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Car prices in Europe are characterized by large and persistent differences across countries. The purpose of this paper is to document and explain this price dispersion. Using a panel data set extending from 1980 to 1993, we first demonstrate two main facts concerning car prices in Europe: (1) The existence of significant differences in quality adjusted prices across countries, with Italy and the U.K. systematically representing the most expensive markets. (2) Substantial year-to-year volatility that is to a large extent accounted for by exchange rate fluctuations and the incomplete response of local currency prices to these fluctuations. These facts are analysed within the framework of a multiproduct oligopoly model with product differentiation. The model identifies three potential sources for the international price differences: price elasticities generating differences in markups, costs, and import quota constraints. Local currency price stability can be attributed either to the presence of a local component in marginal costs, or to markup adjustment that is correlated with exchange rate volatility; the latter requires that the perceived elasticity of demand is increasing in price. We find that the primary reason for the higher prices in Italy is the existence of a strong bias for domestic brancs that generates high markups for the domestic firm (Fiat). In the U.K. higher prices are mainly attributed to better equipped cars and/or differences in the dealer discount practices. The import quota constraints are found to have a significant impact on Japanese car prices in Italy, France and the U.K. With respect to local currency price stability, a large percentage of the documented price inertia can be attributed to local costs, and a smaller fraction to markup adjustment that is indicative of price discrimination. Based on these results we conjecture that the EMU will substantially reduce the year-to-year volatility observed in the car price data, but without further measures to increase European integration, it will not completely eliminate existing cross-country price differences.
Goldberg et al. (Mon,) studied this question.