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News Release

World Economy Could Gain $600 Billion from Reducing Global Price Differences

February 26, 2002

Contact:    Gary Clyde Hufbauer    (202) 328-9000

Washington, DC—Budget-minded retirees quickly discover that monthly living costs are a lot lower in Phoenix than San Diego. World travelers are shocked by the price of a cup of coffee in Tokyo. These commonplace observations have not escaped the notice of scholars, and many economists have studied why prices differ so greatly between cities. They consistently find that the "law of one price", despite its compelling logic, seldom describes the real world.

The world economy could gain $600 billion in annual income if price differences across the globe could be reduced to the level of differences that now exists within the United States, according to a speculative new study by the Institute. The poorest countries would experience a 20 percent rise in their standards of living, the longest relative gain of any grouping. These gains could be achieved by further reductions of trade and investment barriers, reforms of internal policy distribution, and continued exploitation of declines in global transportation and communication costs.

It is fascinating to explore why this basic economic paradigm is so widely violated. The new Institute study by Senior Fellow Gary Clyde Hufbauer, Visiting Fellow Erika Wada and Tony Warren of the Australian National University, however, focuses on "what if" rather than "why" questions. What if the forces of globalization could compress the enormous extent of price divergence that now characterizes the world economy? Econometric evidence suggests that economic integration—compelled by the force of free markets—can bring about a considerable degree of price convergence. Prompted by this evidence, the authors carry out speculative calculations, illustrating the benefits that might accrue if policy liberalization and e-commerce reduce the barriers that separate economies from one another.

Traditional approaches to quantifying the benefits of economic integration start with estimates of induced trade and investment volumes, and induced changes in productivity, that result when trade and investment barriers are lowered (tariffs, quotas, restricted sectors). Traditional approaches then use various models—macroeconomic models, computable general equilibrium models, and partial equilibrium models—to translate changes in trade and investment volumes, and higher productivity, into calculated economic benefits. Based on these approaches, scholars almost always conclude that when a country chooses to reduce its barriers, it will enjoy a higher level of income.

This new study from the Institute complements traditional approaches. The authors start by quantifying the possible extent of price convergence that might emerge in a world economy free of trade and investment barriers. Then, using a simple supply and demand model, they calculate the possible economic gains to each country. While the calculations are speculative, the authors view their work as a first step in using detailed price data to analyze the potential benefits of freer trade and investment.

The potential gains from the integration of world markets, calculated from the compression of price divergence, are very large. The finding that nations can benefit from closer economic integration is not new, but these calculations portray a familiar result in a new light.

The central calculation made by the authors postulates that, with sustained policy liberalization, the world economy will eventually attain the same degree of competition, market integration, and hence price convergence as now exists within the United States. This is not the same as assuming that the law of one price will eventually characterize the world economy, for (as the authors and others document) there is a great deal of persistent price divergence between US cities. However, price divergence within the United States, while large, is considerably less than price divergence between cities in different countries. Using simple partial equilibrium analysis, the authors calculate the benefits from narrowing the enormous range of worldwide price dispersion to the range now observed in the United States.

These calculations suggest large potential gains: 2.1 percent of global GDP or $0.6 trillion per year (see table 1). Low-income and middle-income countries have the most to gain (as a percent of GDP) from price convergence. The authors' calculations suggest that the total potential benefits for high-income countries are 0.6 percent of their GDP; for middle-income countries, 3.8 percent of GDP; and for low-income countries, 19.4 percent of their GDP.

Since exchange rates for the currencies of most low-income and middle-income countries are significantly and persistently undervalued from their purchasing power parity (PPP) exchange rates, it may appear that the gains presented in the study are nothing more than a reflection of the gap between market exchange rates and PPP exchange rates. On the contrary, the authors show that if market exchange rates were suddenly transformed into their PPP levels, the benefits from subsequent price convergence would be still larger than the benefits calculated starting with market exchange rates.

The authors emphasize that price convergence for low-income and middle-income countries cannot occur in isolation from substantial economic development. Policy liberalization and price convergence, working in tandem, will force the reallocation of resources among economic sectors and a reorganization of markets towards more competition. Huge infrastructure investments—roads, airports, and much else—will be necessary to accommodate the large expansion of trade volumes. These changes will take time, perhaps decades. At the end of the process, however, low-income and middle-income countries will become far more powerful competitors in world markets than they are today.

Policymakers might ask, "OK, we see the potential benefits, but what can we do to accelerate price convergence beyond pushing the development plans we already have on the drawing board?" Rough estimates made by the authors show that openness, distance, and income levels are all significant in determining the extent of price divergence. Of most interest in the policy context is the openness index—an index that reflects core policy decisions. The components are tariff rates (reflecting trade policy), inflation rates (reflecting monetary policy), and black market activity (reflecting governance). When a country improves its performance on these indicators, it can achieve a substantial degree of price convergence. In other words, countries that slash their trade and investment barriers, practice monetary discipline, and reduce the corruption that erupts in black market activity can achieve a substantial fraction of the benefits described in this study.

Follow-up work by one of the authors (Erika Wada), not published in this study, reinforces the case for policy reform. In her ongoing research, Wada addresses the "why" question: why are prices so different among different cities in the world? Her preliminary results show that volatile exchange rates, distance, and bigger differences in country size and per capita incomes, serve to widen price divergences between country pairs. On the other hand, liberal economic policies—such as free trade agreements, low trade and investment barriers, monetary discipline, and sound regulatory frameworks, work to narrow price divergences between country pairs.

Combining the speculative calculations in this study with Wada's preliminary results suggests that the potential gains from further economic integration are huge, and that a substantial portion of the potential gains can be attained through better public policy.

About the Authors

Gary Clyde Hufbauer, Reginald Jones Senior Fellow, was formerly the Marcus Wallenberg Professor of International Finance Diplomacy at Georgetown University (1985-92); deputy director of the International Law Institute at Georgetown University (1979-81); deputy assistant secretary for international trade and investment policy of the US Treasury (1977-79); and director of the International Tax Staff at the Treasury (1974-76). He is the author of Fundamental Tax Reform and Border Tax Adjustments (1996) and US Taxation of International Income (1992), coauthor of World Capital Markets: Challenge to the G-10 (2001) and NAFTA and the Environment: Seven Years Later (2000), and coeditor of The Ex-Im Bank in the 21st Century: A New Approach? (2001) and Unfinished Business: Telecommunications after the Uruguay Round (1997).

Erika Wada, visiting fellow, is a Ph.D. candidate at Michigan State University.

Tony Warren is a principal at Network Economics Consulting Group, where he provides economic and regulatory advice on a range of economic issues to regulators and major telecommunications and transport companies in Australia, New Zealand, and South East Asia. He is also an associate at the Australia-Japan Research Centre at the Australian National University. He is the coeditor of Measuring Impediments to Trade in Services (Routledge, 2000).

About the Institute

The Institute for International Economics, whose Director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. Its staff of about 50 focus on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and cover all key regions—especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site. In 2001, it celebrated its twentieth anniversary and moved into its new headquarters at 1750 Massachusetts Avenue, NW. The Institute has recently helped create the Center for Global Development, an independent but closely affiliated institution that will address poverty issues in the developing countries and policies toward them in the United States and other industrial nations.