Price Dynamics with Customer Markets

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. As firms compete for customers, the price pass-through of productivity shocks is incomplete, with the most productive firms passing-through more. Moreover, an increase in the utility of consumption relatively to the cost of search results in higher customers search intensity and, therefore, lower prices, amplifying the effects of demand shocks on consumption.