REGULATING A CONSUMER GOOD MARKET IN THE PRESENCE OF AN ENDOGENOUS BLACK MARKET ALTERNATIVE
AbstractThis paper studies the regulation of markets where legal products compete against illegal substitutes, such as weapons, cigarettes, transplantation organs, and shadow banking. Our focus is on the impacts of regulatory measures affecting asymmetrically the legal and the illegal segments of the market on competition patterns, market outcomes and welfare. We present a game-theoretical model to endogenize companies’ decision between going legal or illegal. Such decision is associated with different costs, but also with a different type of competition in the market place: horizontal product differentiation if all firms are legal and tightly regulated, or vertical differentiation if not. Regulation may backfire if the black market is not considered. More stringent regulation – which only impacts the legal segment – fosters the incentives for going illegal whenever the new regulatory measure increases the costs of legal entry. Regulation in such a context leads to lower average product quality and consumer welfare.
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