The role of two frictions in geographic price dispersion: when market friction meets nominal rigidity

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 cities in the U.S., 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 contribute significantly to volatile and persistent movements of intercity price disparities, nominal rigidity is associated with higher persistence, but not with a greater volatility of the intercity price disparity. This empirical evidence is different from what is predicted by standard theoretical models based on price stickiness. Second, the strength of the marginal effect of a market friction hinges on the extent of nominal rigidity, in a counteracting manner. The marginal effect of a market friction dwindles as the extent of price stickiness increases. 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 andd market frictions can successfully explain the salient features of the dynamic behavior of intercity price differences.