Why are Goods and Services more Expensive in Rich Countries? Demand Complementarities and Cross- Country Price Differences

Empirical studies show that tradable consumption goods are more expensive in rich countries. This paper proposes a simple yet novel explanation for this apparent failure of the law of one price: Consumers’ utility from tradable goods depends on their consumption of complementary goods and services. Monopolistically competitive firms charge higher prices in countries with more complementary goods and services because consumer demand is less elastic there. The paper embeds this explanation within a static Krugman (1980)-style model of international trade featuring differentiated tradable goods. Extended versions of the model can also account for the high prices of nontradable services in rich countries. The paper provides direct evidence in support of this new explanation. Using free-alongside-ship prices of U.S. and Chinese exports, I demonstrate that prices of specific subsets of tradable goods are higher in countries with high consumption of relevant complementary goods, conditional on per capita income and other country-level determinants of consumer goods prices. Acknowledgements: I am incredibly grateful to Alan Deardorff, Lutz Kilian, and Andrei Levchenko for their guidance and to Jagadeesh Sivadasan and Michael Olabisi for sharing the Chinese export data. Thanks also to Dan Ackerberg, Jonathan Eaton, Yuriy Gorodnichenko, Andrew McCallum, Ina Simonovska, Martin Strieborny, Lucia Tajoli, Alberto Trejos, Jing Zhang, and seminar participants at Michigan, Dartmouth, Virginia, Federal Reserve Board, Miami, UCSD, UBC, and Penn State for helpful comments and discussions. Contact Address: Darden School of Business, Charlottesville, VA 22906. Email: [email protected].