Price Dispersion in Dynamic Competition

Rafael R. Guthmann∗

September 2021

Abstract

Substantial price dispersion exists for transactions of physically identical goods,

and in these markets, incumbent sellers sell at higher prices than entrants. This
study develops a theory of dynamic competition that explains these facts as re-
sults from the same fundamental friction: buyers are imperfectly aware of which
sellers are operating, and the degree of awareness about a seller is endogenous.
The equilibrium is unique and approximately efficient, featuring randomized pric-
ing strategies where incumbents post higher prices than entrants. The equilibrium
converges to a stationary equilibrium. If buyers’ awareness does not depreciate
and the exit rate of sellers converges to zero, then the stationary equilibrium
converges to perfect competition.

Keywords: buyer awareness, price dispersion, customer capital, industry life cycle,
information frictions
JEL codes: C78, D11, D40, D83
∗
Email: rafaelguthmann@hotmail.com. This paper is a shortened version of the second
chapter of my PhD thesis, and research for this paper began in Spring 2015 at the University
of Minnesota. I am indebted to David Rahman, Jan Werner, Guido Menzio, Varadarajan V.
Chari, Erzo G. J. Luttmer, Aldo Rustichini, Thomas Holmes, Christopher Phelan, Leonardo
Rezende, and the seminar participants of the Spring 2018 Midwest Economic Association
Meeting, Fall 2018 Midwest Trade and Theory Meeting, 2018 Economics Graduate Student
Conference, and a seminar at PUC Rio in 2019, for helpful comments and discussion.

1
1 Introduction

In the textbook model of perfect competition, each decision-maker in the economy has
access to the same price vector that allows him or her to trade any quantity of goods
desired at fixed prices, equal to the marginal costs of production. The current state of
the empirical evidence paints a very distinct picture in product markets: Substantial
dispersion exists in the prices for transactions of identical goods (Sorensen [46]). After
entering a market, sellers slowly accumulate demand for their product, and prices for
transactions with incumbent sellers tend to be higher than those with entrants (Foster
et al. [18, 19]). Further, the markup over marginal cost tends to be substantial and
varies across industries.1 This study develops a model of dynamic price formation in
an industry that explains these deviations from competitive conditions as the result of
an imperfect awareness friction among buyers. This model of imperfect awareness also
nests the model of perfect competition as its frictionless limit.
This study features a novel approach to customer capital accumulation based on the
diffusion of information, which provides microfoundations for the literature that exam-
ines pricing as an investment (e.g., as Foster et al. [19] and Besanko et al. [5]). In
the environment under consideration, at a given point in time, buyers have imperfect
awareness of the sellers; that is, each buyer is aware of only a subset of the sellers
from which he can purchase the good in that period. The buyers retain some memory
of their past awareness and can discover additional sellers over time through word of
mouth from active customers. Just as the number of customers who actively shop at
the seller determines the intensity of awareness diffusion, the seller’s sales activity is the
driving force of the accumulation of its customer base.2 Because buyers have memory,
the age of the industry as a whole and buyers’ awareness dynamics are determinants of
the degree of frictions of trading present at a point in time in that industry.3
The particular trading mechanism used in this study proceeds as follows: At each
period, sellers choose which prices to post, and buyers choose whether to purchase the
good among the set of sellers that buyers are aware of.4 Rational expectations equilibria
1
See, for example, De Loecker et al. [10] for evidence on the markup levels of the US and De
Loecker and Eeckhout [11] for international evidence.
2
In the marketing literature it has been argued that word of mouth is a dominant form of customer
capital accumulation (see Trusov et al. [48]).
3
This is in contrast to Dinlersoz and Yorukoglu [14], who find that increasing the memory of their
agents has little effect on the model’s equilibrium.
4
This price posting mechanism is similar to the trading mechanism used in Satterthwaite and

2
are examined where sellers know the distribution of the number of other sellers that their
customers might know and choose prices to post that maximize expected discounted
lifetime profits. Buyers observe only the prices of the sellers that they are aware of, while
sellers know the distribution of the sellers’ customer bases, as well as the distribution
of posted prices across the whole industry. However, it is reasonable to suppose that
sellers in an industry know more about their competitors than their customers do.5
The model has a unique symmetric equilibrium. The assumption that buyers have
imperfect awareness of the sellers and that the degree of the buyer’s awareness is dy-
namic has significant consequences for the properties of the equilibrium. Demand for a
seller’s product can grow over time thanks to the diffusion of awareness through word of
mouth imparted by the sellers’ sales activity. Imperfect awareness also results in price
dispersion caused by mixed pricing strategies: A pure strategy is inconsistent with equi-
librium as sellers have an incentive to undercut other sellers at any pure strategy higher
than marginal cost. Also, a price equal to the marginal cost is not an equilibrium, as
imperfect awareness of competitors means that some buyers are captive and continue
to shop at the seller if prices increase. However, there are dynamic gains in customer
accumulation, and they are asymmetric across sellers with different customer bases.
These differences imply different equilibrium pricing strategies: Entrants find it more
profitable to sacrifice present profits to grow their customer bases, while incumbents
who tend to have larger customer bases have less room to increase their customer bases
further and instead focus on maximizing present profits. Therefore, incumbent sellers
post higher prices than entrants.
If the seller exit rate function is constant, and buyers have perfect memory, then as the
industry matures, the quantity traded increases, and the average markup decreases.
Those properties result from the diffusion of awareness regarding the sellers among the
buyers, which makes the industry more competitive over time. That means this type
of model can replicate the stylized fact that markups and average profitability levels
vary across industries without any variation in the underlying environment of different
industries or the entry value for firms. That is, asymmetric levels of markups and
Shneyerov [44, 45] and Lauermann et al. [33], where agents trade through first-price auctions: buyers
post offers, and the seller sells to the highest posted offer.
5
A possible avenue for further research in this framework is to relax this assumption by allowing
sellers to not know the population and the distribution of the customer bases of competitors operating
in the industry. Then, a solution for this modified model would require a description of the process
that determines the evolution of the sellers’ beliefs in addition to the evolution of the buyers’ awareness
and the resulting allocation and prices.

3
profitability can be consistent with a free-entry condition across industries.
These properties imply a tendency for the equilibrium of the industry to converge to
competitive conditions over time. This property of the model is related to the concept
of competitive equilibrium being the limit of random matching and trading games
when the frictions of trading become small (see Osborne and Rubinstein [40], Gale
[23], Mortensen and Wright [39], Lauermann [32]). In the present study, the frictions of
trading are buyers’ imperfect awareness regarding sellers in the market, but this friction
is dynamic in itself as buyers’ awareness changes over time. This dynamic property
means that this tendency is also related to the original concept of tatonnement from
Walras as a dynamic adjustment process toward a perfectly competitive equilibrium
where output increases and profit margins fall (Walker [50]). This model explains that
the deviations from competitive conditions suggested by the empirical evidence are
features of the price formation process, which, under certain conditions, converges to
the competitive equilibrium.6
The model’s equilibrium is approximately efficient. It is approximately efficient in
the sense that as the state space, represented by a grid of possible customer base
levels, becomes finer, the equilibrium allocation approximates the efficient allocation.
Therefore, this model provides a theory of efficient markups, as in Gilbukh and Roldan
[24]. Additionally, by allowing the sellers to exit endogenously, this model can also
explain the stylized fact that exit rates are declining in the seller’s age: The longer a
seller is in the industry, the greater the degree of buyer awareness the seller. Thus,
the opportunity cost of leaving the industry increases, which lowers the exit rate. The
model also can incorporate endogenous entry with intuitive consequences: as entry costs
fall, the posted prices in the stationary equilibrium converge to the marginal cost.
The following section presents a discussion of the literature related to this paper. The
model’s description begins in Section 3, which describes the environment. Section 4
describes the equilibrium and the main result, and Section 5 presents the several ana-
lytical properties of the equilibrium and a numerical simulation of the model. Section
6.1 discusses the incorporation of endogenous choice of seller entry and exit in the
model, and Section 7 presents concluding remarks.
6
This model is related to Arrow [3] in that all endogenous variables, including prices, are deliberately
chosen by rational agents, which is a distinct notion of tatonnement from its use in the stability
literature (see Fisher [15] for a survey), where the mechanism of price formation is exogenous to the
agents in the economy.

4
2 Related literature

The study of pricing and competition is one of the oldest fields in economics, resulting
in extensive literature related to the present study and requiring its literature review
in the paper. This section relates this study to the existing literature that is perhaps
the closest to this model.
Previous studies have used imperfect awareness of the buyers regarding the sellers
operating in the market, such as Butters [9], McAffe [36], and, more recently, Perla
[42]. In particular, the present study presents a closely related model to Butters [9],
but the model in this study incorporates a dynamic process of awareness diffusion
among buyers similar in concept to Perla’s [42] paper. However, in the present study,
awareness diffusion occurs through a word of mouth matching process, closely related
to the way the concept is employed in Fishman and Rob [17]. Another closely related
paper, Guthmann [26], provides a more profound treatment of the concept of buyer
awareness by relating it to the decision theory literature that distinguishes unawareness
from uncertainty (see, e.g., Modica and Rustichini [37], Karni and Vierø[30], and Heifetz
et al. [28]).
Existing models of equilibrium price dispersion (e.g., Butters [9], Varian [49], Burdett
and Judd [7], and Stahl [47]7 ) feature symmetric price posting strategies for all sellers
and the distribution of prices posted with a strictly decreasing and convex density
that peaks at the lower bound of the support of the distribution. These properties of
the distribution of prices follow from the indifference condition on different prices in
the support. To maintain indifference over the support, the increase in the quantity
sold to a decrease in posted price must be decreasing on the support. That is so to
compensate for the lower profit margin at lower prices. The predictions of existing
price dispersion models can be consistent with the observed distribution of prices only
with explicit or implicit assumptions of product heterogeneity, such as postulating that
buyers assign different reservation prices to the good if purchased from different sellers.8
This paper shows that such assumptions are not needed to explain the morphology of
price dispersion.
7
Recent applications of equilibrium price dispersion models include Kaplan and Menzio [29],
Moraga-Gonzáles et al. [38] (in the online appendix), Braido and Ledo [6], and Burdett and Men-
zio [8].
8
Some authors use the concept of “amenities” provided by individual sellers to explain this assump-
tion of heterogeneity (see, e.g., Sorensen [46] and Kaplan and Menzio [29]).

5
Regarding the literature on customer-capital accumulation, Foster et al. [19] use the
phrase “demand accumulation by doing” to describe the effect of past sales activity
on the present demand for a seller’s product, as opposed to “demand accumulation by
being,” which represents the accumulation of demand due to the continued presence of
the seller in the industry. They show that the seller’s “demand accumulation by doing” is
the dominant factor in demand accumulation. The demand accumulation mechanism
used in the present study is similar to the mechanism used in other studies such as
Luttmer [34] and Perla [42]. However, in the present study, the seller’s previous sales
activity directly influences the diffusion of information regarding sellers in a product
market among the buyers to incorporate Foster et al.’s [19] empirical findings.
Studies such as Klemperer’s [31], Fishman and Rob [16], Dinlersoz and Yorukoglu [14],
Gourio and Rudanko [25], and Paciello et al. [41] feature various forms of customer
capital accumulation. However, this study has a distinct concept of customer capital
compared to these papers. Klemperer’s [31] model of switching costs has a form of cus-
tomer capital accumulation due to previous sales activity: the switching costs create
incentives to lock in customers. Dinlersoz and Yorukoglu’s [14] work is similar to the
present paper in that both papers offer dynamic versions of Butters’s [9] price competi-
tion model. In Dinlersoz and Yorukoglu [14], the customer base consists of buyers who
shopped at the seller in the preceding period, and the seller can attract new customers
by sending ads to other buyers. Dinlersoz and Yorukoglu examine a stationary equilib-
rium, and time enters their model by assuming the buyers’ path dependency: buyers
can always shop at the last seller they shopped at, which creates intertemporal incen-
tives for sellers to retain customers. Gourio and Rudanko [25] present an environment
where the buyers are fully aware of the sellers’ operating and prices. In their model,
each buyer is matched to only one supplier at a time and is constrained from changing
suppliers due to coordination frictions.9 The models in Fishman and Rob [16] and Pa-
ciello et al. [41] are similar to the model in Dinlersoz and Yorukoglu [14]. Each buyer
is matched to one firm at a time in these papers, but in the two former papers, buyers
can shift from one supplier to another through a random search mechanism instead of
receiving ads from the firms as in Dinlersoz and Yorukoglu [14].
The present study presents a tractable model of the dynamics of price formation in
the non-stationary equilibrium caused by the diffusion of awareness regarding sellers.
9
More specifically, in Gourio and Rudanko’s model, buyers choose a specific seller to shop at, which
yields a matching probability to this seller. This probability is given by a function of the queue length,
which is the ratio of buyers to sales representatives that the seller chooses to employ.

6
Buyers are said to be part of a seller’s customer base if they are aware of the seller;
buyers have memory, so a buyer’s consideration set is durable. A buyer can be part
of any seller’s customer base simultaneously as there is no limit on the number of
sellers a buyer can be in contact with at a point in time. The relative sizes of sellers’
customer bases yield relative matching probabilities, which is the empirical measure of
the customer base in Allen et al. [1], where, as in this paper, incumbency advantage is
associated with a larger customer base.

3 Environment

Consider an industry with a continuum of buyers and sellers, both of measure 1. Time
is discrete, denoted by t = 1, 2, 3, . . .. Buyers and sellers are assumed to be infinitely
lived, and sellers can enter and exit the market. There is a single perishable good. At
each period, each buyer has unit demand for the good and a reservation price equal to
1, and each seller can produce a quantity q ∈ R+ of the good with a constant marginal
cost, normalized to 0.10 Sellers discount future profits according to discount factor
β ∈ (0, 1).
Buyers have incomplete consideration sets due to imperfect awareness of the sellers
operating in the industry. The degree of awareness of buyers regarding a seller is
determined by the seller’s state m ∈ M = {m0 , m1 , m2 . . .} ⊂ R+ , where m is the size
of a seller’s customer base, and M is the set of states that a customer base can take.
A seller with customer base mk is said to be a seller of type k. Sellers’ customer bases
can overlap, which means that buyers can include multiple sellers in their consideration
sets (as depicted in Figure 1). A seller in state m0 = 0 is a potential entrant, and a
seller in state mk , k ≥ 1 is an incumbent that competes in the product market. For
all k ≥ 1, mk > mk−1 and mk − mk−1 = c for some constant c > 0, so the set of states
is a grid of customer base sizes.
Each buyer has unit demand, and m represents the size of the seller’s customer base
therefore the quantity sold by a seller of type k is constrained to the interval [0, mk ].
10
That is, in each period, each buyer can generate a unit surplus by matching with any seller. The
products sold by each seller do not need to be interpreted as physically identical but only as potentially
perfect substitutes (if the buyers are aware of both products offered by a pair of sellers). For example,
two brands of smartphones might yield the exact same utility to tech-savvy buyers, but naive buyers
might prefer the phone brand they are used to. In this model, these types of buyers are distinguished
by different awareness levels.

7
Let nkt be the measure of sellers of type k (thus k nkt = 1 for all periods since the
P

measure of sellers is 1), the profile of seller types in a period t is nt = {nkt }∞

k=0 which
determines the intensity of competition between sellers in a given period. The state
of the industry in some period t is described by the profile of seller types nt .

3.1 The determination of sales

At each period each seller operating in the industry chooses a price p ∈ R to post.
Sellers’ customer bases can overlap, which means that buyers can include multiple sellers
in their consideration sets. Buyers shop at the lowest priced seller in their consideration
sets as long as the posted price is lower than their reservation price. If multiple sellers
in a buyer’s consideration set post the same lowest price, then we assume a sharing rule
where the buyer shops at each of them with equal probability.
As in Butters [9] and Dinlersoz and Yorukoglu [14], the cardinality of buyers’ consid-
eration sets of type k in period t is distributed according to a Poisson distribution
with parameter m̂kt , where m̂kt = nkt mk . This property follows from the classical urn
model of probability theory: Suppose there are N buyers and Mk sellers of type k;
each buyer is an urn that can receive up to one ball per seller, and each seller sends,
independently, mk ≤ N balls to buyers. Therefore, the distribution of the number of
balls a buyer/urn receives is described by binomial distribution with parameters mk /N
and Mk . If the number of buyers and sellers increases to infinity with the property
that lim N/Mk → nkt , then the Poisson limit theorem implies that this distribution
converges to a Poisson with parameter m̂kt = nkt mk . Let π(n, m̂kt ) be the probability
mass function at n of a Poisson distribution with parameter m̂kt . Therefore, buyers are
aware of on average nkt mk sellers of type k, and the number of sellers they are aware of
is distributed according to a Poisson distribution with parameter given by the measure
of the sellers of that type, ntk , times their customer base mk . See Appendix 8.1 for a
presentation of this argument applied to an environment with a continuum of buyers
and sellers.
If the prices posted by sellers of type k are distributed according to Ftk , then if a seller
is posting a price p ≤ 1, the probability that a buyer finds p more attractive than any
price by a competitor seller of type k, denoted by Pr(p < min{pj : j is type k}), is

8
 Buyers

1’s customer base 2’s customer base

Figure 1: Example of a Venn diagram of buyer awareness in a duopoly of sellers 1 and

2. The two sellers are in competition as their customer bases overlap.

given by
∞
X
Pr(p < min{pj : j is type k}) = π(l, m̂kt )[1 − Ftk (p)]l (1)
l=0
∞
X (m̂k )l [1 − F k (p)]l
t t
= exp(−m̂kt )
l=0
l!
= exp[−m̂kt Ftk (p)],

where [1 − Ftk (p)]l is the probability that p is simultaneously lower than the prices
posted by l sellers of type k.
The probability of sale in period t, Ptk (p), is the probability that p is the lowest price
a buyer observes among sellers that the buyer is aware of. It is a function of the profile
of distributions of prices posted by each firm type F = {Ftk }k , the profile of firm types
currently operating in the market n, and the price posted by the seller p. Because each
seller’s distribution of prices is independent, the probability of sale Ptk (p) is given by
the product of 1 across all seller types, thus:
∞
Y
Ptk (p) = exp[−m̂kt Ftk (p)] (2)
k=0
X
= exp[− m̂kt Ftk (p)].
k

9
Thus, the quantity sold by seller of type k in period t is

qtk (p) = mk Ptk (p) (3)

and the profits of a seller of type k in the current period are

Πkt (p) = pqtk (p). (4)

3.2 Entry and exit

At the end of each period, a population λ ∈ (0, 1) of sellers enters the industry, and a
fraction λ of the sellers of each type in the industry exit. The state of the sellers who
exit, changes to m0 = 0, and the state of the sellers who enter the industry is m1 > 0.
In period 0, the industry does not have any sellers operating, so all sellers are potential
entrants. Thus, in subsequent periods, the first cohorts of sellers enter; in period 1,
there is only one cohort of measure λ > 0 with customer base size m1 . The age of a
seller is the number of periods since a seller’s entry into the industry.

3.3 The evolution of customer bases

As buyers discover or forget the seller the customer base of an incumbent seller can
change over time. Incumbent sellers of type mk can change to type mk−1 or mk+1 in the
next period. The probability of change of type is determined by a continuous, strictly
increasing, and strictly concave function Φ : R+ → [−1, 1], which I call the customer
accumulation function, with Φ(0) ≤ 0 (i.e., buyer’s awareness can depreciate in the
absence of sales). If Φ(q) > 0, then the transition probability from mk to mk+1 is
Φ(q). If Φ(q) < 0, then the transition probability to mk−1 is −Φ(q) if k > 1; if k = 1,
then the transition probability to state m0 = 0 is 0. That is, the growth of a seller’s
customer base depends on the quantity sold, and m1 is the lower bound of the customer
base size for incumbent sellers. Appendix 8.3 presents microfoundations underlying the
assumptions on the properties of Φ.
Because buyers have unit demand, the quantity sold is the number of buyers who shop
at the seller. This state transition process represents the spread of awareness regarding
a seller among buyers through word of mouth: a larger number of buyers who shop at a
seller implies a higher rate of word of mouth awareness diffusion. The strict concavity of

10
the function Φ represents decreasing returns to word of mouth, and Φ(0) < 0 represents
the depreciation of a buyer’s memory regarding a seller if the seller is not selling at the
current period.
t
Let gk−1 be the measure of sellers of type k − 1 whose customer base grows from period
t to t + 1, so their type changes to k by period t + 1. Let stk be the measure of sellers
of type k whose customer base stagnates from t to t + 1, which means they stay type
k from period t to period t + 1. Let dtk+1 be the measure of type k + 1 whose customer
base decreases from t to t + 1 due to depreciation. Thus, for each operating type k > 1
its measure in period t + 1 is

nt+1
k
t
= (1 − λ)(gk−1 + stk + dtk+1 ). (5)

In each period a fraction λ of all sellers exit and there is the entry of a measure λ of
sellers of type 1. Thus, the measure of sellers of type 1 in period t + 1 is given by

nt+1
1 = λ + (1 − λ)(st1 + dt2 ). (6)

t
The profile (gk−1 , stk , dtk+1 ) is determined according to quantities sold. As sellers pricing
strategies are distributed according to the profile of cumulative distribution functions
(Ftk )tk=1 , the profile (gk−1t
, stk , dtk+1 ) is determined as follows:

Z 0
t
gk−1 = ntk−1 Φ[qtk−1 (p)]dFtk−1 (p) (7)
qk
( "Z #)
0 Z qk
stk = ntk 1− Φ[qtk (p)]dFtk (p) + −Φ[qtk (p)]dFtk (p) (8)
qk 0
Z qk
dtk+1 ntk+1 −Φ[qtk+1 (p)] dFtk+1 (p),
 
= (9)
0

where Φ(q k ) = 0. Equations 5,7,8, and 9 determine the evolution of the state of the
industry from nt to nt+1 . Note that in period t, the set of states an incumbent seller
can be is {m1 , m2 , . . . , mt }, thus we denote the profile of distribution of prices in a
period t by F t = (Ftk )tk=1 .

11
3.4 The seller’s problem

Let Vt (mk ) be the value of a seller with customer base mk ∈ {m1 , m2 , . . .} to satisfy
the following recursive problem of choosing a price to post that maximizes the present
profits plus the value in the next period:

k
Vt (mk ) = max Πkt (p) + βE[Vt+1 | p], (10)
p∈R

k
where F is the profile of price posting strategies, and E[Vt+1 | p] is the expected value
of the seller in the next period t + 1 conditional on posting p. In period t + 1, the state
of the industry is nt+1 , and the type of the seller can change to k + 1 or k − 1 depending
on the quantity sold. Thus,


Φ[q k (p)]V + 1 − Φ[qtk (p)] Vt+1 (mk ) if Φ[qk (p, F , n)] ≥ 0
k t t+1 (mk+1 )
E[Vt+1 | p] =
.
−Φ[q k (p)]V (m ) + 1 + Φ[q k (p)] V (m ) if Φ[q (p, F , n)] < 0
t t+1 k−1 t t+1 k k
(11)

4 Equilibrium

The solution concept is Markov perfect equilibrium. Equilibrium is Markov perfect be-
cause sellers do not condition their strategy on the previous history of play. Instead, the
sellers maximize only their present value, given by 10. Equilibrium is also anonymous:
sellers do not condition their strategies on the state of other individual sellers.11

Definition 1. An equilibrium is a profile of price distribution for each type of seller

and each period {F t }∞ k t
t=1 = {(Ft )s=1 }t≥1 such that for any period t, a seller of type
k ∈ {0, 1, . . . , t} posting a price in the support of Ftk is consistent with maximizing the
present value of profits. That is, for each period t ≥ 1 and type k ∈ {1, 2, . . . , t}, a price
p ∈ supp(Ftk ) is a solution to the seller’s problem of type s, given that prices posted
by the sellers are distributed according to F t and with mt as the profile of customer
bases induced by the sellers posting prices according to {F t }t .

Theorem 1 later in this section describes the unique equilibrium. In equilibrium, posted
prices by the sellers are continuously distributed over a non-degenerate support due to
11
As shown in Osbourne and Rubinstein (1990) [40] and Gale (2000) [23], anonymity is an important
assumption for random matching games to yield an outcome equivalent to a competitive equilibrium.

12
the following factors: (1) The existence of captive buyers. That is, there are always
some buyers in a seller’s customer base who have only that seller in their consideration
set, so sellers do not behave as in Bertrand competition. Thus, marginal cost pricing
by the sellers is not an equilibrium. (2) Sellers have the incentive to undercut other
sellers if the distribution of prices posted by competing sellers has an atom at any price
above the marginal cost.
The equilibrium is unique and consists of a profile of distributions of prices {F t }t and
their supports have disjointed interiors for each type of seller. Sellers of different types
post different prices; that is, for each period t and type k ∈ {1, . . . , t − 1}, a seller of
type k always posts a lower price than a seller of type k + 1. The reasoning behind
the result is as follows: as Φ is strictly concave and mk − mk−1 is constant, there are
decreasing returns to word of mouth. Thus, sellers with smaller customer bases have
higher expected growth rates of their customer bases if they sell the same quantity in
proportion to their customer base size. Therefore, smaller sellers have more incentives
to post lower prices than larger sellers, as shown in Figure 2.
As sellers’ customer bases grow over time, younger sellers (i.e., sellers who entered the
market later) tend to have a smaller customer base than older sellers. This model then
provides a theoretical foundation for the empirical regularity that entrants sell at lower
prices than incumbent firms because the entrants are “investing” in building up future
demand (Foster et al. [18, 19]).

Theorem 1. The model has a unique equilibrium {F t }∞

t=1 . The equilibrium features
the following properties:
(1) In this unique equilibrium for each period t ∈ {1, 2, . . .} and seller type k ∈
{1, 2, . . . , t}, Ftk is continuous and has support [pkt , pkt ].
(2) For each period t ∈ {1, 2, . . .} the supports {[pkt , pkt ]}tk=1 satisfy pkt = pk+1
t
for each
t
type k ∈ {1, 2, . . . , t − 1} and pt = 1 (the monopoly price).
(3) If Assumption 1 holds, then, as t → ∞, for each type k ∈ {1, 2, . . .}, Ftk converges
to a stationary distribution F k , and nt converges to a stationary distribution of seller
types n = (nk )∞
k=0 .

Proof. The proof of this theorem and all the following theorems is contained in the
Proofs subsection of the Appendix.

13
 Ftk Ftk+1

pM C = 0 p1t ptt = 1

Figure 2: Partition of the supports of the strategy profile F t in the equilibrium.

5 Properties of the model

5.1 Efficiency

There is unrealized surplus in this industry due to the presence of imperfect awareness:
The total surplus realized in the equilibrium of the industry given the profile of types
nt is 1 − π(0, m̂t ), which is the probability that a buyer has at least one seller in
his consideration set. As the evolution of awareness is endogenous to the assignment
of buyers to sellers, this assignment may be inefficient in the sense that in a given
period, 1 − π(0, m̂t ) is lower than the highest feasible value. However, as shown in this
section, the symmetric equilibrium yields an assignment that converges to the efficient
assignment as the measure of sellers of each type tends to zero. That is, a finer grid
of types implies in an assignment of buyers to sellers that is more efficient and as the
grid of types approximates a continuum of types the assignment of buyers to sellers
converges to the efficient assignment.
To define efficiency in this environment, we must define the set of feasible allocations.
Allocations are defined as an assignment rule of buyers to sellers, that is, an order of
preference for the assignment of buyers to the sellers they might be aware of. Clearly,
a price posting policy for the sellers implies an assignment rule of buyers to sellers, and
we define the set of feasible assignment rules as those that can be implemented by some
pricing policy {F t }∞
t=1 .

Definition 2. An assignment rule {F t }∞t=1 is efficient if it yields a sequence {m̂t }t

and corresponding industry surpluses {1 − π(0, m̂t )}∞
t=0 such that there is no feasible
P t
assignment rule that implies in a higher present value (i.e., t β [1 − π(0, m̂t )]) of
industry surpluses.

Theorem 2. The optimal assignment rule consists of {F t }∞ t=1 characterized by pure

pricing strategies in each period {pt }k=1 such that all sellers of type k post pkt < 1 and
k t

14
pkt > pk−1
t for each k ∈ {2, . . . , t}.

The equilibrium is inefficient because sellers of the same type post prices according to
a non-degenerate distribution, thus some sellers of the same type post lower or higher
prices than others. Because the customer base accumulation function Φ is strictly
concave, it is more efficient for sellers of the same type to divide customers among
themselves equally by posting the same price. However, suppose that the number of
types increases and the proportion of sellers of each type becomes smaller; in that case,
the degree of inefficiency decreases. That is, a model with a finer grid of types has lower
inefficiency.
Therefore, for a sequence of progressively finer customer base grids, then, the equilib-
rium pricing strategies converge to the optimal assignment rule as the number of types
increases to infinity and the fraction of sellers of each type converges to zero.

5.2 Dynamics of sales prices

Let m̂t = k nkt mk be the average customer base size in the equilibrium of the model
P

in a given period t. Let SPt be the average sales prices in equilibrium in period t =
1, 2, 3, . . .; SPt is determined by the profile of the distribution of prices posted F t and
the distribution of seller types nt . Explicitly,
Pt R k
pqt (p)dFtk (p)
SPt = Pk=1
t R k k
,
k=1 q t (p)dFt (p)

that is, the average sales price, SPt , is determined by the gross revenue pqtk (p) divided
by the quantity sold.
When we study the consequences of the absence of memory depreciation a seller cus-
tomer bases does not contract, so we assume that Φ is bounded below by 0. This as-
sumption implies that competition between sellers is increasing over time as customer
bases overlap to a greater degree as shown in Figure 3.
Assumption 1. (No memory depreciation) The customer base never depreciates, that
is, Φ(0) = 0.
Under Assumption 1, a seller’s customer base does not decrease. This assumption
implies that competition between sellers is constantly increasing as the customer bases

15
 Industry in period t Industry in period t + y, y > 0
buyers buyers

seller 2 seller 2

seller 1 seller 1

Figure 3: Customer bases can grow over time increasing the intensity of competition
between sellers, as in this duopoly example.

16
tend to overlap to a greater degree. As the intensity of competition increases, we
can conjecture that the average sales price decreases over time. However, I could
not analytically prove that prices are always strictly decreasing over time; however,
numerical simulations of the model suggest that is the case (see Subsection 5.4, in
particular Figures 6 and 7).

5.3 Convergence to perfect competition

The competitive equilibrium that corresponds to the physical environment described

in this paper has the following properties: in every period, each seller posts a price
equal to the marginal cost of 0 while each buyer purchases a unit of the good; thus, the
aggregate quantity sold in every period is 1, profits are 0, and buyers capture all the
surplus. In addition, note that the set of core allocations in this environment consists
of the competitive equilibrium allocation. To see that, take the coalition of all buyers
and sellers and note that the marginal product (defined for a subset of agents as the
marginal increase of feasible total surplus by incorporating that subset in the coalition)
of a subset of buyers of measure µ is also µ, while the marginal product of additional
sellers is 0 because sellers produce the good at constant marginal cost without capacity
constraints.
The equilibrium allocation of this economy converges to the competitive equilibrium
allocation as t → ∞ under certain conditions, stated on Theorem 3. Intuitively, these
conditions are such that if sellers stay in the industry forever, and the growth rate
of customer bases is sufficiently high, then the rate of increase in the intensity of the
sellers’ competition is sufficiently high to drive prices down to the marginal cost as
t → ∞. As we saw in Theorem 1, given Assumption 1, the equilibrium converges to a
stationary equilibrium.

Theorem 3. Suppose Assumption 1 holds and if Φ satisfies the condition that for some
y > 0 and z > 0 that Φ(x) > yx for x ∈ [0, z], then in the stationary equilibrium, as the
seller entry and exit rate λ converges to 0, the distribution of posted prices converges
in probability to the marginal cost, and the allocation corresponds to the competitive
equilibrium.

17
Figure 4: The empirical evidence of price dispersion in transactions in red normalized
relative to the average price from Burdett and Menzio (2018) [8].

5.4 Numerical examples

When solving for the model’s equilibrium in numerical simulations, one desirable prop-
erty obtained from the simulations is that the equilibrium distribution of prices can
exhibit distinct morphology from traditional models of equilibrium price dispersion. In
the models of Butters [9], Varian [49], and Burdett and Judd [7], both the distributions
of prices posted by sellers and for sales (executed transactions) have the highest density
at the lower bound, and the density is strictly decreasing over the support. In contrast,
empirical studies of the morphology of price dispersion show that the distribution of
prices for transactions appears to be approximately symmetric at the mode. The model
presented in this paper can replicate this property. The main reason for the difference
between the equilibrium distribution of prices generated by this model and traditional
models of equilibrium price dispersion is that, in this model, the sellers with smaller
customer bases post lower prices than the sellers with larger customer bases. Because
they have smaller customer bases, the volume of transactions with the sellers posting
low prices is relatively small.
Consider a state-space s = {0, 0.05, 0.10, 0.15, 0.20, 0.25, ...}. Figures 5 and 6 in this
numerical example have entry and exit rate λ = 0.02, a discount factor β = .97, and
the type transition function

Φ(x) = [1 − 1/(q + 1)].4 .

18
Figure 5: An example of the distribution of posted prices and sales prices at t = 200.

Figure 6: An example of the evolution of the distribution of prices posted and sales
over time.

19
Figure 7: Comparative dynamics of the average sales price over time: The blue line
depicts the average sales price in the industry relative to marginal cost if the exit rate
is fixed and the same as the entry rate at .020. The green line depicts the average sales
price in the industry with an exit rate that varies from .028 for states s with ms ≤ 2
and decreases to .010 for states with ms > 2 (consistent with the empirical evidence
that larger firms have lower exit rates).

20
Marginal cost is set at 1.16 times the buyer-seller surplus, so the standard deviation of
prices is 10% at the stationary equilibrium. Figure 4 shows the empirical data on the
distribution of prices. Figure 5 shows the distribution of prices posted by the sellers
and prices for transactions (sales) executed in the industry in period 200. Figure 6
shows the distribution of prices posted and sales prices in the industry at four different
moments in time. Figure 7 shows the dynamics of the average sales prices with fixed
entry rates and varying the entry rate while keeping the exit rate fixed.

6 Extensions

6.1 Endogenous exit

Instead of postulating a fixed exit rate, consider an extension of the model that allows
for the endogenous exit of sellers. Suppose any seller j operating in the industry can
e
exit and let Vt,j be the value for j of exiting the industry at the end of period t. The
value of exiting is random, distributed according to a continuous cumulative distribution
function G. The stochasticity of the exit value represents the changing opportunities to
do business outside the industry. A seller exits at the end of a period if the opportunity
cost of staying in the industry is higher than the return.
The state of the industry must incorporate information regarding the population of
sellers who decided to stay, given fixed entry rate λ. Let nt be the profile of seller types
in period t and λt be the equilibrium profile of exit rates by seller type. The value of
a seller with a customer base mk is

k
Vt (mk ) = πt (mk ) + βE[Vt+1 ],

k
where πt (mk ) are the equilibrium profits if the seller’s customer base is mk , and E[Vt+1 ]
is the expected value next period given current type k. Sellers choose to exit at the end
e k
of the period if Vt,j > E[Vt+1 ]; that is, the opportunity cost of staying in the industry
in the next period is higher than the expected return.
Thus, the fraction of sellers of type k who exit the industry is given by

e k e k



Prob Vt,j > E[Vt+1 ] = 1 − Prob Vt,j < E[Vt+1 ]
k


= 1 − G E[Vt+1 ] .

21


Therefore, the exit rate of a seller of age a in period t is λkt = 1 − G E[Vt+1 k
] . Note
that for any period t, Vt is strictly increasing in customer base m, which implies in the
equilibrium that λkt > λk+1
t for any type k. As older sellers tend to have larger customer
bases, they are less likely to exit the industry, which is consistent with the empirical
evidence.

6.2 Endogenous entry

So far, we assumed that a measure λ ∈ (0, 1) of sellers enters the industry at each
period and that sellers exit the industry at the rate λ. These assumptions imply that
as t → ∞ the population of sellers operating in the industry converges to a measure
1. Instead, suppose that a measure a > 0 of sellers enter the industry, and the exit
rate is constant at λ. Then, as t → ∞, the measure of sellers operating in the industry
converges to a measure a/λ.
Consider a stationary equilibrium with free entry: the industry is in stationary equi-
librium, and the value of entry is equal to the cost of entry. In that case, it can be
shown that in stationary equilibrium, the average profitability of sellers operating in
the industry decreases as the population of sellers increases, and therefore the value
of entering the industry decreases. If the cost of entry converges to zero, then the
present value of entering the industry in stationary equilibrium also converges to zero.
Thus average markups tend to zero. Therefore, this model predicts that as the cost
of entry falls, the distribution of prices in the stationary equilibrium of the industry
approximates the marginal cost.

7 Concluding remarks

This paper presented a theory of dynamic price formation in an industry that considers
the effects of imperfect awareness and seller discovery through word of mouth among
buyers in the market. The model has a unique symmetric equilibrium that converges
over time to a stationary equilibrium. The equilibrium properties include: (1) Price
dispersion occurs as sellers randomize their price posting strategies. (2) Demand for
the output of entrant sellers tends to be lower than for incumbents. (3) On average,
entrants post lower prices than incumbent sellers. (4) Given the assumption of the

22
absence of customer base depreciation, the average markup over the marginal cost falls
over time as the industry converges to a stationary equilibrium. (5) Equilibrium tends
to approximate efficiency when the set of possible states for the customer base grows
larger. (6) Under certain assumptions, the awareness friction vanishes over time, and
the equilibrium converges to the allocation corresponding to perfect competition. (7) If
the decision to exit is endogenous, the model suggests that older sellers are less likely
to exit than younger sellers.
One crucial observation is that numerous studies12 show that the choice of trading
mechanisms and particular details of the environment may imply that the equilibrium
might not converge to perfect competition as frictions vanish.13 However, classic results
obtained in cooperative game theory (e.g., Debreu and Scarf [12] and Aumann [4]) and
the mechanism design literature (e.g., Hammond [27]) suggest that in large economies
(i.e., economies with a continuum of agents) without frictions of trading and any re-
strictions on specific trading mechanisms should arrive at allocations that correspond
to competitive equilibria. These results suggest that satisfactory models that describe
frictions of trading should use a trading mechanism that implies an allocation that ap-
proximates the competitive equilibrium allocation as frictions vanish, which is the case
of the model described in the present paper.
Many price indexes are constructed based on average posted prices and not on average
prices for transactions. A possible application of this model is that it can estimate the
average transaction price from the average posted price, given sufficient data on the
market’s characteristics, to allow for higher precision of the estimates of price changes
over time. Another candidate for further research is extending the awareness model de-
veloped in this paper to a more general environment. An environment that incorporates
awareness frictions on the supply side as well as on the demand side (as it is implicitly
assumed that sellers have full awareness of the competitors operating to estimate their
demand curves), and in a general equilibrium environment (so there is an endogenous
decision for sellers to enter individual industries).
Finally, it seems necessary to emphasize that this study does not present a model for
12
Such as Diamond [13], Rubinstein and Wolinsky [43], Gale [23, 22, 20, 21], Mortensen and Wright
[39], Satterthwaite and Shneyerov [44, 45], Lauermann [32], and Lauermann et al. [33].
13
In particular, Gale [23] shows that the assumption of anonymity, that is, that traders do not
condition their strategies on a particular individual agent in the market, is critical for the convergence
to perfect competition to occur when market frictions converge to zero. Lauermann [32] provides
a general approach to the set of conditions required for random matching and bargaining games to
converge to the competitive outcome as frictions vanish.

23
firm growth (unlike Luttmer [34, 35] or Dinlersoz and Yorukoglu [14]). For example,
the sellers in the model can be interpreted to be individual product lines in an industry
as we have considered only a market for a homogeneous good (in the sense that any
buyer-seller pair can generate a unit surplus; thus, from the perspective of a buyer,
other sellers are perfect substitutes). Empirical studies indicate that firms usually
sell many products, and firm growth tends to involve expanding the firm’s activities
into additional products beyond the expansion of their sales in markets in which they
currently operate (Argente et al. [2]). However, this study provides a model of industry
consolidation that can be used to construct a model of firm growth that incorporates
varied product portfolios.

24
8 Appendix

8.1 Derivation of Poisson distribution of the size of the buyer’s

consideration sets

Let nt = {nkt }∞
k=0 be the profile of seller types and A(i) be an assignment correspondence
from the set of buyers to the set of sellers that represents the subset of sellers in each
buyer i’s consideration set.
Consider a sequence of assignment correspondences {Az (i)}∞ z=1 such that the set of
sellers of each type k ∈ {0, 1, 2, . . .} is partitioned into z partitions {Jxk }zx=1 , each of
equal measure, nkt /z, and buyers are assigned to at most one seller of each partition (i.e.
|Az (i) ∩ Jxk | ∈ {0, 1}). The assignment correspondence Az (i) is such that a measure
αzk = (nkt mk )/z of buyers are assigned to sellers in partition Jxk , so the probability a
buyer is assigned to a seller in Jxk is αzk (thus Pr{Az (i) ∩ Jxk 6= ∅} = αzk ).14
As buyers’ awareness regarding sellers is independent, the probability that a buyer i
is aware of l ∈ {0, 1, . . . , z} sellers of type k is distributed according to a binomial
distribution with parameters z for the number of trials and αzk for the probability of
success for each trial. Suppose buyer i is aware of at least one seller of type k, then
the probability that a buyer is aware of l ∈ {0, 1, . . . , z − 1} other sellers of type k is
distributed according to a binomial distribution with parameters z − 1 for the number
of trials and αzk for the probability of success for each trial.
As zαzk = nkt mk and limz→∞ (z − 1)αzk = nkt mk , the Poisson limit theorem implies that
as z → ∞ both the unconditional and conditional binomial distributions converge to
the Poisson distribution with parameter m̂kt = nkt mk . Take At (i) to be an assignment
correspondence Az (i) with z large so the distribution of buyer‘s awareness regarding
sellers of each type is approximated by Poisson distributions of parameter m̂kt . Since
we are working on a dynamic environment, in the Appendix subsection 8.2 presents an
argument regarding the validity of the independence assumption in a dynamic setting.
For example, let [0, 1] be the set of sellers. Suppose there is one seller type m1 , thus n1t = 1, and
14

this set of sellers is partitioned into 10 partitions, so Jx1 = [(x − 1)/10, x/10) for x ∈ {1, . . . , 10}. Then,
Pr{A10 (i) ∩ Jx1 6= ∅} = m1t /10.

25
8.2 Preservation of the Poisson property of the distribution of
the size of the buyer’s consideration sets when the customer
base is a stock

As a seller’s customer base is a stock that might accumulate or depreciate from one
period to the next, in this subsection of the Appendix I explain how the independence
of the buyer’s consideration sets is preserved in a dynamic environment.
Consider an environment with 2 sellers, j and h. If the customer base of one seller
increases from period t to period t+1 we say that some buyers discovered the seller. For
buyer i, and sellers j and h with h 6= j, the probability of discovery is independent. That
is, the probability P that i discovers j in period t conditional on being aware of h is the
same as the unconditional probability: Pr(j ∈ Ait+1 \ Ait | h ∈ Ait ) = Pr(j ∈ Ait+1 \ Ait ).
The loss of memory is independent, which means that the probability an arbitrary
buyer i forgets seller j is the same whether i was aware or not of seller h, h 6= j:
Pr(j ∈ Ait+1 \ Ait | h ∈ Ait ) = Pr(j ∈ Ait+1 \ Ait ). In period 0, awareness is assumed to
be independent. Then, as argued in Lemma 1 below, awareness is independent for any
period t. That is, the probability of buyer i being aware of seller j is αjt conditional on
buyer i being aware or not of another seller h; thus Pr(j ∈ Ait | h ∈ Ait ) = Pr(j ∈ Ait ) =
αjt .

Lemma 1. If discovery and memory loss are independent, and awareness is independent
in period 0, then at any period t > 0, awareness is independent. That is, for any period
t the probability that buyer i who is aware of some seller j is also aware of another
seller h is αth ; that is, Pr(h ∈ Ait | j ∈ Ait ) = Pr(h ∈ Ait ) = αth .

Proof. To see that the assumption of independent discovery implies that the evolution
of {αj }t does not affect the independence of awareness consider the following case:
Without loss of generality, there are two sellers 1, 2 and suppose that independence of
awareness holds in some period t: Buyers who were aware of seller 1 are aware of seller 2
with probability αt2 ∈ (0, 1), so Pr(2 ∈ Ait | 1 ∈ Ait ) = Pr(2 ∈ Ai | 1 ∈
/ Ait ), and both are
equal to Pr(2 ∈ Ait ), which is equal to αt2 . Also, suppose that δ > 0 and D(n) ∈ (0, 1)
for n ∈ [0, 1). Which means that, from period t to period t + 1, a positive measure
of buyers who were aware of seller 2 forget seller 2 and also that a positive measure
discovers seller 2.

26
Consider the partition the buyers into the following subsets in period t + 1:

1
Rt+1 = {i : 1 ∈ Ait ∩ Ait+1 }
1
Ft+1 = {i : 1 ∈ Ait ∩ (Ait+1 )c }
1
Ut+1 = {i : 1 ∈ (Ait )c ∩ (Ait+1 )c }
1
Dt+1 = {i : 1 ∈ (Ait )c ∩ Ait+1 }.

1
In words, Rt+1 is the subset of buyers who were aware of seller 1 in period t and still
1
remember 1 in period t + 1, Ft+1 is the subset of buyers who were aware of seller 1
1
in period t and forgot about 1 in period t + 1, Ut+1 is the subset of buyers who were
1
unaware of seller 1 in period t and are still unaware in period t + 1, and Dt+1 is the
subset of buyers who were unaware of seller 1 in period t and discover seller 1 by period
t + 1.
As Pr(2 ∈ Ai | 1 ∈ Ait ) = Pr(2 ∈ Ai | 1 ∈
/ Ait ), and by the assumption that discovery
and memory loss are independent, the fractions of buyers in each of these four subsets
who discover 2 or forget 2 are the same. Thus,

Pr(2 ∈ Ait+1 | i ∈ Rt+1

1
) = Pr(2 ∈ Ait+1 | i ∈ Ft+1
1
)
= Pr(2 ∈ Ait+1 | i ∈ Ut+1
1
)
= Pr(2 ∈ Ait+1 | i ∈ Dt+1
1
)
= Pr(2 ∈ Ait+1 ).

Therefore,April

Pr(2 ∈ Ait+1 | 1 ∈ Ait+1 ) = Pr(2 ∈ Ai | 1 ∈

/ Ait+1 )
= Pr(2 ∈ Ait+1 )
2
= αt+1 .

Therefore, independence holds for the period t + 1. Independence is assumed to hold

in period 0 so, by induction, it holds for all periods.

27
8.3 The microfoundations of customer base accumulation

This subsection presents a description of the economic reasoning underlying the as-
sumptions made for the customer accumulation function Φ used in this paper.
Consider an environment with finitely many sellers where buyers can become aware of
additional sellers through a word of mouth awareness diffusion process. Let mjt ∈ [0, 1]
be the size of the customer base of a seller j in period t, mjt is the proportion of all
buyers who are aware of seller j. At the end of each period, a buyer i that is unaware of
seller j can become aware of j by meeting a customer of j with probability D(s) ∈ [0, 1].
Where qtj ∈ [0, mjt ] is the measure of buyers who shop at j (equal to the quantity sold
as buyers have unit demand), and D : [0, 1] → [0, 1] is a strictly increasing concave
function such that D(0) = 0. The probability that a buyer discovers a seller is strictly
increasing in the number of buyers who are actively shopping at j but is strictly concave,
which means there are decreasing returns to word of mouth. The function D represents
diffusion of awareness through word of mouth: an increase in the number of customers
of a seller increases the probability that the buyer hears about the seller through word
of mouth. Also, at a period t a buyer i who is aware of seller j has a probability
δ/mjt ∈ (0, 1) that he forgets about j in the next period.
Then, the change in customer base size is

mjt+1 = (1 − δ/mjt )mjt + (1 − mjt )D(q).

Note that we can write the law of motion for the customer base accumulation as

mjt+1 = Φ(mjt , q) + mjt ,

where
Φ(mjt , q) = (1 − mjt )D(q) − δ.

In this paper, we consider an environment with a continuum of sellers, where each

seller has an infinitesimal size relative to the size of the market. Thus mjt , interpreted
as the fraction of all buyers who include j in their consideration set, is 0. Then, we can
write the customer accumulation function as Φ(mjt , q) ' Φ(q), a strictly increasing and
strictly concave function.

28
Note that in the paper, as the set of feasible customer base sizes is a discrete grid
{0, c, 2c, 3c, . . .} so our customer accumulation function is defined as a function that
yields the probability of transition from one state to the other instead of a function
that yields the quantitative change in customer base size.

8.4 Proofs

8.4.1 Proof of Theorem 1

Proof. The proof structure is as follows: In step 1, we construct a candidate equilibrium

strategy profile. In step 2, we show that this candidate equilibrium strategy profile is
an equilibrium. In step 3, we show uniqueness. In step 4, we show that if Assumption
1 holds, the equilibrium converges to a stationary equilibrium as t → ∞.
Step 1. The construction of a profile of strategies {F t }∞ t=1 as candidate equilibrium
using indifference conditions, in particular in regards to the bounds of the support.
Note that the highest type operating in the industry in period t is the type t, the sellers
who entered in period 1 and their customer bases increased to mt by period t. Consider
the profile of distributions of prices {F t }∞ k t ∞ k k t
t=1 = {(Ft )k=1 }t=1 with supports {[pt , pt ]}k=1
for each period t ≥ 1, where pk+1 t
= pkt for each k ∈ {1, . . . , t − 1}: Let nt be the
distribution of types in some period t, therefore tk=0 nkt = 1.
P

Let m̂t = tk=1 m̂kt be the sum of the Poisson parameters {m̂kt } for each type k operating
P

in the industry. Thus, the probability that a buyer is not aware of any seller operating
is exp(−m̂t ). Let the upper bound of ptt = 1, the monopoly price. Then define ptt by
the following equal profit condition

ptt exp[−(m̂t − m̂tt )]mt + βE[Vt+1

k
| ptt ] = ptt exp[−(m̂t )]mt + βE[Vt+1
k
| ptt ],

note that exp[−(m̂t − m̂tt )] is the probability that the buyer is not aware of any seller
operating that posts a price lower than ptt (as by construction ptt is higher than all prices
posted by types lower than t), and ptt exp[−(m̂t )]mt are the profits a seller makes by
posting ptt conditional on ptt being higher with probability 1 than any other price posted
by other sellers.
In addition, for the lower types k ∈ {1, . . . , t − 1}, let [pkt , pkt ] satisfy the following equal

29
profit condition:

k−1
X k
X
pkt exp[− m̂lt ]mk + βE[Vtk | pkt ] = pkt exp[− m̂lt ]mk + βE[Vt+1
k
| pkt ].
l=1 l=1

Note that exp[− k−1 l

P
l=1 m̂t ] is the probability that a buyer is unaware of sellers of type
l < k and exp[− kl=1 m̂lt ] is the probability that a buyer is unaware of sellers of type
P

l ≤ k.
The value function in period t for type k ∈ {1, . . . , t},Vt (mk ), satisfies

k
X
Vt (mk ) = pkt exp[− m̂lt ] + βE[Vt+1
k
| pkt ].
l=1

The profile of price distributions in period t, F t = {Ftk }tk=1 satisfies for each type
k ∈ {1, . . . , t} and price p ∈ (pkt , pkt ) the equal profit condition below:

Xk−1 k
X
p exp[−( m̂lt − m̂kt Ftk (p))]mk + βE[Vt+1
k
| p] = pkt exp[− m̂lt ]mk + βE[Vt+1
k
| pkt ].
l=1 l=1

Step 2. Show the candidate equilibrium is an equilibrium.

To show it is an equilibrium, first, we show that the value functions are well defined,
and second, that deviations are not profitable for the sellers.
To see that the value functions are well defined, consider a profile of functions V = {Vt }t
that are concave and increasing. Let {pk }k are constructed as in step (1) given the profile
of functions {Vt }t . Consider the following operator for Vt for each period t:

k
X
T (Vt )(m) = p(m) exp[− m̂lt ]m + βE[Vt+1 | p(m), m], (12)
l=1

where 


pk if m ∈ [mk , mk+1 ] for some k

p(m) = p if m < m1 (13)
 1


1 if m > mt

is the condition on the posted price p(m) that (as we will see) is consistent with maxi-
mization with the present value of profits given value functions V , and E[Vt+1 | p(m), m]

30
is the analogous to 11 for a customer base size m with possible transition to states m+c
and m − c.
Note that the operator satisfies Blackwell’s sufficiency conditions for it to be a con-
traction, therefore the value functions V = {Vt }t are well defined. To show that the
strategies defined in Step 1 constitute an equilibrium we must show that deviations are
not profitable, to show that first we must check that V are strictly concave and strictly
increasing. Note that since Φ is strictly increasing and strictly concave, then 12 implies
that for {Vt }t that are concave and increasing then {T (Vt )}t are strictly concave and
strictly increasing, therefore V must be strictly concave and strictly increasing.
To show that {F t }∞ t=1 constitute an equilibrium we must show deviations are not prof-
itable for the sellers. To show that we check that the indifference conditions for {pk }k
given the candidate equilibrium value functions {Vt }t are consistent with maximization
of the present value of sellers of all types. Suppose there are at least two types operating
in the market. Consider a seller of type k > 1, then note that for a seller of type k − 1
the equal profit condition implies that

k−2
X k−1
X
pk−2 exp[− m̂lt ]mk−1 + βE[Vt+1
k−1
| pk−2 ] = pk−1 exp[− m̂lt ]mk−1 + βE[Vt+1
k−1
| pk−1 ]
l=1 l=1
(14)
Note that as the decrease in profits from posting pk−2 compared to pk−1 > pk−2 implies
k−1 k−1
that the increase in βE[Vt+1 | pk−2 ] over βE[Vt+1 | pk−1 ] is exactly compensated, that
is 14 can be rewritten as
k−2 k−1
β k−1 k−2 k−1 k−1 k−1
X
l k−2
X
m̂lt ].


E[Vt+1 | p ] − E[Vt+1 | p ] = p exp[− m̂t ] − p exp[−
mk−1 l=1 l=1

However, since Φ and {Vt }t are strictly concave then as mk > mk−1 therefore(3) Show
that {F t }∞
t=1 is the unique equilibrium.

k−2 k−1
β k
X X
| pk−2 ] − E[Vt+1
k
| pk−1 ] < pk−1 exp[− m̂lt ] − pk−2 exp[− m̂lt ]


E[Vt+1
mk l=1 l=1

31
Therefore, we can conclude that

k−2
X k−1
X
k−2
p exp[− m̂lt ]mk + k
βE[Vt+1 |p k−2
]<p k−1
exp[− m̂lt ]mk + βE[Vt+1
k
| pk−1 ].
l=1 l=1

k
That is, the increase of βE[Vt+1 | pk−2 ] over βE[Vt+1
k
| pk−1 ] is smaller than the decrease
in profits from posting lower prices.
An analogous argument holds for seller of type k ≥ 1 who posts a price pk+1 and for
prices on the interior of the supports. Thus, sellers of type k have lower present value
by posting prices outside of [pk−1 , pk ] than prices on [pk−1 , pk ]. Therefore {F t }∞
t=1 is an
equilibrium.
Step 3. Show that {F t }∞
t=1 is the unique equilibrium.

We show that any equilibrium must feature the properties of {F t }∞

t=1 , thus the condi-
tions that define {F t }∞
t=1 characterize the unique equilibrium.

Let {Vt0 }t be a profile of value functions in some equilibrium; it is easy to see that Vt0
is strictly increasing: take a seller which is following a price posting strategy where
an increase in the customer base implies in a strict increase in the present value of
profits. In any equilibrium, the distributions of prices must be atomless; that is, there
is no point p̃ where sellers post prices with strictly positive probability mass. Otherwise,
sellers have an incentive to undercut by posting a price slightly lower than p̃. Therefore,
in any equilibrium, the distribution of prices is continuous.
Suppose the supports of the profile of distributions of prices (Ftk )tk=1 do not constitute an
interval. Then, there is an interval [p, p] in the convex hull of the union of the supports
of (Ftk )tk=1 where no sellers post prices on the interior of the interval but sellers post
prices arbitrarily close top. Thus, sellers can strictly increase profits by posting p over
those prices close to p, as the quantity sold stays the same, but the profit rate is strictly
greater. Therefore, in any equilibrium, the distribution of prices has convex support.
We established that every equilibrium must feature a continuous distribution of prices
with connected support. To show uniqueness, we need only to show that in equilibrium,
the supports of the distributions of prices for each type do not overlap (that is, the
intersection of the supports of the distributions of prices for any type has measure zero)
and lower types (that is, types with smaller customer bases) post lower prices than
higher types.

32
As shown in the Step 2, the strict concavity of Φ and {Vt0 }t implies that the interiors of
the supports by type are disjointed and higher types posts higher prices. By assumption
Φ is strictly concave. To see that in any equilibrium the profile of functions {Vt0 }t is
strictly concave, consider a profile of concave functions {Ct }t , a profile of equilibrium
strategies {Glt } and the operator
!
X
T (Ct )(mk ) = max p exp[− Glt (p)m̂lt ]mk + k
βE[Ct+1 | p] , (15)
p≤1
l

then, as {Gkt }k are distributed continuously over a convex support, the operator is
well defined and the strict concavity of Φ implies that T (Ct )(mk ) is strictly concave.
Therefore, any equilibrium features a profile of distributions of prices {Gkt }k that are
continuous, with supports [g kt , g kt ] where g kt = g k−1
t for each type k > 1. Then the
equal profit conditions (which must hold for non-degenerate price distributions to be
consistent with equilibrium) imply that t {Gkt }k = F t for each t.
Step 4. To show equilibrium converges to a stationary distribution we show that the
sequence of equilibrium distribution of types {nt }t converges to a stationary profile n.
We know that for each t, nt = {nkt }∞
P k
k=0 such that k nt = 1, thus by Bolzano-
Weierstrass it {nt }t has a convergent subsequence. Suppose that {nt }t has converges
to multiple different limits. Without loss of generality suppose that {nt }t converges
to two distributions n and n0 , with n 6= n0 . This implies in an equilibrium strategy
profile where the firm’s price posting strategies imply that if the industry is in state n
at some period t then the distribution of types shifts to n0 in period t + 1 and n0 shifts
back to n in period t + 2. Since n 6= n0 without loss of generality we can suppose that
n and n0 are such that
X X
mk nk > mk n0k .

In this case, the total sales in the state n are higher than in state n0 but the average
customer base must decrease from n to n0 while it it must increase from n0 to n.
This is a contradiction with the properties of the customer accumulation function Φ.
Therefore, {nt }t has to converge to some n.

33
8.4.2 Proof of Theorem 2

Proof. Consider n and n0 which are identical except that n0k+1 = n +  and n0k = n − e,
that is an shift of a measure  > 0 of seller type k to k + 1. Note that the function that
determines the probability that a seller’s customer base grows by c does not depend
on the seller’s type. Then, at the distribution of types n0 , the total surplus that
can be generated in the present and the future is higher than at n. Therefore, the
efficient assignment rule must maximize the growth rate of the average customer base,
m̂t = k m̂kt , at each period.
P

Given that Φ is strictly concave, the efficient assignment rule must prioritize sellers with
smaller customer bases, and sellers of the same type must share customers equally by
posting the same price. Thus the efficient assignment rule is a profile of prices by type
{pkt }tk=1 such that all sellers of type k post pkt and pkt > pk−1
t for each k ∈ {2, . . . , t}.

8.4.3 Proof of Theorem 3

Proof. The proof is divided into steps.

Step 1. Show that as the entry and exit rate λ converges to 0 the average age of sellers
operating in the industry diverges to infinity.
A constant exit rate of λ implies that the average age of the sellers operating in the
industry converges to (1 − λ)/λ as t → ∞. Clearly, λ → 0 implies that the average age
of operating sellers diverges to infinity as t → ∞.
Step 2. Show that if Φ(x) > yx for x ∈ [0, z] for some y > 0 and x > 0, then the
expected size of the customer base of a seller of age a diverges to infinity as a → ∞.
Let Ea,λ [m] be the expected customer base size and Ea,λ [q] be the expected quantity
sold of a seller of age a given an entry/exit rate λ ∈ (0, 1). Consider a customer base
accumulation function Φ that satisfies Assumption 1 and is such that Φ(x) > yx for
x ∈ [0, z] for some y > 0 and x > 0. Suppose, by taking a subsequence if necessary,
that
lim Ea,λ [m] = z
a→∞

for some z > 0. Therefore, Ea,λ [ms ] ≤ z, ∀a, the quantity sold by a seller with customer
base mk is at least
mk exp(−c) ≥ m1 exp(−c) > 0,

34
as the fraction of captive buyers is at least as large as exp(−c) and prices posted in
equilibrium are equal or lower than 1. That is, the quantity sold is bounded below by
m1 exp(−c). Therefore,

Ea+1,λ [m] − Ea,λ [m] ≥ ym1 exp(−c),

which is a contradiction with Ea,λ [ms ] converging to some z > 0. Therefore, lima Ea,λ [m] =
∞.
Step 3. Let m̂(λ) be the stationary equilibrium level of m̂ given exit rate of λ ∈ (0, 1).
Show that the stationary equilibrium level of m̂(λ) diverges to infinity as λ ↓ 0.
As Ea,λ [m] diverges to infinity for every λ ∈ (0, 1), let λ ↓ 0, then

lim lim Ea,λ [m] = ∞.

λ↓0 a→∞

Let m̂t (λ) be the average equilibrium customer base in period t given entry/exit rate
λ ∈ (0, 1). Since Φ is strictly concave, Jensen’s inequality implies that m̂t (λ) satisfies

lim m̂t (λ) > Eâ(λ),λ [m], (16)

t→∞

where
1
â(λ) = arg max{x ≤ − 1}.
x∈N λ
That is, note that the average age of sellers operating in the industry is ∞
P
a=0 aλ(1 −
1
λ)a = λ − 1. The condition 16 then states that the average customer base m̂t (λ) in
period t is larger than the expected customer base size of the seller of age that is not
higher to the average age operating in the industry in the stationary equilibrium, which
follows from the strict concavity of Φ and Jensen’s inequality.
Note that â(λ) → ∞ as λ ↓ 0, therefore 16 and Step 2 imply that

lim lim m̂t (λ) = ∞.

λ↓0 t→∞

Step 4. Let F̂t (λ) be the average cumulative distribution function of prices posted in
the equilibrium of period t if seller exit rate is λ ∈ (0, 1) weighted by the size of seller’s

35
customer bases. We need to show that

lim lim F̂t (λ, p) = 1, ∀p > 0.

λ↓0 t→∞

To see that note that the fraction of captive buyers in a customer base is given by
exp[−m̂t (λ)], which converges to zero as λ ↓ 0. Therefore, the incentives to undercut
competing sellers imply that, as m̂t (λ) increases to infinity, the probability of under-
cutting any price that is strictly higher than the lower bound of the support increases
to 1.
To be consistent with equilibrium, the lower bound of the distribution of prices con-
verges to 0. To see that, suppose otherwise that the lower bound converges (taking a
subsequence if necessary) to a price p > 0, then the quantity a seller sells from posting
p diverges to be infinitely higher than quantity sold by posting any price strictly higher
than p. This is a contradiction with equilibrium, which concludes the proof.

36
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