How Far Can We Push the "Law of One Price"?

Students exposed to the pure theory of international trade have been seduced by visions of an imaginary world with few goods, each typically produced by several countries but nevertheless homogeneous. In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage insures that each good is uniformly priced (in common currency units) throughout the world-the "law of one price" prevails. In reality the law of one price is flagrantly and systematically violated by ernpirical data. This paper presents evidence that exchange rate changes substantially alter the relative dollar-equivalent prices of the most narrowly defined domestic and foreign manufactured goods for which prices can readily be matched. Moreover, these relative price effects seem to persist for at least several years and cannot be shrugged off as transitory. In other words, for manufactured goods selected from the most disaggregated commodity lists for which U.S. and foreign prices can be matched, the products of different countries exhibit relative price behavior which marks them as differentiated products, rather than nearperfect substitutes. To clarify discussion it is useful to distinguish two contexts in which the law of one price is valid from a third context in which the law of one price does not hold. First, in a comparison of U.S., European, and Japanese prices of various well-defined steel items (plate, galvanized sheet, coldrolled sheet, and hot-rolled sheet) c.i. f. for delivery in a common port, Laurence Rosenberg found that relative dollar prices charged by different countries were fairly constant over time and were not significantly affected by exchange rate realignments. The dollar prices of primary commodities are also generally considered to be fairly independent of country of origin. ' These are cases in which the products of different countries are close to identical, or near-perfect substitutes, so that any price disparities would be rapidly eliminated by commodity arbitrage. Second, in the absence of restrictions on commodity arbitrage, a product of any single country sold competitively in two different markets (foreign or domestic) would also obey the law of one price in the sense that its dollarequivalent prices in the two markets could not differ by more than the cost of transportation between these markets. Many U.S. manufactured goods do not have near-perfect substitutes on the lists of products manufactured abroad, however, and in this third context the law of one price is denied as an empirical proposition. Agricultural tilling machinery produced in the United States, for example, is apparently not a close substitute for agricultural tilling machinery produced in Germany. More generally, the most disaggregated groupings of manufactured goods for which both U.S. and German prices are readily available are dominated by products for which German dollar price indexes diverge over time from U.S. dollar price indexes2 in a manner that is strongly correlated with exchange rate movements. This divergence is evident in comparisons of U.S. wholesale transactions prices and German export transactions prices for various 2and 3-digit sectors of the WPI industry breakdown (Section I),