Productivity and Prices in Europe: Micro-evidence for the period 1975 to 1990

In the absense of free trade, domestic productivity will be a major determinant of prices. I consider an empirical framework where an industry’s R&D determines its productivity. Using repeated cross-sections of absolute prices of individual goods across European countries, I find that products of an industry tend to be cheaper in countries with higher stocks of R&D in that industry. I proceed to consider a model with two sectors: a non-R&D-performing service sector and a manufacturing sector whose R&D expenditures lead to productivity gains. Here, higher productivity for the R&D-intensive sector is associated with lower prices of manufactures and a higher price ratio of services to manufactures for the country. Indeed, the data shows that high productivity countries have lower prices for manufactures and, implicitly, higher services to manufactures price ratios. This implies that the overall price level will be lower in the more productive country as long as the size of the productive sector is sufficiently large.