Bargains and rip-offs: A model of monopolistic competitive price dispersion

Table of content

Summary

Placement in the literature
What led to Salop’s and Stiglitz’s paper?
The contribution of the paper
Other research in that time
Other models of price dispersion
Steven Salop, 1977
Gerhard R. Butters, 1977
John Pratt, David Wise and Richard Zeckhauser, 1979
Yuval Shilony, 1977
Stiglitz, 1979
Louis Wilde and Alan Schwartz, 1979
H. Varian, 1980

How did the literature proceed after the paper?
H. Varian, 1980
Doyle, 1986
Hallagan, Joerding, 1985

Today’s relevance
Brynjolfsson, Smith; 2000
Morgan, Orzen, Sefton, 2002

Critique

Simple example

References

Summary

The main issue in the article is the derivation of a model in which prices can differ in equilibrium, even though the goods are homogeneous and there is asymmetric information in the market. The reason for this price dispersion is caused by consumer heterogeneity. Salop and Stiglitz explain, that “because of differences in preference or ability, some agents perform much better than others in market decisions.” To model this kind of heterogeneity they assign different costs of gathering certain information to the consumers. For simplicity they part the consumers in two groups: The first one consists of low-cost information gatherer and the other group has higher cost to gain complete information. For further simplicity there are just two levels of information: to be completely informed or to be not informed at all. Furthermore the costs to become an informed consumer are fixed. The differences in information in this model regard the locations of the shops. All consumers know about all prices that are in the market, they just do not know where the shop with a certain (the lowest) price is.

The shops on the other hand have complete information about the market. They know about the differences between the consumers and can compute the demand that will occur, when they ask a certain price. So they face a trade-off between higher prices and lower demand. It is important to state why there is a possibility of raising the price and not to loose all demand like it would be in a perfect market. When the rise in price is not too high, it does not pay for the high-cost information gatherer to become completely informed. Their expected loss by buying randomly either in low- or high-priced shops is lower than the fixed cost of gathering the information.

All together this consumer heterogeneity and the fully informed shops can lead to price dispersion in equilibrium, even though the goods are homogeneous and there is the difference in information between the actors.

Placement in the literature

Salop and Stiglitz influential paper was published in October 1977. It is one part of a series of papers in which Joseph Stiglitz, Sandford Grossmann and Stephen Salop tried to remedy some deficiencies of the traditional economic theory. Grossmann and Stiglitz (1976) explains, that the “Questions of how the price system leads the economy to respond to a new situation, how it conveys information from informed individuals to uninformed individuals, and how it aggregates the different information of different individuals, are never directly attacked.” Stiglitz together with George Akerloff and Michael Spence received “The Sverige Riksbank Prize in Economic Sciences in Memory of Alfred Nobel” in 2001 because “Their work transformed the way economists think about the functioning of markets.”

What led to Salop’s and Stiglitz’s paper?

The first, who brought differences in information between the market-participants into the economic discussion, was George Stigler in 1961 with his famous article “The economics of information”. He stated, that “information is a valuable resource”^[1]. His work showed, “that some important aspects of economic organization take on a new meaning when they are considered from the viewpoint of the search for information.”^[2] In classical theory price dispersion is impossible in equilibrium, because the consumers are assumed to be completely informed and would purchase just from the cheapest supplier and everyone charging a higher price would end up without demand. But in the new framework with differences in information “price dispersion is […] the measure of ignorance in the market.”^[3] And Stigler already noted, that “only those differences could persist which did not remunerate additional search.”^[4] This is exactly what Salop and Stiglitz formalized and proofed in their paper.

Nine years later (1970) Akerlof published his well-known paper “The markets for Lemons: Quality Uncertainty and the Market Mechanism”. His paper is concerned with consumers who can’t observe differences in product quality. “There are many markets in which buyers use some market statistic to judge the quality of prospective purchase. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of good and also in the size of the market.” This will happen until the market is destroyed or some other action is taken to get rid of the hidden information (e.g. guarantees).

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^[1] Page 213

^[2] ebenda

^[3] Page 214

^[4] Page 219