Error of Omission


Leigh Caldwell identifies a (rather embarassing) error of omission on my part in the comments of my recent post about Paul Krugman’s NYT column (and just to rub it in, on his blog as well ;]).

Niklas says this violates the law of one price – but the law of one price applies only when there is one good. In fact, hardly any goods are the same between Germany and Greece – labour is not as productive in Greece, the local tastes are for different products, and many services are non-tradable and not subject to the law of one price. An important example of this is that retailing is a service. Both the cost of retailing and the demand for it (which in Greece is strongly derived from tourism) affect the price of goods sold in shops. So the existence of the euro doesn’t by itself imply that wages and prices should equalise quickly.

I apologize. What I should have said is that the “law” of one price suggests price convergence for identical goods in the absence of transaction costs. Or to be more clear, all discrepancies in prices should be attributable to various transaction costs.

Leigh also brings into consideration the Balassa-Samuelson effect, which states that consumer price levels are systematically higher in wealthier countries due to productivity growth rates in the traded goods sector being higher than other sectors. If, in fact, Greece deals primarily in non-traded goods (goods which have to be delivered at the point of origin — like haircuts), then of course the law of one price would not be applicable.

I have one question, probably originating from my (mis)understanding of the B-S effect. In a demand-side model of the B-S effect, consumer prices are de facto a function of the level of NGDP of a particular economy, and the reason they differ is because economies have differing levels of NGDP. In this type of model, a consumer could get a hair cut in a poorer part of town cheaper than in a rich part of town (minus transaction costs like transportation) due to the differing levels of nominal income between. But it is also potentially true that the same consumer could get a traded good for cheaper in a poorer part of town, as well. So what does the “law” of one price really tell us? That search costs are too high to overcome? That advertisers are missing something big?

More broadly, is the law of one price simply a story macroeconomists tell eachother to justify not making the big bucks in finance: where they would spend all of their time attempting to disprove the law of one price? It seems to me that there are fairly specific conditions that are almost never met for the “law” to hold. I know Leigh (who is a behavioral economist) is pretty skeptical about the concepts of perfect rationality and perfect competition…

In any case, I do thank him for linking to the Greek productivity article. Maybe I shouldn’t agree with Krugman (or at least whole heartedly)?

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