Expanding the Informativeness of the Price System with Law.

The use of false regular prices is a major case of misleading advertisement in what seems to be quite competitive markets. The authors construct a competitive model with rational expectations in which such misleading advertising emerges. They assume that there is competition locally, but that different qualities can exist on different markets. The quality-revealing process is noisy: some high quality firms experience problems and announce a bargain sale. There is a legal penalty, K, to be paid if someone is convicted of misrepresenting the quality of its product. As K increases, the price system becomes "more" informative by increasing the credibility and average quality associated with the signal "bargain sale."