Search costs are a facet of transaction costs or switching costs and include all the costs associated with the searching activity conducted by a prospective seller and buyer in a market. Rational consumers will continue to search for a better product or service until the marginal cost of searching exceeds the marginal benefit. Search theory is a branch of microeconomics that studies decisions of this type.
The costs of searching are divided into external and internal costs. External costs include the monetary costs of acquiring the information, and the opportunity cost of the time taken up in searching. External costs are not under the consumer's control, and all he or she can do is choose whether or not to incur them. Internal costs include the mental effort given over to undertaking the search, sorting the incoming information, and integrating it with what the consumer already knows. Internal costs are determined by the consumer's ability to undertake the search, and this in turn depends on intelligence, prior knowledge, education and training. These internal costs are the background to the study of bounded rationality.
There is an optimal value for search cost. A moderate amount of information maximises the likelihood of a purchase. Too much information to consumers may lead to negative effect. Too little information may not be enough to support consumers' purchasing decisions.
Nonsequential search
When consumers commit to purchasing from the lowest-cost store retailer after acquiring a random sample of l (> 1) costs. [24] A per-price search cost customer selects the number of stores to solicit to minimize the total expected cost or the sum of the total search costs and the expected price for the product. [22]
Sequential search
Unlike nonsequential-search, sequential buyers opt to buy at the lowest price found thus far or do another search one after another. [24] There is a choice value tied to looking again at any price, and the optimum search problem is related to the "optimal stopping" issue. [22]
Search cost models
Numerous search cost models exist to depict the process of consumers searching for alternative goods and services.
Basic price search model
The most basic search cost model serves as a foundation for subsequent models. Peter A. Diamond's Model of Price Adjustment illustrates that small search frictions have an important role in market structure, and a firm's capacity to deviate from Bertrand Competition.
Proposition of the model:
A unique nash equilibrium is: , where, s = Cost of obtaining price at quote with , CS = Consumer surplus and p = Price.
The model implies that search frictions can result in the perfectly competitive market price shifting to the monopoly price. However, Diamond's original model is rudimentary and ignores some empirical observations:
Agents in an economy only search once, whereas there is a continuous search for goods and services. Few consumers search in equilibrium, which is inconsistent with empirical observation. The model uses an alternative to the “law of one price”. The monopoly price is used as opposed to marginal cost, with no consideration for price dispersion in an equilibrium.
Heterogenous search model
Using Diamond's model as a base, a distinction is now made in the heterogenous search model. There are potential consumer heterogeneities for search costs being consistent with market observations (search costs can be 0 and negative). In 1989, Ingemar Stahl expanded on Diamond's model; the model has the same assumptions as Diamond's model with the additions of ‘shoppers’ (μ) having a range of search costs ().
Stahl's model addresses the three issues present in Diamond's basic price search model. Firstly, this model assumes that search costs are changing as ‘shoppers’ search costs change. Secondly, all searches are now assumed to be done in equilibrium with different qualities of searches being conducted by different consumers (refers to the changing fraction of ‘shopper’ and their changing search costs, as consumers search at different times). Finally, the model achieves price dispersion, which is consistent with empirical market observations.