Pretend-but-perform regulation and limit pricing

Abstract

If limit pricing under perfect information fails because incumbent cannot present potential entrants with a credible deterrent threat about how it would react to entry, a simple institution of legally binding commitments can remedy the failure. We study ‘Pretend-but-Perform Regulation’ (PPR), whereby incumbent and entrant each commits itself to exhibit a Cournot reaction consistent with a self-declared linear cost function, where true costs and demand are all linear and commonly known with costs private. Incumbent declares pretended (constant) marginal cost first, as leader, followed by entrant's declaration, the Cournot equilibrium of the pretended firms then being enacted. This generally sets them off bragging about their cost-effectiveness, declaring and committing themselves to exaggeratedly low costs and high output reactions. Incumbent ends up deterring entrant - limit pricing - for certain parameters where this did not happen without PPR. PPR is better for society than ordinary Cournot equilibrium. PPR is compared also with other regulatory devices, a similar one of Koray and Sertel, and two types of franchise bidding.