This paper applies the recently developed econometric methods of panel unit root tests and nonlinear mean reversion to investigate price convergence in China--the largest transitional economy in the world. We find that prices did converge to the law of one price in China for an overwhelming majority of goods and services, based on a large panel data set. The finding sheds light on the extent of the market economy in China, and casts doubt on Young's proposition that the economic reform has led to the fragmentation of Chinese domestic markets.
We are indebted to the late Professor Herschel I. Grossman for inspiration. We are grateful to Dani Rodrik and two anonymous referees for constructive comments and suggestions, which improved the paper significantly. We would like to thank Stefan Gerlach, John Wong, Wing Thye Woo, and Geng Xiao for comments, and particularly Marco Liu, Gary Wong, and Zuo Zhi for excellent research assistance. We also thank Alwyn Young for making a part of the data used in this paper available through his Web page. The financial support from the Hong Kong Research Grant Council Competitive Earmarked Grant (LU3112/03H) and Lingnan University Direct Allocation Grant (DS03A1) is gratefully acknowledged. Any remaining errors are our own.