When the law of one price is violated it can be difficult to determine a product’s contribution to the CPI. Does a low price competitor discount also on quality, or are market frictions at play? This column examines key product characteristics to separately identify these effects. Chinese firms discount both on price and quality, while Taiwanese firms use their productivity advantage to dynamically take advantage of market frictions.

China’s integration into world markets over the past 35 years has been dramatic both in pace and scope. An important aspect of this growth has been China’s expansion into relatively sophisticated product categories (Rodrik 2006, Schott 2008). In such cases one wonders whether the lower prices offered by Chinese firms reflect true discounts, or rather lower product quality (Schott 2008).

This question of how to identify quality differences in international markets is the latest manifestation of a long-standing challenge concerning how to interpret price dispersion across suppliers. The U.S. Bureau of Labor Statistics International Price Program generally resolves this by assuming that a low price charged by a new supplier must compensate for lower quality of the item or an inferior overall “shopping experience”.¹Â Otherwise, according to this reasoning, higher-priced competing suppliers could not sustain market share. Therefore, price reductions associated with entry are typically not incorporated into the price index.²

Although quality differences surely exist, price measures should also account for real price dispersion that can arise if arbitrage is impeded. To this end, our research illustrates a new way to identify real price dispersion when there are differences across suppliers in both product attributes and the quality of service (Byrne, Kovak, and Michaels 2013). We find that real price dispersion is substantial in the market we study. Critically, failing to account for its presence can skew official measures of inflation: omitting price declines due to the entry of lower-priced suppliers results in an upward biased price index. In turn, growth in real imported inputs will be understated and as a result, the growth of productivity – how much is made per unit input – will be overstated (Houseman, Kurz, Lengermann, and Mandel 2011).

Contract semiconductor wafer manufacturing

We focus on the market for semiconductor wafers, which contain the integrated circuits used in modern electronics. This market has played an outsized role in aggregate labor productivity growth (Byrne, Oliner, and Sichel 2013). Our data cover arms-length transactions, in which contract manufacturers of semiconductor wafers implement the designs of “factoryless” firms specialising in design and marketing.³Â Â This pattern of vertical specialisation has grown substantially in the semiconductor industry, paralleling its growth throughout manufacturing (Bayard, Byrne, and Smith 2013, Bernard and Fort 2013).