Costly diagnosis and price dispersion

Abstract

In the standard search model under monopolistic competition, when the consumer encounters a seller he knows the price before purchasing the commodity. Consequently, the price cannot exceed the consumer's reservation price. In a market with rational and homogeneous agents the price distribution must therefore be degenerate. In markets for indivisible professional services the consumer does not necessarily know the price of the service when he encounters the seller. This possibility arises when the cost of ascertaining the price (the diagnosis cost) is high and the consumer decides to enter the market without searching. In contrast to the standard model, under monopolistic competition, price dispersion in equilibrium is possible even when fully rational economic agents on both sides of the market are homogeneous. We characterize such equilibria and provide a sufficient condition for their existence. We then study the effect of manipulating the search technology (typically, through a professional code of ethics) on the equilibrium in markets for such professional services.