The Diamond Paradox: A Dynamic Resolution
We consider the role of repeat business in resolving the paradox of Diamond (1971). In each period, consumers engage in sequential price search at a positive search cost. Consumers enforce pricing discipline via a simple loyalty-boycott search rule that directs future-period seraches away from firms that raise prices in the current period. In consumers' best equlibria, the equilibrium price decreases continuously with the level of search costs, and the competitive outcome obtains as search costs approach zero. We show further that Rotemberg and Saloner's (1986) finding of countercyclical markups does not arise in the presence of positive search costs.
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