Varieties as a Source of Law of One Price Deviations

Abstract

We analyze a new mechanism for prices to deviate from the Law of One Price. If stores differ in the varieties offered in a given product category, prices diverge more often regardless of distance. A simple extension to the Hotelling (1929) explains this result. We test our prediction using a unique country-level detailed price database. To have one difference in variety in a product category between two stores increases price difference by 0.6–0.8%. The store characteristics explain nearly half of the effect, which partially account for the selection of varieties. This result is robust to several controls and alternative specifications and increases as the distance between stores decreases. We offer causal evidence of the varieties-to-prices channel by exploiting an exogenous shock to store demand that changes the relative number of varieties. The results of the causal effect are in line with the baseline estimations. Our results show that store decisions on variety selection could have a significant aggregate impact on prices volatility.