Truly Costly Search and Word-of-Mouth Communication

TL;DR

This paper examines how firms' market power is affected by increased word-of-mouth communication among consumers in markets with search frictions, showing that market power persists even with widespread information dissemination if acquiring price info remains costly.

Contribution

It demonstrates that technological progress does not necessarily erode market power when consumers face costly price information acquisition.

Findings

Prices remain dispersed when search is costly.

Expected prices stay above marginal cost despite more WOM.

Market power persists with increased consumer connectivity.

Abstract

In markets with search frictions, consumers can acquire information about goods either through costly search or from friends via word-of-mouth (WOM) communication. How do sellers' market power react to a very large increase in the number of consumers' friends with whom they engage in WOM? The answer to the question depends on whether consumers are freely endowed with price information. If acquiring price quotes is costly, equilibrium prices are dispersed and the expected price is higher than the marginal cost of production. This implies that firms retain market power even if price information is disseminated among a very large number of consumers due to technological progress, such as social networking websites.