The Role of Search Costs in Determining the Relationship between Inflation and Profit Margins

Abstract

Previous empirical studies have found a negative relationship between inflation and industry profit margins. Recent theoretical findings, however, suggest that buyer search costs can significantly impact this relationship. We use an actual measure of search cost that varies across wholesale industries to estimate the impact of these costs on the relationship between inflation and markups. Using firm-level data from 57 industries, we show that margins increase during inflation if search costs become sufficiently high. Our findings reconcile the theoretical and empirical literatures on this topic.