Firm strategy and biased decision making: the price dispersion puzzle

Abstract

This article confronts the empirical evidence and theoretical predictions about the correlation between price dispersion and price. Theoretically, search and location differentiation models suggest that price dispersion is a function of search and transportation costs, but is independent of the good's price. Empirical evidence, however, suggests otherwise: price dispersion and price are strongly correlated. This article points out the discrepancy between theory and evidence, which it denotes as ‘the price dispersion puzzle’. It then explains why the documented behaviour of relative thinking (people behave as if their search or transportation costs are increasing in the good's price) can solve the puzzle.