Varieties as a Source of Law of One Price Deviations

We offer a new mechanism for prices to deviate from the Law of One Price. If stores differ in the varieties offered in a given product category, prices diverge more often regardless of distance. A simple extension to the Hotelling (1929) explains this result. To have one difference in variety in a product category between two stores increases price difference by 0.6-0.8%. Nearly half of the effect is explained by store characteristics. The effect is robust to several controls and alternative specifications and increases as the distance between stores decreases. We offer causal evidence of the varieties-to-prices channel by exploiting an exogenous shock to store demand that change that resulted in a change in the relative number of varieties. The results of the causal effect are in line with the baseline estimations. Our results show that within-store decisions on variety selection could have a large aggregate impact on prices’ volatility