. In this case, Nucor’s management anticipated USX’s behavior. Nucor decided to enter the flat-rolled sheet steel business because it expected that integrated producers, such as USX, would not adopt thin-slab casting.
In the strategic situations described above, firms are fully informed about market conditions and costs, they know their rivals’ goals and capabilities, and they can observe each other’s actions. In reality, strategic commitments are almost always made under conditions of uncertainty. For example, in deciding whether to sink money into building the first CD plant in the United States, Philips had no idea whether CDs would appeal to a mass audience or only to the most dedicated audiophiles. When
234 • Chapter 7 • Dynamics: Competing Across Time
competitive moves are hard to reverse and their outcomes are shrouded in uncertainty, the value of preserving flexibility by keeping one’s future options open must be considered when evaluating the benefits of the commitment.
A firm can preserve its flexibility in a number of ways when making a strategic commitment. A firm can separate a single large commitment into smaller components. For example, Wal-Mart brought its hypermarts to Mexico by opening a few stores in select metropolitan areas. This partly reflected the limited resources available to Wal-Mart (e.g., individuals capable of managing the stores were in short supply), but it also allowed Wal-Mart to learn about market conditions before proceeding with its store rollout. Of course, a smaller commitment will have a smaller strategic effect. If Wal-Mart had thought that by entering Mexico domestic rivals would scale back their own expansion plans, it would have been disappointed.
Real Options
By delaying important decisions, firms can always learn more about market conditions. But this is not an excuse to postpone key decisions indefinitely. By the time the firm acts, it may have lost considerable profits that it might never recapture. And by the inexorable properties of discounting, the future profits that it eventually realizes will be worth less than comparable profits it might have earned earlier on. This raises the question: What is the best time to make a strategic investment when faced with uncertain conditions? The answer is given by the study of real11 options.12
A real option exists when a decision maker has the opportunity to tailor a decision to information that is unknown today but will be revealed in the future. Real options analysis can be mathematically complex because the formula for valuing an option often involves differential equations. But the underlying intuition is straightforward and can dramatically improve strategic decision making.
To illustrate real options analysis, consider the value of delaying a commitment. Specifically, suppose that a firm can invest $100 million in a plant to enter a new market but is uncertain whether the product will gain widespread acceptance. The firm forecasts two scenarios: with wide product acceptance, net cash flows from the investment will have a present value of $300 million; with low market acceptance, the present value of the net flows will be $50 million. The firm believes that each scenario is equally likely. If the firm invests today, the expected net present value (NPV) of the investment is 0.5(300) 1 0.5(50) 2 100 5 $75 million. Using traditional rules for investments—invest in all positive NPV projects—the firm should go ahead with the investment.
But suppose, by waiting a year, the firm can learn for certain which scenario will arise (perhaps by observing the demand for the product in another geographically distinct market). If the product turns out to have a high level of market acceptance, the firm can still invest and obtain a net present value of $200 million. But if the product has low acceptance, the firm is better off putting its money in the next best alternative, which we will assume is a zero NPV investment. Assuming a 10 percent annual discount rate, if the firm waits, its expected NPV is [0.5(200) 1 0.5(0)]/(1.10) 5 $91 million, which exceeds the $75 million NPV from immediate investment. In other words, an investment project that embodies an option to delay is more valuable than one for which the firm faces a “now-or-never” choice of investing or not investing in the project. Delay is valuable because it allows the firm to avoid the money-losing outcome of investing when market acceptance is low.