Inter-local price differences and (non)changes in exchange rates

ER z money units ($) Corresponding

sets of actions y money units

(£)

Final End x money units

($)

The content of the “Corresponding sets of actions”

P1(£) P2 ($)

z money units ($) sets of goods

+ production y money units

(£)

Figure 21: Price differentials and exchange rates, scenario number 2

The summary of the analysis could be found in the tables below:

Holders of dollars

Price Currency Type of change

Effect on the quantity of

$ demanded P1 £ increase decrease P1 £ decrease increase P2 $ increase increase P2 $ decrease decrease Holders of Pounds

Price Currency Type of change

Effect on the quantity of

$ demanded P3 $ increase decrease P3 $ decrease increase P4 £ increase increase P4 £ decrease decrease

Table 21: Price differentials and changes in quantities of pounds supplied and demanded, scenario number 2

purchasing power parity theory (PPP)³⁴. We would like to refer at this place to arguments based on the absolute version of the PPP theory, where comparison of absolute prices of two bundles of the same goods in two different countries is provided. Using the exchange rate, the price of one basket is transformed into units of the currency of the other basket and consequently total prices of these two baskets are compared. One might argue that if these absolute prices in different countries do not match each other, one currency is underpriced or overpriced in respect with the other³⁵. People from the overpriced country should correspondingly supply their currency at the foreign exchange market in order to buy underpriced goods.

This concept is directly related with our previous considerations on price differentials. Is not the message of the PPP theory directly related with the fact of existence of a price differential that is to be exploited by people making profit out of this type of transactions? Let us consider the case of individual goods, as the differences of prices of selected bundles are in the end created by differences in prices of individual types of goods.

If the price of a good in the dollar country sufficiently exceeds³⁶ its price in the pound country, is not there a reason for (at least some of) the people in the dollar country to purchase pounds and buy underpriced goods? Could not banana for 100$ in the dollar country compared to the 1£ banana in the pound country, the exchange rate being 1$/£, be a good reason for this type of transactions if all costs related with transportation amount to the equivalent of 10$? In case it is regarded as a good reason, the obvious result is increase in the quantity of pounds demanded at the given exchange rate.

Although sometimes people behave exactly in accordance with the scenario suggested in the paragraph above, we will be presently concerned with opposite cases – with cases where people persistently do not consider these price differentials to be relevant for their actions.

The reason is that some price differentials between physically same goods located in different places do not really represent price differentials. The reason is that location matters: location of goods might stand for the reason that, although being physically the same, they represent different goods in eyes of the people concerned. Mises points out this fact by contrasting

34 For detailed overview of PPP theories cf. Rogoff (1996) or Sarno and Taylor (2003, pp. 51 ff.).

35 In order to be realistic, one could adjust the necessary differential by transportation costs that are necessary in order to make use of arbitrage.

36 In the meaning that it allows for all costs related with transportation including interest and risk premiums.

money, that in his eyes tends to not to be much affected by its actual position in space due to the design of the banking system, and other goods, that are affected by the spatial position³⁷:

“The purchasing power of money is the same everywhere; only the commodities offered are not the same. They differ in a quality that is economically significant—the position in space of the place at which they are ready for consumption.” Mises (1971), p. 176 (emphasis in the original)

The reason why the position matters is two-fold. The first has already been mentioned – costs related with transportation³⁸. However, this effect – the fact that that the good to be transported is actually only a production factor in respect with the good in the place of the final consumption – often does not seem to explain the whole price differential. Here comes the second reason – the value of the specific position in space itself:

“[T]he Austrian insight regarding the influence of the spatial element on the quality of (non-monetary) goods does not merely embrace the pure distance between the location of the consumer and the location of the good, but also the consumer’s positive or negative psychic response to the very site of purchase or consumption. For example, even in equilibrium, the same brand of men’s shirt may simultaneously sell for different prices at a mall boutique and at a downtown clothing store, because, at the margin, consumers are prepared to offer a higher price for the shirt purchasable at the mall location, which is perceived to be more easily accessible and more pleasant.” Salerno (1994, pp. 251-252)³⁹

Space is scarce good. And it is often necessary a production factor for producing other goods.

As it is scarce, it also tends to limit the number of these other goods that could be potentially sold. Different position in space has different value for individuals – like in the “mall versus downtown” example. It is not of a much importance at this place why this is it so – whether because of proximity of additional services, reputation, or a nice view. The important fact is that it is so. As the space is scarce and the number of goods that could be provided is usually limited, higher demand for the good in the specific location could bring only higher price of the good in comparison with the price of the “same good” in other locations. However, it is the price of the package - “physical good in the specific position” and this, due to the scarcity, could not be arbitraged away by importation of the physically same goods from other

37 Cf. Mises (1971, pp. 170- 172).

38 “[T]wo economic goods, which are of similar constitution in all other respects, are not to be regarded as members of the same species if they are not both ready for consumption at the same place. For many purposes it seems more convenient to regard them as goods of different species related to one another as goods of higher and lower orders.” Mises (ibid., p. 170).

39 Cf. also Mises (1971, pp. 175-178).

locations. To talk about price differentials of the “same goods” in different locations that are supposed to bring about changes in related prices, including exchange rates if the locations in question are in two different currency areas, is meaningless. It is the same as to talk about price differential between a plum and a Mercedes. These are two different goods and no related actions of individuals could be deduced barely from their price differential.

We are now at the point to sum up the present section. Price differentials between costs of the production process and potential revenue of its outcome could play an important issue in explanation of exchange rates. However, one should be aware of all production factors that are to be involved in the production process. In the case where production represents transportation of “underpriced” good to a place where it is “overpriced”, one should not forget to include into the “costs of production” also purchase or renting of the spatial position as it might represent important production factor that matters.