Consumer Search and the Uncertainty Effect

Abstract

We consider a model of Bertrand competition where consumers are uncertain about the qualities and prices of firms' products. Consumers can inspect all products at zero cost. A share of consumers is expectation-based loss averse. For these consumers, a purchase plan, which involves buying products of varying quality and price with positive probability, creates scale-dependent dis-utility from gain-loss sensations. Even if their degree of loss aversion is modest, they may refrain from inspecting all products and choose an individual default that is first-order stochastically dominated. Firms' strategic behavior can exacerbate the scope for this "uncertainty effect'", and sellers of inferior products may earn positive profits despite Bertrand competition. We find suggestive evidence for the predicted association between consumer behavior and loss aversion in new survey data.