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Price Dispersion June 10, 2007

Posted by jyu in Qualifying.
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Price dispersion is offering physically identical items for sale at different prices.  There is a large price dispersion observed in the literature:

  • Sorenson (2000): Average coefficient of variation of prices of prescription drugs ==> 22%
  • Dahlby and West (1986): Coefficient of variation of auto insurance prices ==> 7-18%
  • Pratt, Wise, Zeckhaouser (1979): Coefficient of variation of average of 21.6% across 29 items
  • Pan, Ratchford and Shankar (2002): Average coefficient of variatin across 8 categories ==> 8.3% – 15.4%.  Service explains only about 25% of price dispersion in this study, search costs are still the primary reason for price dispersion according to past literature.

Four explanations for equilibrium price dispersion in the literature:

(1) Due to differences in buyers search and seller costs

–Carlson and McAfee 1983:  Price dispersion is driven entirely by differences in unit costs in the model. If costs are the same for all firms, each firm will charge an equilibrium markup that is proportional to the highest search cost.  Search costs affect price levels and the variation in costs drives price dispersion

–Dahlby and West 1986: Study price dispersion in an automobile insurance market.  Price dispersion can be explained by costly consumer search.

(2) Periodic sales due to adoption of mixed strategies by competing sellers to capture sales from high and low search cost segments

–Varian 1980:

  • Temporal price discrimination of informed and uninformed customers in a market with identical firm cost functions and free entry
  • No pure strategy ==> firms are torn between the desire to extract surplus from the uninformed consumers and the desire to capture all of the business of the informed consumers by charging the lowest price
  • Mixed strategy equilibrium exists ==> allows each firm to capture a surplus from the uninformed consumers while occasionally having the lowest price and therefore getting business of the informed consumers
  • The practice of randomly offering relatively low prices in an effort to capture the informed consumers is that these low offers represent sales or promotions.  Thus, Varian’s analysis provides a rationale for sales and promotions as the outcome of mixed strategies in a competitive market

–Other mixed strategies examples that explains price dispersion, promotion, advertising and others.

  • Narasimhan (1988) employs a mixed strategy model to study the frequency and depth of promotions
  • Bagwell and Ramey (1994) constructs a mixed strategy model that considers segments that are aware and unaware of advertising
  • Iyer and Pazgal (2003) present a mixed strategy model that explains the dispersion of posted prices at Internet Shopping Agents (ISAs)
  • Baye and Morgan (2004) have shown a mixed strategy model that offer prices dispersion can be generated even if firms depart from maximizing behavior and all consumers have zero search costs.

(3) Markdowns due to demand uncertainty – reducing prices over time in response to information about consumer willingness to pay (Lazear 1986, Pashigian 1988)

–Promotions and sales is based on search information by the seller.  Sellers who are uncertain about demand may initially charge a high price to see if any customers will pay it and reduce the price if the consumer’s willingness to pay lies below that price.  Mostly applicable to goods that have fixed supply (fashion merchandise).

(4) Differences in services provided by sellers (Ehrlish and Fisher 1982; Ratchford and Stoops 1988, 1992)

–Advertising and other services are valued by consumers because they cut down on search costs, and that consumer will therefore willngly pay a higher price for goods that are bundled with services.  Differences in prices across sellers result from differences in advertising or other services provides (differences in consumer demand for the services).

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