The Importance of Price Beliefs in Consumer Search

Abstract

A consumer’s decision to engage in search depends on the beliefs the consumer has about an unknown product characteristic (e.g., price). Because beliefs are rarely observed, researchers typically assume that consumers have rational expectations or update beliefs consistent with Bayesian updating. These assumptions are restrictive and do not enable the researcher or the retailer to price discriminate among consumers on the basis of heterogeneity in beliefs. The authors use Monte Carlo experiments to show how these assumptions affect estimates of search cost. Next, they design an incentive-aligned online study in which participants search over the price of a homogeneous good, and the authors elicit distributions of price beliefs before and after each search. Drawing on data collected from a nationally representative panel, they find substantial heterogeneity in prior price beliefs, such that participants update their beliefs in response to search outcomes but deviate from Bayesian updating in that they underreact to new information. Importantly, the authors show that (1) assuming Bayesian updating does not significantly bias search cost estimates at the aggregate level if the researcher accounts for heterogeneous prior beliefs, (2) eliciting heterogeneity in prior expected prices is much more important than eliciting heterogeneity in prior price uncertainty, and (3) a retailer can increase profits through third-degree price discrimination by recognizing the heterogeneity in prior beliefs.