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If we abolished the penny would prices go up or down?
I should have known you were going to ask.
I will bet on up. Remember when Western Europe moved to the Euro? A disproportionate share of retail prices went up, leading to the designation "the Teuro." ("Teuer" means "expensive" in German.) It seems that retailers had wanted to increase their prices in the first place, but were afraid of irritating their loyal customers. The regearing of the monetary unit gave an "excuse" for price increases plus not everyone noticed the higher prices in the new monetary unit. I predict similar results, albeit smaller ones in absolute terms, from abolishing the penny.
How bad an outcome would this be? Ironically it was Greg Mankiw who wrote of excessively high prices, by a small degree, leading to large welfare costs for the economy as a whole. But this model may not apply to abolition of the penny.
Under one scenario, prices go up but they would have gone up sooner or later anyway. Within a year or two, inflation has caught up with the price increase. In the long run the whole thing is more or less a wash, although we do suffer from higher prices and higher deadweight loss for just a little while.
Under a second scenario, prices go up and remain at a permanently higher plateau. Future price decisions are taken from this new reference point. For this model to work, we must assume that price is a signal of quality and that the frame of reference for interpreting the meaning of a price is based upon an observed status quo. So the price boost comes, everyone assumes that is just how much food (or whatever) is now worth, and that is our new marker for judging future price movements. Keep in mind that these assumptions cannot be true globally (there cannot be Walrasian slack at every margin), but only have to be true across relatively small price increases (N.B.: many tricks lie in here, since the price increases will be large in percentage terms for some goods).
I would bet my money on the first scenario, as I assume Greg Mankiw would as well. If you believe in the second, you probably shouldn't want to abolish the penny.
You can modify these scenarios in many ways, including through the explicit recognition of option value. Do you know of any empirical tests on which model of prices is the better guess?
Posted by Tyler Cowen on June 6, 2006 at 03:24 AM in Economics | Permalink
Comments
There is apparently a psychological effect associated with having a price just below a dollar mark, e.g., $1.99 instead of $2.00. If so, this could mean abolishing the penny reduces some prices, because merchants are loath to jump above the dollar mark. Thus, $1.99 might drop to $1.95. On the other hand, if merchants bite the bullet and go above the dollar mark, they might be more willing to incur further price increases that don't suffer from the same discontinuity.
Posted by: Glen Whitman at Jun 6, 2006 5:22:07 AM
Umm, I'll just mention that here in Australia we have got rid of one and two cent coins quite a while ago
but we still pay $1.99 etc for items when we go shopping. The price of all the items you buy in a store
are added together and the final amount is rounded up to the nearest five cents. Or I think it's rounded
up. Maybe sometimes it's rounded down? I dunno. I've never bothered to check. Of course there could be
something about America that I'm unaware of which will prevent stores from doing this.
Posted by: Ronald Brak at Jun 6, 2006 6:00:51 AM
Great question! I've been wondering what the point of the penny is for a few years now, since inflation has left it all but useless.
Posted by: Christopher at Jun 6, 2006 6:20:01 AM
Australia rounds up if the sum ends at 5 or more and down otherwise...i think they moved to this system more than 10 years ago
Posted by: jck at Jun 6, 2006 6:20:45 AM
As far as I've understood, there is NO evidence that Euro would have led to general price increases. A few daily articles may have had their prices rounded upwards, and the tabloids made a big fuss about it, of course..
Posted by: Jaff at Jun 6, 2006 6:25:39 AM
Correction:rounding up or down works like this
$2.51 will be rounded down to $2.50
$2.52 will be rounded down to $2.50
$2.53 will be rounded up to $2.55
$2.54 will be rounded up to $2.55
$2.56 will be rounded down to $2.55
$2.57 will be rounded down to $2.55
$2.58 will be rounded up to $2.60
$2.59 will be rounded up to $2.60
Posted by: jck at Jun 6, 2006 6:40:24 AM
My solution: don't abolish the penny per se--just stop making pennies and don't tell anyone. Businesses will gradually shift to rounding to the nearest nickel. Probably no major effect on price levels.
Posted by: Eli at Jun 6, 2006 9:46:25 AM
You should check out the experience in Australia when they eliminated their one and two cent coins (in the early 90's if I remember correctly).
The goverment mandated that prices should be rounded to the nearest five cents - when paying in cash.
Vendors still price at the psychological points e.g. $1.99. If you are paying cash for one item at this price you pay $2.00. If you pay electronically you pay $1.99. But if you buy three items at this price for a total of $5.97 then you pay $5.95 with cash.
Posted by: Dan Hill at Jun 6, 2006 10:22:14 AM
Before we all go around assuming that prices actually did get higher with the introduction of the Euro, let's read this: http://fistfulofeuros.net/archives/cat_life.php
My guess is that prices will stay the same (except $1.99 things will go to $1.95 as noted by a commenter above) but everyone will THINK they went up.
Posted by: Foolish Jordan at Jun 6, 2006 10:23:25 AM
"Teuer"--surely the etymological antecedent for "dar" in the same usage. "Pa wanted to buy the horseshoes, but Ma said they were too dear." Cool.
Posted by: Anderson at Jun 6, 2006 11:48:23 AM
How about asking how the Fed would respond, and what would happen to the money supply.
Tom Mayer
Posted by: Thomas Mayer at Jun 6, 2006 1:25:08 PM
The Australian change happened in 1991. My guess is the same as yours, but certainly you don't notice anything in the effect in the inflation statistics.
Posted by: Andrew Leigh at Jun 6, 2006 8:57:09 PM
Let's get a jump on things and eliminate the nickel too.
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