Search In The Product Market And The Real Business Cycle
Source: European Central Bank
The authors develop a search-matching model, where firms search for customers (e.g. in form of advertising). Firms use long-term contracts and bargain over prices, resulting in a price mark up above marginal cost, which is procyclical and depends on firms' relative bargaining power. Product market frictions decrease the steady state equilibrium, improve the cyclical properties of the model and provide a more realistic picture of firms' business environment. This suggests that product market frictions may well be crucial in explaining business cycle fluctuations. Finally, they also show that welfare costs of price rigidities are negligible relative to welfare costs of frictions.