From The Globe and Mail
Parity or not, Canadian shoppers are suckers
NEIL REYNOLDS
From Wednesday's Globe and Mail
October 3, 2007 at 6:01 AM EDT
OTTAWA — A decade ago, two U.S. economists published an intriguing Federal Reserve Board study of cross-border consumer prices and concluded that price differences between U.S. and Canadian cities defied rational explanation.
Charles Engel (University of Washington) and John Rogers (Federal Reserve) indeed found that these price differences - equivalent to the cost of shipping goods as much as 75,000 miles (120,700 kilometres) - disproved economic theory. They identified an inexplicable "border effect" that, if it exists, means that Canadians shouldn't hold their breath waiting for exchange-rate parity to reduce the price of goods that sell for much less throughout the United States.
Mr. Engel and Mr. Rogers examined the prices of 14 categories of goods in 14 U.S. cities and 10 Canadian cities, using prices from 1990 and from 1995 (before and after the North American free-trade agreement came into effect). They made the necessary adjustments for fluctuating exchange rates, for transportation costs, for labour costs, for tariffs and taxes. They controlled, in other words, for all the usual barriers to trade that influence retail prices.
"With few impediments to trade, goods should flow freely between countries, cities and provinces," they observed. "[Further], a fundamental proposition of economic theory is that identical goods should sell for the same price." They found, instead, that The Law of One Price did not apply across the U.S.-Canada border. They determined that price differences were "much greater" between a given U.S. city and a given Canadian city than they were between two U.S. cities or two Canadian cities equidistant apart. Using the most conservative assumptions, the divergence was equal to an extra 2,500 miles of transportation costs; using the least conservative assumptions, the divergence was equal to an extra 75,000 miles.
In their review of this mysterious "border effect," another two U.S. economists concluded earlier this year (with the Canadian dollar approaching parity with the U.S. dollar) that the Engel-Rogers conclusions may well have minimized the extent of the inexplicable divergences in U.S.-Canadian prices.
Yuriy Gorodnichenko and Linda Tesar (both from the University of Michigan) describe the phenomenon this way: "The magnitude is surprisingly large - some would say unbelievably large. Taken literally, it is odd that Canada and the U.S. can remain such important bilateral trading partners."
They looked at the prices of identical goods on each side of the border and accounted for all the possible costs, leaving the mysterious "border factor" as the only variable. On the U.S. side, this was the equivalent of the cost of shipping the goods an additional 47 kilometres. On the Canadian side, they found product prices were higher by the cost equivalent of shipping goods an additional 108 million kilometres - or 141 round trips to the moon. Unbelievable, indeed.
What's happening here? In what way can the U.S.-Canada border, all by itself, defy fundamental laws of economics? In its own analysis of this mystery, the Federal Reserve Bank of San Francisco decided that consumer prices are often set by factors that have little to do with actual cost - factors that operate independently of exchange rates.
In principle, the bank observed, retail prices of imported goods should simply reflect the cost of production multiplied by the appropriate exchange rate: "Suppose you were importing a car from South Korea. In a simple economic model, the U.S. price of the car would be the price expressed in Korean won [the Korean currency] multiplied by the dollar-won exchange rate. If the dollar depreciates against the won, then the cost of the car in dollars would increase."
In practice, however, the bank says, "final goods prices are not very sensitive to the exchange rate [and] consumer prices are much less sensitive to exchange rate prices than import prices." Thus, "national borders play a more important role than physical distances in explaining consumer prices."
(The bank observed that, in a globalized economy, distribution costs can be quite significant. It noted that Mattel buys a Barbie doll from a manufacturer in China for $2 [U.S.], sells it in the United States for $10 - but keeps only $1 for itself. The company spends $7 to get the doll to the store shelf where it will be sold.)
What explains the extraordinary divergence in retail prices between the U.S. and Canada? Put it down, in the end, to a deeply entrenched Canadian willingness to pay more for many goods than they are worth. Put it down to consumer laziness. Especially now, Canadians can pay much less by crossing the border or by ordering direct from the U.S. Most Canadians, though, won't.
Merchants will continue to price to the market - to charge what people will pay. This is why we will keep paying intergalactic prices - whether we have parity or beyond.
