Who Searches for Whom: The Role of Search Costs in a Vertical Market

Abstract

The role of search costs in consumer markets has been well documented, but its role in vertical markets is under-explored. Considering that transactions in a vertical market are initiated through searches conducted by firms, this study separately examines the trading partner search of either two upstream or two downstream firms faced with the same search costs, and analyzes the impact of search costs on transactions through a firm entry effect and a trade-matching effect. The analysis shows that the role of search costs depends on “who searches for whom” if the transactions in the market are based on a linear price contract. Specifically, a competitive (duopoly) market structure led by downstream firms’ search is more likely than that led by upstream firms’ search, while a monopoly market structure led by upstream firms’ search is as likely as that led by downstream firms’ search. However, the pricing contract moderates the role of search costs. If transactions in a vertical market are based on a two-part tariff contract, both monopoly and duopoly market structures led by upstream firms’ search are as likely as those led by downstream firms’ search. Based on this, the study further examines and compares how search costs from different search directions affect transaction outcomes, such as transaction price, transaction volume/value, and social welfare. The findings of this study not only offer a theoretical contribution to research on the role of search costs in vertical markets but also provide a framework to empirically analyze the impact of search-facilitating technologies on transactions.

Keywords: search cost, bargaining, firm entry effect, trade-matching effect, vertical market