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Deviations from the Law of One Price : Sources and Welfare Costs

We explore failures of the law of one price across European cities, attempting to move beyond a “first-generation” of papers that document very large border effects. We document two very distinct types of border effects embedded in relative prices. The first is a “real barriers effect”, caused by various barriers to trade. The second is a sticky-consumer-price cum volatile exchange-rate effect. Both are shown to be important empirically, the second type especially so. For the first type of effect, the larger is the border effect the larger is the deadweight welfare loss. But for the second type of effect the issue is not so clear. While the existence of a border effect of the second type does imply economic distortions, it is not necessarily true, comparing two border effects across two pairs of countries, that a larger border effect of this type implies a larger deadweight welfare loss. First Draft: June 3, 1999 This Draft: July 29, 1999 Charles Engel Department of Economics University of Washington Seattle, WA 98195-3330 E-mail: cmengel@u.washington.edu John H. Rogers International Finance Division Stop 22 Board of Governors of the Federal Reserve System Washington, DC 20551 E-mail: john.h.rogers@frb.gov