Understanding Long-run Price Dispersion
One sentence summary: At the PPP level, almost all of price dispersion is attributed to unskilled wage dispersion, while at the LOP level, borders and distance contribute about equally to price dispersion that is rising in the distribution share.
The corresponding paper by Mario J. Crucini and Hakan Yilmazkuday has been published at Journal of Monetary Economics.
Abstract
We use a unique panel of retail prices spanning 123 cities
in 79 countries from 1990 to 2005, to uncover six novel properties of long-run
international price dispersion. First, at the PPP level, virtually all (91.6%)
of price dispersion is attributed to service-sector wages, consistent with a
dominant role of the retail distribution margin. Second, at the level of
individual goods and services, the average contribution of service-sector wages
is significantly reduced, one-third as large (31.9%). This reflects the fact
that good-specific sources of price dispersion, such as trade costs and
good-specific markups, tend to average out across goods. Third, at the LOP
level, borders and distance contribute about equally to price dispersion with
distance elasticities consistent with the existing trade gravity literature
which links trade volumes (rather than relative prices) to borders and
distance. Fourth, in the cross-section, price dispersion is rising in the
distribution share consistent with the notion that baby-sitting services and
haircuts embody local wages to a far greater extent than highly traded
manufactured goods. Fifth, we provide the first estimates of distribution
margins at the micro-level and show them to be very different across goods and
substantial in the aggregate, where they account for about 55% of consumption
expenditure. Sixth, these estimates are broadly consistent with more aggregated
U.S. NIPA measures currently used in the literature.
Non-technical Summary
The
Law-of-One-Price (LOP) is the theoretical proposition that, absent official and
natural barriers to trade, international prices are equated in common currency
units, and a laborer's purchasing power (i.e., real wage) is determined only by
their labor productivity. A stark empirical implication of this proposition is
that the cross-country correlation between price levels and wage levels is
zero. As is well known, this implication of goods market integration is grossly
at odds with the data. The Penn Effect, in recognition of the ambitious work of
Heston, Kravis, Lipsey, who developed the Penn World Tables, shows a strong
positive correlation between international price levels and per capita income.
The following figure shows the
microeconomic counterpart of this fact using the panel data of our study.
Microeconomic in this context means the prices of individual goods and services
across cities of the world, as opposed to aggregate price levels at the
national level. Specifically, each point in the scattterplot is the price of an
individual good or service in a particular city plotted against the hourly wage
of domestic cleaning help in that particular city. Prices and wages have been
averaged over the period 1990 to 2005 to eliminate transitory deviations
associated with business cycles and exchange rate fluctuations.
Specifically, there are 300 goods and services (up to
missing observations) for each city and there are 123 cities in total. The
prices and wages used to construct these time-averages are from the Economist
Intelligence Unit (EIU) World Cost of Living Survey which spans 79 countries.
As far as we know, this is the first study to use time-averaged data to study
long-run deviations from the LOP and Purchasing Power Parity (PPP). The points
labeled with an asterisk are price levels computed as expenditure-weighted
averages of the individual prices.
In the figure, the
estimated line through the scatter of price levels has a slope of 0.52 and an
R-squared value of 0.37. The estimation is by geometric mean regression to consider
for possible measurement errors in both the price and wage data. A common set
of consumption expenditure weights are used for all cities. These consumption
expenditure weights are taken from the PWT, averaged across all OECD nations.
In words: a doubling of wages is associated with a 52
percent higher price level. This finding is typically associated with the
seminal works of Harrod (1933), Balassa (1964), and Samuelson (1964); however,
the HBS theory assumes that LOP holds for traded goods but not for non-traded
goods. According to this view, called the classical dichotomy, there should be
a horizontal line traced out by traded goods for which the LOP holds and a line
with a slope of unity for non-traded goods. The trivial example is the hourly
wage of domestic help itself, which produces a slope of one by recognizing that
the market price of this non-traded service is, in fact, the hourly wage for
unskilled labor. The figure above, obviously, is not much more sympathetic to the
classical dichotomy than it is to complete market integration.
To help resolve
this puzzle, this paper estimates distribution and trade cost wedges using a
trade model augmented with a retail distribution sector (developed in Crucini and Yilmazkuday, 2009). We have two sets of results, one for relative price levels
(PPP) and the other at the level of individual goods (LOP).
Regarding PPP, the variance of price levels for
international city pairs is found to be almost entirely explained by
international wage differences, 92% by our estimate. Both the absolute amount
of price dispersion and the relative importance of wage differences falls when
the sample is restricted to cities in countries at similar stages of
development while the role of retail productivity increases. The contribution
of cross-city wage differences falls to 8% when the sample is restricted to
city pairs within the same country. It is important to keep in mind that the
amount of price level dispersion across cities that are located in the same
country is a trivial 3-5%; as such, a modest amount of wage or retail
productivity variance goes a long way in terms of accounting for the lion's
share of the variance. The thrust of the PPP analysis is that when long run
price level differences are consequential, the differences are attributable to
the level of economic development, not traditional trade frictions.
The table turns
dramatically in favor of borders and trade costs and away from wages and retail
productivity, as explanatory factors, when the focus is LOP deviations. Pooling
all international city pairs, the explanatory power of the HBS theory (wage
dispersion) falls by a factor of three, to about 32%. Traditional theories of
trade that emphasis distance and borders now account for the lion's share of
price disperison, about 41%. City effects account for almost none of the
international LOP variation. Essentially, this is because international LOP
deviations are both large and idiosyncratic to the good once we condition on
the wage level. The remainder is a residual term, which may reflect good and
location-specific markups as well as other variables omitted from the model. The following figure shows how this decomposition changes across goods, where the vertical axis shows the deviations from LOP, while the horizontal axis shows the distribution share of goods.
The corresponding paper by Mario J. Crucini and Hakan Yilmazkuday has been published at Journal of Monetary Economics.