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Moral Hazard as an Entry Barrier

  • Joseph Farrell

In an experience-goods industry, an entrant who could make positive profits by providing a better deal to buyers than do incumbents may cheat buyers by providing goods of low quality to make even greater profits. If buyers foresee this possibility, they will be unwilling to buy from an entrant. As a result, moral hazard in a seller's choice of the quality of an experience good can lead to a barrier to entry. In particular, since hit-and-run entry is likely to lead to low-quality choice, the threat of such entry may not discipline the pricing of incumbents. We also show that the temptation to dishonest entry -- the moral hazard problem -- is stronger if buyers are already receiving some consumer surplus. As a result, there is a first-entrant advantage because the first entrant faces less temptation to provide inefficiently low quality than do subsequent entrants, and with rational buyers this works to his advantage. The scale of entry may affect quality incentives, and therefore introductory offers may assure buyers of an entrant's quality but this cannot happen under a suitable definition of "constant returns."

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Paper provided by Massachusetts Institute of Technology (MIT), Department of Economics in its series Working papers with number 387.

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Date of creation: Jul 1985
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Handle: RePEc:mit:worpap:387
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