When you look for a digital camera or LCD TV on Amazon, often you can’t see the price till you add it to the shopping cart.  This is a little bit on an inconvenience so why does Amazon do it?

It turns out the producers force Amazon to do it.  Adding the extra step to shopping  has two effects.

First, the prices do not turn up on comparison shopping sites like Pricegrabber.com so it is harder to search for a good deal.  Second, every time you search you incur an extra cost to discover the price at another internet retailer.  These small differences can make a huge difference.

The classic logic for how small search costs can have a dramatic impact on prices is offered by the Diamond search model.  Suppose stores are selling a homogenous good but you do not know the price they set till you visit the store.  Each visit costs you a few pennies in search cost.

If there is no search cost, the unique equilibrium has all stores setting price equal to cost and making no profits on sales.  But this cannot be an equilibrium with positive search costs.  Then, one store can raise its price secretly by a few cents.  Once the customer has entered and sunk his cost of search, he will buy anyway knowing that taking the cost of search into account for his visit to another store, it is not worth it to search.  It is easy to see what any equilibrium must be symmetric, otherwise all consumers will go to the store with the lowest prices and the store with the lowest prices has an incentive to raise them.  So, what is the symmetric equilibrium?  It is the monopoly price!  Only at that price does no store have the incentive to raise the price as it will choke off too much demand.

So, a small search cost leads to a dramatic change in prices from zero profit to monopoly profit.  This conclusion is too stark and it can be made less dramatic by adding product differentiation but the core idea remains the same.  Search costs give firms  some degree of market power and allow them to raise prices.  This is the strategy being attempted on Amazon.  It will be interesting to see how it plays out.

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