Search, price setting and inflation

A model of monopolistic competition in an inflationary environment is developed which embodies optimal sequential search, price dynamics and entry on the part of consumers and firms respectively. Equilibrium price strategies are (S, s); these bounds increase continuously with consumer search costs, and so does price dispersion. Indeed, the whole equilibrium varies smoothly from the competitive (Bertrand) to the monopolistic (Diamond (1971)) end of the spectrum. The latter’s paradoxical result is explained as a limiting case where frictions on firms’ side of the market (price adjustment costs) but not on buyers’ (search costs) tend to zero. A positive relationship between (smooth and perfectly anticipated) inflation and price dispersion or uncertainty is established.