Pricing, product diversity, and search costs a Bertrand.pdfVIP

RAND Journal of Economics Vol. 30, No. 4, Winter 1999 pp. 719–735 Pricing, product diversity, and search costs: a Bertrand-Chamberlin-Diamond model Simon P. Anderson* and Re´gis Renault** We study price competition in the presence of search costs and product differentiation. The limit cases of the model are the ‘‘Bertrand Paradox, ’’ the ‘‘Diamond Paradox, ’’ and Chamberlinian monopolistic competition. Market prices rise with search costs and decrease with the number of firms. Prices may initially fall with the degree of product differentiation because more diversity leads to more search and hence more competi- tion. Equilibrium diversity rises with search costs, while the optimum level falls, so entry is excessive. The market failure is most pronounced for low preference for variety and high search costs. 1. Introduction Why do consumers shop around before buying? One reason is to find a low price. Another is to find a product they like. There are many industries in which buyer search is an important feature of market interaction. Shopping for shoes is one example; another is a business that must decide between competing suppliers (e.g., builders choosing where to buy inputs). One would expect lower search costs to lead buyers to search more options before purchasing and hence lead to lower prices. Likewise, stan- dard economic intuition suggests that prices would be lower if there were more firms because consumers can search across more options. The consequences of buyer search on market performance are potentially severe. Diamond (1971) provides an extreme example, in what has been called the Diamond Paradox. There are two parts to the paradox. First,