Preventing commercial piracy when consumers are loss averse

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 consumers 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 overestimate 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 government 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.