Search, price illusion and welfare

We analyze the effects of price illusion in a decentralized economy a la Diamond (1971) where trade coordination is achieved through costly consumer search. Following a nominal shock, a fraction of the consuming public is subject to price illusion attributable to computing difficulties or lack of information. Firms adapt their pricing strategies in order to discriminate against various consumer types. Three types of equilibria can occur depending on the degree of consumer confusion: one yields a non-degenerated distribution of prices. In this model, suboptimal behavior of some consumers alters the terms of trade for the entire economy and may entail a welfare improvement.