Referrals in Search Markets

Abstract:     
This paper compares equilibrium outcomes in search markets with and without referrals. Although it seems clear that consumers would benefit from honest referrals, it is not at all clear whether firms would unilaterally provide information about competing offers since such information could encourage a consumer to purchase the product elsewhere. In a model of a horizontally differentiated product and sequential consumer search, we show that valuable referrals can arise as a part of equilibrium: a firm will give referrals to consumers whose ideal product is sufficiently far from the firm's offering. The effect of referrals on the equilibrium prices is examined, and it is found that prices are higher in markets with referrals. Although consumers can be made worse off by the existence of referrals, referrals lead to a Pareto improvement as long as the search cost is not too low relative to product heterogeneity. The effects of referral fees and third-party referrals are examined, and policy implications are drawn.

Keywords: horizontal referrals, consumer search, information, matching, broker commission

JEL Classifications: C7, D4, D8, L1

Working Paper Series