|Home BADM449 Handout #13||Joseph T. Mahoney|
UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN
Using Strategic Commitment to Influence
Up until this point in the course, we have tended to talk about strategy as matching a firm's resources and capabilities (strengths and weaknesses) to its competitive environment (opportunities and threats) in order to gain a sustainable competitive advantage. If we were to stop here, the implicit suggestion is that firms can do little to influence their competitive environment, that they must take the evolving environment as given. However, if we think about the cases we have looked at, it is clear that this is a simplifying assumption that typically does not hold. For example, in "Coke v. Pepsi," the actions taken by both companies shaped the competitive landscape. Because the competitive environment is an endogenous outcome of the interaction between competitors, it follows that we must ask the question: "How can we influence the actions (or non-actions) of competitors to our benefit?" To answer this question, we must refer to the concept of strategic commitment and game theory.
For example, consider the following hypothetical example from the commercial aircraft industry. Imagine that Airbus and Boeing are both considering launching a new aircraft to service regional air routes in the range of less than 2,000 miles. Currently, both companies have products to service this segment. However, these designs are more than 20 years old and customers are demanding dramatic improvements in efficiency and carrying capacity. The problem is that given the size of the market and the costs associated with developing the new aircraft, only one competitor can profitably design and launch a new product. Based on this information, industry financial analysts have forecasted differing payoffs under various scenarios (see Figure 1). For example, if both companies continue to sell their existing models (no launch), it is projected that Boeing will make an operating profit of $300 million over the next three years while Airbus will have an operating profit of $400 million. If Boeing launches the new aircraft and Airbus does not, Boeing will receive $400 million (after R&D expenditures) and Airbus will receive $200 million (assuming that Airbus would be able to keep part of the market by slashing prices to compensate for the technological advantages the new aircraft would have.) Assuming that Airbus is not as efficient as Boeing in the design of new aircraft, it is projected that if they launch the new aircraft and Boeing does not, Airbus will make profit of $300 million and Boeing will make $200 million. If both companies launch the new aircraft, Boeing will lose $100 million per year and Airbus will lose $200 million. How will the competitive interaction play out in this situation?
To understand the importance of strategic commitment and first mover advantages in this situation, we analyze two different versions of the "game," one in which the two companies choose their strategies simultaneously and one where Airbus goes first. Where the two companies choose their strategies simultaneously, the outcome of the game is the upper right-hand corner of the matrix where Boeing launches the aircraft and Airbus does not.
To understand why the upper right-hand corner is the predicted outcome, lets take a closer look at the "payoff matrix." In this payoff matrix, the No launch strategy is a dominant strategy for Airbus. By dominant strategy, we mean that no matter what Boeing does, Airbus would always prefer to go with the no launch strategy. For example, if Boeing doesn't launch then Airbus would prefer $400 million to $300 million. If Boeing does launch, Airbus will not launch since Airbus would prefer $200 million to -$200 million.
Boeing can use this information to its advantage. Since they know that Airbus will always choose the no launch strategy, Boeing will launch the aircraft since they prefer $400 million to $300 million. In game theory, this upper right-hand strategy is referred to as a Nash equilibrium. A Nash equilibrium is an outcome where, given the other player's strategy, you cannot make yourself better off by playing a different strategy than the one you have chosen. Also, the other player(s) cannot unilaterally change their strategy and make themselves better off. In the aircraft example, "Boeing launches and Airbus does not launch" is a Nash equilibrium because:
Now, what if the game is changed so that Airbus moves first or can pre-commit itself to playing a particular strategy? Will the outcome of the game change? Yes, it will. If Airbus goes first, then it would choose to launch the aircraft. If Airbus goes first and chooses not to launch, Airbus will receive $200 million (since Boeing would choose to launch). When they have the first move, Airbus would be better off launching the aircraft. If Airbus chooses to launch the aircraft, Boeing's best response is to not launch since $200 million is better than -$100 million. Under these circumstances, Airbus ends up with $300 million and Boeing ends up with $200 million. This sequential game is also a Nash equilibrium.
The differences between these two versions of the game reveal something very important about strategy. Often the outcome of a particular competitive situation depends greatly on the timing and order of competitive moves. In the aircraft game, if the companies move simultaneously (or Boeing moves first), Airbus ends up with a lower payoff than when they move first. Where Airbus moves first, it was able to choose an action that lead to a higher payoff. It should be noted however, that the outcome of the second version of the game is contingent on Airbus being able to "credibly commit" itself to acting in a certain manner. If Boeing thought that Airbus would back off its strategy if Boeing launched the new aircraft, then Boeing would launch the aircraft because they know that Airbus will not launch the aircraft in order to preserve their positive cashflow in the business. The key to Airbus' strategy is pre-commitment to launching the aircraft; it's the only way it can influence Boeing's behavior.
A few other points about strategic commitment and its use in business strategy: