Costly Price Information

Costly Price Information:

If consumer can costless obtain price information from all sellers of (an identical) product, and if there are many sellers, we would expect that there would be a single price which equals the average cost of production. However, if price information must be acquired at a cost, the equilibrium price could be above average cost, even if there are many sellers who are not cooperating in holding prices high. It could also be the case that sellers want to keep prices hard to obtain in this situation.

“Tourist-trap” Model:

Tourists visiting a city only once (or do not expect to come back) have limited time and incentive to search for a low price of a product. This enables sellers to raise the average price and tourists become “trapped,” i.e., forced to pay a very high price.

Assume that there are many shops in a tourist destination selling the same (tourist) item. To visit a shop costs the tourist, c, to visit two shops 2c, etc. The total cost of buying the item if you visited n shops to search for a low price is therefore p + 2 . n. The full-information, competitive price, is p which is equal to the marginal cost of production; no shop will charge a price less than this price. Will they charge a higher price? If all other shops charge p a single shop can gain by increasing its price to: p1 = p+ε, where ε, is a small positive number. If you expected the price to be pyou would be disappointed but if p1 − p < c, you will not go to another shop. Hence, it pays the individual shop to raise the price above the competitive price with an amount slightly less than the (marginal) search cost. If it pays one shop to deviate from p, it will pay all shops to do this; hence p is not equilibrium.

Is p1 = p+ε and equilibrium price? I.e., will all shops charge this price? The answer is no, because any individual shop can deviate from this price to: p2 = p1+ε = p+2ε. The unfortunate tourist now expected p1, but doesn’t find it worthwhile to search for a lower price. If all shops charge p2, a single shop can now raise the price to p3 = p + 3ε, etc. The average price keeps rising, but this cannot go on forever, because the quantity demanded will eventually go towards zero. The price increase will stop at the monopoly price. Raising the price above the monopoly price will reduce sales and profits. But if the highest price is the monopoly price, pm, couldn’t it pay for an individual shop to lower its price by more than c? Well, if there are only a few shops in the city, tourists may find it worthwhile to search for this single (rumored) cheap shop, but if there are many shops the chances of finding it within time is low so no searching is done, and it doesn’t pay for any shop to cut its price. The monopoly price is the equilibrium price!

Note that this model doesn’t predict that there will be a single price, the monopoly price. It depends on the number of sellers in the market place, which in turn depends on the cost of entry. If the single-price equilibrium can be broken by a single firm, there is either no equilibrium, or multiple-price equilibrium. Firms can find it worthwhile to advertise a low price and thereby attracting tourists, in this case all firms will advertise and there would be low-price, advertising, and equilibrium. But if no firm finds it profitable to advertise, they prefer consumers to be ill-informed and they want to keep prices invisible.

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