Price Setting and Competition with Search Frictions

This paper investigates price determination in a decentralized economy in which buyers’ valuations are stochastic and unobservable. In such a market, each buyer’s reservation utility depends both on the prevailing price and on the price he actually encounters. The buyer’s willingness to trade is shown to be decreasing in the price, and this creates the trade-off for the sellers ’ price setting. Even though the sellers have incentives to manipulate the buyer’s willingness to trade, the economy is not fully competitive; it does not converge to the Walrasian outcome as search frictions disappear. The model is used to study various market structures to explore the nature of market power in search equilibrium. It is shown that price dispersion arises as a result of search frictions and oligopolistic price setting. JEL classification: C78, D4