Information and Consumer Search

Consumer search theory provides a framework to assess the market power of firms that arise from search frictions. The theory has now passed the initial stage of development and it is time to reflect on common assumptions made and inquire about new applications. This research proposal mainly focusses on the informational assumptions made in consumer search theory. Central to the consumer search literature is the idea that consumers do not know the products that are sold in the market and the prices charged. Instead, they have to devote resources on getting to know them. However, other aspects of the market are considered to be known (as in the standard models of market interaction): the number of firms, their costs, etc. Similarly, firms are assumed to know each others` costs and how consumers search. The research proposed here extends consumer search theory by relaxing some of the informational assumptions made and by inquiring into the incentives of firms to share information. The proposal is subdivided into three projects. The first project considerably relaxes the informational assumptions on the consumer side of the market. We develop a search rule that does not critically depend on detailed assumptions on the search environment and ask the question to what extent market behavior is affected by consumers that use a robust search rule that is independent of the model`s parameters. The second project inquires into the incentives of firms to share information. In the consumer search literature the information structure for firms is given, where the information consumers possess is endogenously determined. The second project also endogenizes the information structure of firms. There is a literature on information sharing in markets and auctions and we want to adapt this literature to consumer search markets. The third project develops a more applied perspective and considers the implications of different informational assumptions in a consumer search model with a vertical industry structure. In a recent paper Janssen and Shelegia (2014) reconsider the issue of double marginalization when there is consumer search in the retail market. They mainly focus on the realistic case where consumers do not know the wholesale arrangement between retailers and manufacturer. They show that the double marginalization problem may become significantly worse, but they also have a large region where a reservation price equilibrium does not exist. This third project attempts to analyze equilibria that do not exhibit the reservation price property.

Traditional economic theory assumes that consumers can compare prices and products without spending time, effort and money to do so. This assumption is clearly at odds with real world markets. The consumer search literature that has been developed over the past decades in economics has analyzed to what extent neglecting consumer search cost leads to a misrepresentation of how markets work. That literatures main insight is that search costs do significantly affect market outcomes and that even if search costs are small, market outcomes are expected to be different compared to when they are completely absent. This research project has resulted in three papers that further advance our understanding of the importance of search costs, namely in markets where consumers learn about underlying market characteristics when they search for prices and in markets where the final retail price a consumer observes is the result of a manufacturer and a retailer decision. To understand why learning may be important for consumer search decisions, consider a consumer who observes the price of gasoline at a gas station. Knowing that prices between different stations may vary, the consumer must decide whether to buy at the observed price or search for a better deal. When making this decision, she must estimate how much of the observed price is due to common factors affecting all gasoline stations similarly, such as the price of crude oil, and how much is due to idiosyncratic factors affecting this particular seller. If the consumer believes that common factors are more relevant in determining the price, she might consider searching for a cheaper gas station not worthwhile and, hence, buy at the observed price. A key feature of this problem is that the consumer must take her decision not knowing the gas stations input (production) cost and that by observing some prices, she gradually learns whether all prices are high or not. The first paper in this project is a methodological article showing that the standard techniques analyzing the strategic price setting in these markets are problematic and it proposes an alternative solution method. The second project considers a similar setting, but now explicitly analyzes how the cost of the retailers is strategically chosen by manufacturers or input suppliers. We show that in such settings, markets can be very inefficient. The third project considers a variation of this setting where a manufacturer may charge different prices to different retailers. The project provides a new rationale for why manufacturers may price discriminate retailers, namely to exert a competitive effect on a market in which she is not active herself. Essential to our theory is that the retail market is characterized by consumer search and that the manufacturer can (partially) commit to wholesale prices. A pricing policy that is known under the heading of recommended retail prices provides a way for the manufacturer to commit, resulting in lower welfare.