A Laboratory Study of Customer Markets

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Economic theorists have focused attention on auction markets in which buyers and sellers care only about price and don't care about who they buy from or sell to. Most of the important markets in the modern world are not auction markets, but rather are `customer markets` in which individual buyers form long-term attachments to individual sellers because it is costly to find satisfactory new transaction partners. Customer markets include most modern labor markets and many retail and wholesale markets. Recent development of irreversible investment theory offers new insight into customer markets. The project is a systematic laboratory study of customer markets informed by irreversible investment theory. Human subjects will be recruited to act as buyers and sellers in controlled laboratory markets and will keep their profits, estimated to average about $15-20 per hour. Hence they have serious financial motivation. Buyers in the laboratory markets incur a switch cost whenever they decide to seek a new seller. The switch cost is set at zero, low and high values in different laboratory sessions. Buyers' induced values and sellers' induced costs follow a random walk with the amplitude of per-period shocks set at zero and at a moderate value in different sessions. In the initial series of laboratory sessions, sellers post prices and buyers choose the seller. Later sessions use other market institutions (forms of haggling and sealed bidding), other information conditions, and correlated shocks. The laboratory data will be analyzed in light of published work on fairness norms and oligopoly models as well as irreversible investment theory. The significance of the project is practical as well as theoretic. The work will spur more rigorous application of irreversible investment theory to customer markets and will improve understanding of price dispersion and other issues in industrial organization (I/O). The laboratory data and I/O theory will improve understanding of sluggish (or `sticky`) price adjustment, a central issue in macroeconomics. Ultimately better monetary and fiscal policy and better regulatory practice will result from improved understanding of the performance characteristics of customer markets.