How and why prices differ across eight Texas cities?

Michele Ca’Zorzi, Alexander Chudik and Chi-Young Choi of Dallas Fed have an interesting research on the topic.

They first show how prices differ across eight Texas cities and then look at reasons for the same:

What an item costs in various geographic locations has attracted economists’ attention for decades. One theory—the law of one price— states that the same good should cost the same across different geographic locations. Any departure from a common price should be short-lived. This theory is typically refuted empirically when it comes to markets for consumer goods and services; overwhelming evidence suggests that price differences can persist for long periods. 

Texas provides an interesting location to view how this price mechanism works. Drawing on data for eight cities from 1985 to 2009 collected by the American Chamber of Commerce Researchers Association, it appears that the degree of price dispersion among metropolitan areas has increased over time. Moreover, the magnitude of price differences varies across the types of goods or services, and Dallas is the most expensive city in the sample.

The dataset allows us also to investigate whether the “strong” or “weak” form of the law of one price holds. The strong version clearly fails for Texas cities, since the prices of the same product differ considerably; however, the weak version holds. It postulates that the relative price—the price of a given good in one  city—should revert to some mean or normal level over time.

This mean level could differ from an identical price because of structural factors, such as differences in the scarcity ofland or in income levels. It helps to justify why goods and especially services are more expensive in some locations.

Analysis of the Texas city data suggests that relative prices for all the product categories rapidly revert to their mean. The speed of such convergence of relative prices may be explained by the nature of products (goods that are easily traded and more homogenous converge faster) and by geographic distance.

Interesting way to look at law of one price..

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