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Moral Hazard as an Entry Barrier

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  • Joseph Farrell

Abstract

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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  • Joseph Farrell, 1985. "Moral Hazard as an Entry Barrier," Working papers 387, Massachusetts Institute of Technology (MIT), Department of Economics.
  • Handle: RePEc:mit:worpap:387
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    Cited by:

    1. Bagwell, Kyle, 1990. "Informational product differentiation as a barrier to entry," International Journal of Industrial Organization, Elsevier, vol. 8(2), pages 207-223, June.
    2. Martin Peitz & Paolo G. Garella, 1999. "- Exclusive Dealing Clauses Facilitate Entry," Working Papers. Serie AD 1999-17, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
    3. Zegners, Dainis, 2017. "Building an Online Reputation with Free Content: Evidence from the E-book Market," Annual Conference 2017 (Vienna): Alternative Structures for Money and Banking 168293, Verein für Socialpolitik / German Economic Association.
    4. Horst Raff & Marc von der Ruhr, 2007. "Foreign Direct Investment in Producer Services: Theory and Empirical Evidence," Applied Economics Quarterly (formerly: Konjunkturpolitik), Duncker & Humblot, Berlin, vol. 53(3), pages 299-321.
    5. Anthony Creane & Thomas D. Jeitschko, 2016. "Endogenous Entry in Markets with Unobserved Quality," Journal of Industrial Economics, Wiley Blackwell, vol. 64(3), pages 494-519, September.
    6. J. Miguel Villas-Boas, 2000. "Competing with Experience Goods," Econometric Society World Congress 2000 Contributed Papers 0771, Econometric Society.
    7. Gene M. Grossman & Henrik Horn, 1988. "Infant-Industry Protection Reconsidered: The Case of Informational Barriers to Entry," The Quarterly Journal of Economics, Oxford University Press, vol. 103(4), pages 767-787.
    8. de Bijl, Paul W. J., 1997. "Entry deterrence and signaling in markets for search goods," International Journal of Industrial Organization, Elsevier, vol. 16(1), pages 1-19, November.
    9. Hintermann, Beat & Lange, Andreas, 2013. "Learning abatement costs: On the dynamics of the optimal regulation of experience goods," Journal of Environmental Economics and Management, Elsevier, vol. 66(3), pages 625-638.
    10. Nizovtsev, Dmitri & Novshek, William, 2004. "Money-back guarantees and market experimentation," International Journal of Industrial Organization, Elsevier, vol. 22(7), pages 983-996, September.
    11. Eric Rasmusen, 2008. "Quality-Ensuring Profits," Working Papers 2008-10, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
    12. Gehrig, Thomas & Stenbacka, Rune, 2002. "Introductory Offers in a Model of Strategic Competition," CEPR Discussion Papers 3189, C.E.P.R. Discussion Papers.
    13. Ai‐Ting Goh & Tomasz K. Michalski, 2012. "Quality Assurance and the Home Market Effect," Review of International Economics, Wiley Blackwell, vol. 20(2), pages 237-255, May.
    14. Raff, Horst & Kim, Young-Han, 1999. "Optimal export policy in the presence of informational barriers to entry and imperfect competition," Journal of International Economics, Elsevier, vol. 49(1), pages 99-123, October.
    15. M Suresh Babu, 2007. "Economic Reforms And Entry Barriers In Indian Manufacturing," Working Papers id:978, eSocialSciences.
    16. Martin Peitz, 2000. "Exclusionary Practices and Entry Under Asymmetric Information," Econometric Society World Congress 2000 Contributed Papers 1197, Econometric Society.
    17. Cagé, Julia & Rouzet, Dorothée, 2015. "Improving “national brands”: Reputation for quality and export promotion strategies," Journal of International Economics, Elsevier, vol. 95(2), pages 274-290.
    18. Rasmusen, Eric, 2017. "A model of trust in quality and North–South trade," Research in Economics, Elsevier, vol. 71(1), pages 159-170.
    19. Choi, Jay Pil & Peitz, Martin, 2016. "You are judged by the company you keep : reputation leverage in vertically related markets," Working Papers 16-07, University of Mannheim, Department of Economics.
    20. Tirole, Jean, 2002. "Rational irrationality: Some economics of self-management," European Economic Review, Elsevier, vol. 46(4-5), pages 633-655, May.
    21. Sergi Jiménez-Martín & Antonio Ladrón de Guevara-Martínez, 2009. "A state-dependent model of hybrid behavior with rational consumers in the attribute space," Investigaciones Economicas, Fundación SEPI, vol. 33(3), pages 347-383, September.
    22. Egbert, Henrik & Greiff, Matthias & Xhangolli, Kreshnik, 2014. "PWYW Pricing ex post Consumption: A Sales Strategy for Experience Goods," MPRA Paper 53376, University Library of Munich, Germany.
    23. Guha, Brishti, 2016. "Moral Hazard, Bertrand Competition, and Natural Monopoly," MPRA Paper 70966, University Library of Munich, Germany.
    24. repec:kap:jeczfn:v:121:y:2017:i:2:d:10.1007_s00712-017-0527-7 is not listed on IDEAS
    25. Beat Hintermann & Andreas Lange, 2012. "Learning Abatement Costs: On the Dynamics of Optimal Regulation of Experience Goods," CESifo Working Paper Series 4058, CESifo Group Munich.

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