Price of variety
Consumers' unwillingness to do currency conversions is a good argument for the euro, writes Chris Giles
Published : Nov 20 2001 19:32:49 GMT | Last Updated : Nov 20 2001 23:10:37 GMT

 
We are unable to do basic maths. We find calculators perplexing. We give up easily. Companies exploit our weaknesses.

These rather depressing contentions underpin a powerful argument for the single european currency. In 41 days' time, euro notes and coins will enter circulation in the 12 eurozone countries. Cross-border price comparisons will become simple. Many euro advocates argue that this will enhance almost non-existent competition across national borders. Companies will be forced to "harmonise" prices - which here means to reduce them.

"Prices in the euro area will therefore be likely to move towards those seen in the most competitive regions," says Britain in Europe, the campaigning group.

The power of the argument rests on its clarity and its firm basis in economic theory. One of the first principles students learn is "the law of one price": if there are no impediments to trade, identical goods should sell for the same price throughout the world.

This law holds well in many markets - otherwise newspapers could not publish daily prices for many commodities, currencies and equities.

But retail goods markets are different: products are rarely identical; buyers have imperfect information about prices in different locations; tastes vary around the world; the costs of local inputs differ; and transport costs, taxes and trade barriers affect prices.

So much for the theory. In practice, euro notes and coins will lead to a significant realignment of European consumer prices only if two conditions are met. Imperfect information on price differences must be one of the most important reasons for divergences from the law of one price. And consumers must take advantage of easier price comparisons.

It will be a fascinating natural experiment over many years, allowing economists to test many aspects of the law of one price. But if the results are consistent with other recent studies, euro enthusiasts will be disappointed.

Though there are potential gains from the closer European integration of prices, the power of arbitrage to harmonise prices across borders seems to have been weak.

Cross-border price differences within Europe have existed for at least 700 years, according to research by Kenneth Froot and colleagues.* With remarkable dedication, they compiled annual domestic prices of seven commodities, including wheat, peas and butter, from England and Holland - in some cases stretching back to 1273.

In spite of much lower transport costs and fewer wars and plagues in modern times, price differences have persisted. And the relative price volatility of these basic commodities in the 20th century was remarkably similar to that in previous centuries. Arbitrage in food commodities between Holland and England seems to narrow price differentials only once deviations exceed 25 to 30 per cent.

By contrast, for consumer durables cost is important. For some expensive items, Europe shows similar rates of price convergence to the US. Pinelopi Goldberg of Yale University and Frank Verboven of the Catholic University of Leuven** find that differences in relative prices of new cars in Europe adjust quickly if, for example, exchange rates change. But they concede that absolute differences in new car prices persist for a long time. The same car tends to be 17 per cent dearer in Britain than in Belgium.

At the other end of the price scale, the law of one price seems to fail. Few shops sell goods as uniform as those in Ikea. But using data from Ikea catalogues in 25 countries between 1995 and 1998, Jonathan Haskel and Holger Wolf show that identical products typically sell at prices 20 to 50 per cent apart in different countries.***

Not only are the prices different between countries but the relative price of the same products also changes. In the Netherlands, the "Alg" mirror retails for the same price as the "Krabb" mirror. In Germany, the Alg mirror sells for less than half the Krabb's price. Differences in local distribution costs or taxes cannot be the explanation: consumer arbitrage simply is not strong enough to force convergence.

Even more extraordinary is that firms are able to sell the same goods in the same place at different prices without arbitrage forcing the prices to equalise. Marcus Asplund and Richard Friberg**** found a 4 per cent average price difference in cigarettes and alcohol sold in duty-free shops on Scandinavian ferries, depending on whether the items were purchased in Swedish kroner or Finnish markka. Exchange rates moved but the shops adjusted prices to exchange-rate movements only occasionally. Consumers could pay by credit card, so there was no extra hassle in choosing to pay using either currency. They did not.

It seems we are bad at basic maths and do not like doing currency conversions. But we are even more reluctant to go to much effort to save money. Companies are likely to maintain price differentials in Europe for some time.

*The law of one price over 700 years, K. Froot, M. Kim and K. Rogoff, July 2001;

** Market integration and convergence to the law of one price: evidence from the European car market, P. Goldberg and F. Verboven, August 2001;

*** The law of one price - a case study, J. Haskel and H. Wolf, February 2001;

**** The Law of One Price in Scandinavian Duty-Free Stores, Marcus Asplund and Richard Friberg, American Economic Review, September 2001

Contact Chris Giles