Search in the product market and the real business cycle

This paper develops a search-matching model, where producers provide effort to find customers (e.g. in form of advertising and marketing expenditures). Firms form long-term contractual relationships and bargain over prices. The price bargain results in mark up pricing above marginal cost. The size of the mark up is procyclical and depends on the relative bargaining power of producers and customers. Introducing frictions in the product market decreases the steady state equilibrium, improves the cyclical properties of the model and provides a more realistic picture of firms? business environment, which includes effort in form of advertising and price fluctuations. This suggests that product market frictions may well be crucial in explaining business cycle fluctuations. Finally, we also show that welfare costs of price rigidities are negligible relative to welfare costs of frictions.