Beliefs, Market Size and Consumer Search

Abstract

Traditionally, search model assume consumers hold passive beliefs about prices they have not yet observed. In richer search environments where consumers also care about retailers' cost, this paper argues that symmetric beliefs are often more appropriate and yield quantitatively and qualitatively different predictions. First, prices are higher with symmetric beliefs (and can be as high as the joint profit maximizing prices), and are non-monotone in the search cost. Second, in a model with randomly fluctuating marginal cost that is unknown to consumers, equilibrium behaviour exibits price stickiness and random sales. This form of endogenous price rigidity has not been described before. Third, in a vertical relations model we show that for a large interval of search costs, wholesale and retail prices are decreasing in search cost. This happens when the upstream firm is proactively avoiding Diamond paradox style market breakdown by lowing its own price.