Monopoly and the other: reference-dependence in vertically differentiated markets

Abstract Economic literature has mostly focused on the issue of entry deterrence where incumbents have often been assumed to adopt strategies to keep entrants off the market. We show that an incumbent monopoly can comfortably accommodate a potential entrant and remarkably continue to earn monopoly-level profits (despite now being in a duopoly) provided that the entrant offers a sufficiently different quality level and the consumers’ preferences display reference-dependence (they compare the duopolists’ products against each other). This reduces price elasticity of demand and softens competition. Monopolies, by definition, cannot benefit through this channel because there is no second product for consumers to make comparisons with. Thus, a duopolist can strategically account for this reference-dependent behaviour in their pricing decisions. Oligopolies with three or more firms cannot earn monopoly-level profits because the demand segregation effects outweigh that of high prices.