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

• We investigate the implications of market friction and nominal rigidity on the behavior of intra-national relative prices.
• We use a panel of retail prices of 45 products for 48 U.S. cities over the period 1985–2009.
• We find that the effect of each type of friction on the dynamics of intercity price gaps is quite different.
• We also note that complementarities exist between market frictions and nominal rigidities.
• We provide an alternative theoretical explanation based on the state-dependent pricing (SDP) model of Dotsey et al. (1999).

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 U.S. cities over the period 1985–2009, 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 have a positive impact on volatility and persistence of intercity price dispersion, nominal rigidities have a positive impact on persistence but a negative impact on volatility. This empirical evidence is different from what is predicted by standard theoretical cross-country models based on price stickiness. Second, complementarities exist between market frictions and nominal rigidities such that the marginal effect of a market friction dwindles as nominal rigidities increase. 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 and market frictions can successfully explain the salient features of the dynamic behavior of intercity price differences that have not been captured in previous analysis.