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This paper studies a model in which consumers search among multiple competing firms for products that match their preferences at a reasonable price. We focus on how easier search, possibly due to the adoption of search-facilitating technologies such as the Internet, influences equilibrium prices, assortments, firm profits, and consumer welfare. Conventional wisdom suggests that easier search creates a competition-intensifying effect that puts pressure on firms to lower their prices and reduce assortments. However, in our model we demonstrate that search also exhibits a market-expansion effect that encourages firms to expand their assortment-easier search means that each firm is searched by more consumers. Because of broader assortments, consumers are more likely to find products that better match their ideal preferences, improving the efficiency of the market. In fact, we demonstrate that the market-expansion effect can even dominate the competition-intensifying effect potentially leading to higher prices, broader assortments, more profits, and expanded welfare.
Key words: search; Internet; price competition; assortment; product variety; long-tail phenomenon; game theory; differentiated competition
History: This paper was received January 31, 2006, and was with the authors 7 months for 2 revisions; processed by Z. John Zhang. Published online in Articles in Advance March 31, 2008.
1. Introduction
It was widely believed that the emergence of the Internet would lead to brutal price competition and an erosion of retail profit. The argument is simple and compelling: the Internet lowers the costs consumers incur to search for goods and services, so consumers search more, resulting in more opportunities to compare prices and ultimately more severe price competition among sellers. There is indeed some evidence that the Internet has reduced prices in several markets (e.g., Brynjolfsson and Smith 2000, Brown and Goolsbee 2002, Sorensen 2000). Nevertheless, there is also evidence that firms are able to support prices above marginal cost (e.g., Brynjolfsson et al. 2004, demons et al. 2002, Hortacsu and Syverson 2004).
This paper provides a simple explanation for why firms have been able to maintain at least some pricing power and hence profits. Suppose consumers care about the price they pay but also want to find a product or service that best matches their preferences. For example, a shopper may know she wishes to purchase a pair of shoes but is not...