If we abolished the penny would prices go up or down?

by on June 6, 2006 at 3:24 am in Economics | Permalink

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?

1 Glen Whitman June 6, 2006 at 5:22 am

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.

2 Christopher June 6, 2006 at 6:20 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.

3 Jaff June 6, 2006 at 6:25 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..

4 Eli June 6, 2006 at 9:46 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.

5 Foolish Jordan June 6, 2006 at 10:23 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.

6 Thomas Mayer June 6, 2006 at 1:25 pm

How about asking how the Fed would respond, and what would happen to the money supply.

Tom Mayer

7 Anonymous June 7, 2006 at 1:01 am

Let’s get a jump on things and eliminate the nickel too.

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