DP11753 Price Dynamics with Customer Markets

Author(s): Luigi Paciello, Andrea Pozzi, Nicholas Trachter
Publication Date: January 2017
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11753

The customer base of a firm is an important and persistent determinant of its performance. Using rich U.S. data on consumer shopping behavior and good prices, we document that customer turnover is sensitive to price variation. Motivated by this finding, we study an economy where the customer base of a firm is persistent because of search frictions preventing customers from freely relocating across suppliers of consumption goods, and firms set prices under customer retention concerns. The key feature of our model is that the elasticity of the customer base to price -the extensive margin elasticity of demand- depends on the customers' endogenous opportunity cost of search, and interacts with heterogeneity in firm productivity. More productive firms enjoy less customer attrition and lower elasticity of demand. An increase in customers' search intensity leads to higher demand elasticity and lower prices. This provides a new channel affecting the relationship between consumer search and price markups in response to aggregate shocks. In particular, an increase in the utility of consumption relatively to the cost of search results in higher demand elasticity and lower prices, amplifying the effects of demand shocks on output. We highlight that the price response to demand shocks is heterogeneous across firms affecting dispersion in prices and consumption across consumers.