Equilibrium Effects of Potential Entry When Prices Signal Quality

This paper analyses the effects of introducing potential entry by an uninformed high-quality firm into a market where the privately informed incumbent already uses the price to signal product quality to uninformed consumers. Contrary to most of the literature on potential entry, we show that the effect of potential entry may be to distort the first-period price upwards compared to the no-entry case, and thus to decrease consumer surplus in the first period. When separating equilibria exist, the quality uncertainty is resolved in the unique self-enforcing equilibrium and the pre-entry 'limit pricing' does not limit entry compared to the full information case. Hence, not only the high-quality incumbent but also the consumers suffer a decrease in the present-value of payoffs as a result of potential entry by a high-quality firm.