THE IMPORTANCE OF TRADE COSTS IN DEVIATIONS FROM THE LAW‐OF‐ONE‐PRICE: ESTIMATES BASED ON THE DIRECTION OF TRADE

Abstract

The full impact of trade costs in segmenting product markets cannot be captured by considering aggregate prices or in the absence of information on the direction of trade. We address this problem by utilizing product‐specific prices, cross‐sectional productivity indices, and bilateral trade flows, allowing us to identify the probable source of any one product. We show that trade costs in the form of transportation and distribution costs are important in determining international price differences and segmenting international markets. Physical distance relative to the origin has a precisely estimated positive impact on international deviations from the Law‐of‐One‐Price that is larger than estimates that do not account for the origin of each product. Based on our benchmark estimates, the price elasticity of distance was around 10% in 1990. (JEL F4)