Buyer Search Costs and Endogenous Product Design

In many cases, buyers must incur search costs to find the price of a product. This search cost affects the behavior of consumers, and through that, it affects the profit maximizing behavior of the firms. As search costs change, so do the competitive marketing mix strategies of the firms. In predicting the effect of changing search costs on the equilibrium prices and allocations, it is important to take all effects into consideration. Through a model of buyer and seller behavior in the presence of buyer price search costs and seller uncertainty about the demand, I consider the effects of changing search costs on prices when product differentiation is fixed and when it is endogenously determined in equilibrium. While keeping product differentiation constant, lower buyer search cost for prices leads to lower equilibrium prices. At the same time, lower search costs also lead to higher incentives for the firms to invest in differentiating product design. The resulting higher level of product differentiation decreases the effects of lower search costs on prices, so that lower buyer search costs for prices may even lead to higher prices. Moreover, the overall effect of lower search costs on social welfare may be negative, and the effect on the industry profits may be positive. The result is especially interesting because recent technological changes, such as the Internet shopping, may be affecting the market structure mostly through lowering buyer (consumer) search costs.