Why are Goods and Services more Expensive in Rich Countries?

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 account for the high prices of services in rich countries, as well as for several stylized facts regarding investment rates and relative prices of investment and consumption across countries. Acknowledgements: Thanks to Alan Deardorff, Lutz Kilian, Andrei Levchenko, and seminar participants at the University of Michigan International/Macro Lunch for helpful comments and discussions. Contact Address: Department of Economics, University of Michigan, 611 Tappan St., An Arbor, MI 48104. Email: [email protected].