The Role of Two Frictions in Geographic Price Dispersion: When Market Friction Meets Nominal Rigidity

Posted: 2 Feb 2016

See all articles by C. Y. Choi

C. Y. Choi

University of Texas at Arlington - College of Business Administration - Department of Economics

Horag Choi

Monash University, Economics Department

Date Written: December 17, 2015

Abstract

This paper empirically investigates and theoretically derives the implications of two frictions, market friction and nominal rigidity, on the dynamic properties of intra-national relative prices, with an emphasis on the interaction of the two frictions. By analyzing a panel of retail prices of 45 products for 48 U.S. cities over the period 1985-2009, we make two major arguments. First, the effect of each type of friction on the dynamics of intercity price gaps is quite different. While market frictions arising from physical distance and transportation costs have a positive impact on volatility and persistence of intercity price dispersion, nominal rigidities have a positive impact on persistence but a negative impact on volatility. This empirical evidence is different from what is predicted by standard theoretical cross-country models based on price stickiness. Second, complementarities exist between market frictions and nominal rigidities such that the marginal effect of a market friction dwindles as nominal rigidities increase. We provide an alternative theoretical explanation for this finding by extending the state-dependent pricing (SDP) model of Dotsey et al. (1999) and show that our two-city model with nominal rigidity and market frictions can successfully explain the salient features of the dynamic behavior of intercity price differences that have not been captured in previous analysis.

Keywords: Intercity price differences, Distance, Price stickiness, Persistence, Volatility, U.S. cities, State-dependent pricing

JEL Classification: E31, F45, L16, R12

Suggested Citation

Choi, Chi-Young and Choi, Horag, The Role of Two Frictions in Geographic Price Dispersion: When Market Friction Meets Nominal Rigidity (December 17, 2015). Journal of International Money and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2725584

Chi-Young Choi (Contact Author)

University of Texas at Arlington - College of Business Administration - Department of Economics ( email )

Box 19479 UTA
Arlington, TX 76019
United States

Horag Choi

Monash University, Economics Department ( email )

900 Dandenong Road
Caulfield East, Victoria 3145
Australia
+61-3-9903-2848 (Phone)

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