Consumer Search with Observational Learning

This paper studies observational learning in a consumer search environment. In our model, consumers observe the purchasing decision of a predecessor before deciding which firm to visit. We show that if consumers emulate their predecessor and initiate their search at the firm she purchased from, a social multiplier of demand induces a lower equilibrium price. Further, as the search cost increases, firms compete fiercely to attract consumers and prices converge to the marginal cost. We show that the result can be extended to any number of firms, and the effect of emulation on prices is stronger as the number of firms increases. We also show that, as consumers observe more previous purchasing decisions, the downward pressure on prices grows to the degree that the pure strategy equilibrium may cease to exist. We then provide a rationale for emulation by introducing positive correlation in preferences across consumers. This correlation gives rise to free-riding which deters search, and as a result puts further downward pressure on prices for high search cost.