Preventing commercial piracy when consumers are loss averse

Abstract

I analyze how the loss aversion of consumers affects the strategies of the government and the incumbent for preventing commercial piracy. To that end, I develop a sequential duopoly model of vertical product differentiation with price competition in which con- sumers have a reference-dependent utility. Regardless of the quality of the illegal copy, conventional models that do not take into account the loss aversion of consumers overes- timate the government’s effort to deter piracy but underestimate the incumbent’s effort. Contrary to conventional wisdom, I find that blocking the entry of a pirate by the govern- ment can provide more welfare than accommodating it. However, the government will not block it because socially it is better to encourage the incumbent to establish a price low enough to deter the pirate from entering.