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Lecnotes07 - ECON 696 Managerial Economics and Strategy...

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ECON 696: Managerial Economics and Strategy Lecture Notes 7: Strategic Commitment The previous chapter introduced oligopoly, a market structure with a small number of firms and significant barriers to entry. It is in these markets that strategy is most crucial. In this chapter, we are going to look at issues of strategic commitment among firms in oligopolies operating under conditions of Cournot competition (in which firms choose quantities) and Bertrand competition (in which firms choose prices). The idea that a firm might want to commit to a course of action rather than remaining flexible is somewhat surprising because in most cases having more options is generally preferred to having fewer options. In cases of strategic interaction, however, the opposite is sometimes true. The Example of Table 7.1 The first example given in the chapter is a game where the players can choose aggressive or passive strategies. If you are unfamiliar with this type of game analysis, you should consult the primer at the beginning of the textbook. This game is reproduced here: Firm 2 Aggressive Passive Firm 1 Aggressive 12.5, 4.5 16.5, 5 Passive 15, 6.5 18, 6 The important thing about this game is that "passive" is a dominant strategy for Firm 1. That is, no matter what Firm 2 does, Firm 1 will get a higher payoff from playing "passive" than it will from playing "aggressive". Following the usual logic, Firm 1 should play "passive" because it is always better than playing "aggressive", given Firm 2's behavior , and Firm 2 will then choose "passive". The result is a payoff of 16.5 to Firm 1 and 5 to Firm 2. However, if Firm 1 can somehow commit to playing "aggressive" in a way that absolutely prevents them from choosing "passive", they are no longer taking Firm 2's behavior as given, but instead are using commitment to control Firm 2's behavior. Knowing that Firm 1 will be playing "aggressive", Firm 2 will choose "passive".
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Normally, if Firm 2 plays "passive", Firm 1 would like to switch to "passive" and increase her payoff from 16.5 to 18, but commitment prevents this. The end result is that commitment to "aggressive" gets Firm 1 a payoff of 16.5 rather than their normal Nash equilibrium payoff of 15. This chapter will investigate strategic commitments, situations in which commitment can be beneficial and how to determine what sort of commitment should be used when. Characteristics and Examples of Commitment The necessary characteristics for a good commitment are: It must be visible. Your competitors must be able to clearly see that you have taken actions committing you to a course of action. It must be understandable. It should be clear to someone with a basic understanding of the situation why your actions commit you to a certain course of action. It must be credible. There must be compelling reasons to believe that having taken the initial action, you must carry through with the course to which you have committed.
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