The Balassa-Samuelson Effect and Pricing-to-Market: The Role of Strategic Complementarity

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1 The Balassa-Samuelso Effect ad Pricig-to-Market: The Role of Strategic Complemetarity Eddy Bekkers Uiversity of Ber Ia Simoovska Uiversity of Califoria, Davis ad NBER We propose a ovel determiat of prices of tradable goods: the iteractio of the Balassa- Samuelso BS effect with strategic complemetarities betwee prices of tradables ad otradables. A larger differece i productivity ad i capital itesity betwee tradables ad o-tradables yields a BS effect ad therefore a icrease i the price of o-tradables. With strategic complemetarities, producers of traded goods set higher prices as well. If a small ope ecoomy, populated by cosumers with liear quadratic demad ad firms that eoy market power, becomes richer, ad therefore displays stroger BS effects, it also eoys a higher price of tradable goods. Keywords: strategic complemetarity, relative prices, tradables, o-tradables, Balassa-Samuelso effect JEL codes: F12, F14 pritdate: September 10, 2014 We thak Robert Feestra for his commets ad suggestios. Correspodig author: Ia Simoovska, Departmet of Ecoomics, Uiversity of Califoria, Davis, Oe Shields Aveue, Davis, CA, iasimoovska@ucdavis.edu. Co-author: Eddy Bekkers, Uiversity of Ber, World Trade Istitute, Hallerstrasse 6, 3012 Ber, Switzerlad,. eddy.bekkers@wti.org.

2 The Balassa-Samuelso Effect ad Pricig-to-Market: The Role of Strategic Complemetarity ABSTRACT: We propose a ovel determiat of prices of tradable goods: the iteractio of the Balassa-Samuelso BS effect with strategic complemetarities betwee prices of tradables ad o-tradables. A larger differece i productivity ad i capital itesity betwee tradables ad o-tradables yields a BS effect ad therefore a icrease i the price of o-tradables. With strategic complemetarities, producers of traded goods set higher prices as well. If a small ope ecoomy, populated by cosumers with liear quadratic demad ad firms that eoy market power, becomes richer, ad therefore displays stroger BS effects, it also eoys a higher price of tradable goods. keywords: strategic complemetarity, relative prices, tradables, o-tradables, Balassa- Samuelso effect JEL codes: F12, F14. 1 Itroductio Prices of tradable ad o-tradable cosumptio goods ad services are higher i coutries that are richer i per-capita terms Alessadria ad Kaboski The literature argues that o-tradables are more expesive i richer coutries due to Balassa-Samuelso BS effects ad attributes the higher prices of tradable retail goods to local cost compoets such as distributio costs, rets, ad wages Burstei et al ad Crucii ad Yilmazkuday However, Simoovska 2010 shows that eve idetical tradables, like apparel, purchased via the Iteret, rather tha i physical outlets, are priced higher i richer destiatios, after accoutig for shippig ad hadlig costs, which suggests that variable mark-ups are a importat source of differeces i prices of tradables across coutries. The author attributes the observatio for the apparel idustry to price discrimiatio by moopolistically-competitive firms who serve cosumers with o-homothetic prefereces. 1 While the assumptio of moopolistic competitio is reasoable for the apparel idustry, which exhibits the third lowest cocetratio ratio withi maufacturig, may sectors that produce cosumer goods ex. furiture, food processig, computer ad electroic equipmet, ad appliaces are at least twice as cocetrated, suggestig that a more appropriate modelig tool may ivolve a small umber of firms. 2 I this paper, we examie the implicatios of BS effects higher productivity growth ad a lower labor itesity i tradables relative to o-tradables o prices of tradables whe prices 1 Simoovska 2010 ad Bekkers et al argue that o-costat expediture shares yield varyig price elasticities of demad, ad therefore prices, for a give positively-cosumed variety across destiatios populated by cosumers with o-homothetic prefereces ad differet icome levels. Alteratively, price elasticities may be lower i higher-icome coutries because richer agets are more fiicky to cosume their ideal variety Hummels ad Lugovskyy 2009 or they are less willig to search for low-priced goods Alessadria ad Kaboski Data source: Ecoomic Cesus of the Uited States for year 2007.

3 of the two types of goods are strategic complemets. We develop a small ope ecoomy model where agets with quasiliear prefereces cosume two types of goods produced by a small umber of firms egaged i Bertrad competitio. A stroger BS effect raises the price of o-tradables, while strategic complemetarities esure that the prices of tradables also rise. As the BS effect is positively liked with icome levels, this chael explais the higher traded goods prices i richer coutries. For example, BS effects geerate a higher price for diig ad babysittig services i richer coutries promptig cosumers to stay i. Cosequetly, the price sesitivity of demad for i-house goods like furiture ad electroics falls ad firms price these products higher there. Put simply, exporters set higher prices i richer destiatios because the overall price level is higher there. 3 2 Model Cosider a small ope ecoomy featurig cosumers with prefereces over m t differetiated tradables q t, m o-tradables q, ad a homogeeous tradable good qt 0, represeted by4 : U = q0 t m t + α q t + m q 12 γ m t m q t q m t q t + m q 1 Assumig that q0 t is positive,5 demad for homogeeous tradables q0 t ad differetiated tradables ad o-tradables qi l with prices pl i, l = t, is: q0 t = I mt p t q t m p q 2 m t qi l α = γ + m t + m 1 p t + m γ pl i + γ + m t + m γ p ; l = t, 3 The small ope ecoomy ad the rest of the world produce homogeeous ad differetiated tradables ad ship them without icurrig trade costs. 6 No-tradables ca oly be sourced 3 Murphy 2014 explais the positive lik betwee prices of tradables ad icome via demad complemetarities positive cross-price elasticities of demad. I the model, lower prices of o-tradable catalyst goods raise both the demad for such goods as well as for tradable complemets, thus icreasig the price of the latter. Hece, his model has the opposite predictio about the lik betwee the prices of o-tradables ad icome tha ours. 4 See Melitz ad Ottaviao 2008 ad Ottaviao et al Requires I mt p t q t + m p q > 0. 6 A extesio with iceberg trade costs yields qualitatively idetical results. 2

4 from the home coutry, so trade costs are prohibitively high. From 3, the price elasticity of demad for a good of type l is: ε l i = p l i 1 γ+m t +m q l i ; l = t, 4 Homogeeous tradables q0 t are produced by idetical perfectly-competitive firms uder costat returs to scale. Differetiated tradables ad o-tradables are produced by a small umber of homogeeous firms uder costat returs to scale with productivity ϕ l ad costs of factor iput budles c l for goods of type l = t,. Profit maximizig firms use the markup pricig rule, p l i = εl i c l ε l i 1, which, from 4 implies: ϕ l p t = p i + γ + m t + m c t 2γ + 2 m t + m ϕ t c i ϕ i 5 I equatio 5 prices are strategic complemets. I respose to a icrease i the price p i set by a o-tradable producer i, tradables producer raises his price p t. The followig remarks o strategic complemetarity are useful. First, ote the formal defiitio of strategic complemetarity i Bulow et al. 1985: the cross-derivative of profits with respect to the ow price ad the price of a competitor is egative, 2 πip t t i,p < 0. This property holds i our model. p t i p Tirole 1988 shows that 2 πip t t i,p < 0 implies that prices set respod positively to each other, p t p i p t i p > 0. Secod, Bulow et al poit out that i a settig with price competitio, prices are strategic complemets if demad of firm i becomes more ielastic whe firm raises its price. From 3 ad 4, oe ca see that is the case for our demad system. A icrease i p raises demad for tradable i, q t i, i equatio 3 ad this reduces the price elasticity εt i i equatio 4. Third, prices are also strategic complemets uder other demad systems icludig CES with a small umber of firms see Tirole We work with quasi liear quadratic utility because it geerates closed-form solutios. Fourth, with our utility, strategic complemetarity is drive by the combiatio of p-substitutability ad subcovexity. A icrease i the price of o-tradables raises demad for tradables p-substitutability ad the icreased tradables sales reduce the price elasticity o tradables subcovexity leadig to a higher tradables price. 7 Droppig the firm idex i, we ca solve for the price p l from equatio 5 i combiatio 7 Derivatio available upo request. See Neary ad Mrazova 2013 for defiitio of subcovexity. 3

5 with markup pricig: 8 p l = αγ + γ+mt +m 2γ+2m t +m m t c t ϕ t 2γ + m t + m + m c + γ + m t + m c l 2γ + 2 m t + m ϕ l. 6 We model two compoets of the BS effect. The first is higher productivity growth i the tradable over the o-tradable sector, g t > g, where g l = ϕ l ad variables with a hat idicate relative chages, x = dx x. This assumptio is i lie with fidigs i Herredorf ad Valetiyi 2012 ad Alessadria ad Kaboski Herredorf ad Valetiyi 2012 show i a crosssectio of coutries that the correlatio betwee GDP per worker ad total factor productivity TFP i tradable sectors such as food, maufactured cosumptio, ad equipmet is 0.60, while the correlatio betwee GDP per worker ad productivity i o-tradable sectors such as services ad costructio is Hece, there is a positive correlatio betwee the per-worker GDP ad the relative productivity of tradables to o-tradables, suggestig that as coutries become richer, productivity grows faster for tradable tha o-tradable sectors. Alessadria ad Kaboski 2011 use US time-series data to documet that TFP growth has bee more tha twice as high i tradables tha i o-tradables betwee 1958 ad The secod compoet is higher labor itesity i producig o-tradables over tradables, λ > λ t, where λ l = wll, w ad r are respectively the wage ad the retal rate, ad K l ad L l the amout wl l +rk l of capital ad labour used i the productio of a good of type l. This assumptio is supported by Herredorf ad Valetiyi 2008, who fid that the labor icome share is higher i tradable over o-tradable sectors. To derive aalytical results, we assume that productivity growth ad labor itesity are equal for differetiated ad homogeeous tradables. With costless trade we ca ormalize the price of the homogeeous good at 1. The price of a iput budle for tradables is therefore c t r, w = ϕ t. The rate of retur o capital r is determied globally ad thus give for the small ope ecoomy. Wage growth is therefore give by ŵ = 1 λ t g t ad the implied chage of iput costs relative to productivity i o-tradables is ĉ r,w ϕ = λ λ t g t g. The relative chage i the price of tradables ad o-tradables follows by log differetiatig the pricig equatio i 8 Derivatio i Web Appedix. 9 Hsieh ad Kleow 2007 provide idirect evidece of the existece of a BS effect. The authors documet that the relative price of o-tradable to tradable cosumptio is higher i richer coutries, which potetially reflects productivity differeces betwee the two sectors. 4

6 6 ad substitutig the expressio for ĉ r,w ϕ : p t = p = γ+m t +m m c 2γ+2m t +m 2γ+m t +m p t γ+m t +m 2γ+m t +m m c 2γ+2m t +m p λ λ t gt g + 1 λ λ t gt g 7 8 Equatio 7 ca be summarized as follows: Propositio 1. The price of imported tradables is risig i with a larger productivity growth differetial betwee tradables ad o-tradables ad, ii with a larger relative labor itesity of o-tradables tha tradables. Larger costs to produce o-tradables as a result of the two compoets of the BS effect, the differece i productivity growth ad capital itesity betwee tradables ad o-tradables, lead to higher o-tradables prices. Because prices of tradables ad o-tradables are strategic complemets, prices of tradables are higher as well. 3 Cocludig Remarks We propose a ew mechaism to positively lik importers icome per capita ad prices of tradables the iteractio betwee the BS effect ad strategic complemetarity of prices of tradables ad o-tradables. We assume that productivity growth ad labor itesity are idetical for differetiated ad homogeeous tradables, which implies that the cost of iputs relative to productivity stays costat for differetiated tradables, eablig us to derive aalytical results. If istead productivity growth i differetiated tradables is smaller tha i homogeeous tradables, prices of tradables cotiue to rise uambiguously with the stregth of the BS effect. 10. Marti ad Mitra 2001 provide empirical evidece that supports the latter assumptio. They fid that productivity growth i agriculture i a large cross-sectio of coutries has sigificatly outpaced productivity growth i maufacturig. I additio, labor markets could be segmeted betwee differetiated ad homogeeous goods so that productivity i homogeeous goods is o loger determiig the price of iput budles. Numerical simulatios i Web Appedix show that, i this settig, a stroger BS effect raises the price 10 If the opposite is true, the effect is ambiguous. 5

7 of imported tradables. Future extesios iclude a geeral equilibrium multi-coutry versio of the model as well as edogeous tradability as i Bergi et al The richer framework ca be used to quatify the importace of the proposed mechaism i accoutig for the positive relatioship betwee per capita icome ad the price of tradables observed i the data. Refereces Alessadria, G. ad J. P. Kaboski 2011: Pricig-to-Market ad the Failure of Absolute PPP, America Ecoomic Joural: Macroecoomics, 3, Bekkers, E., J. Fracois, ad M. Machi 2012: Import Prices, Icome, ad Iequality, Europea Ecoomic Review, 56, Bergi, P. R., R. Glick, ad A. M. Taylor 2006: Productivity, tradability, ad the log-ru price puzzle, Joural of Moetary Ecoomics, 53, Bulow, J. I., J. D. Geaakoplos, ad P. D. Klemperer 1985: Multimarket Oligopoly: Strategic Substitutes ad Complemets, Joural of Political Ecoomy, 93, Burstei, A., J. Neves, ad S. Rebelo 2003: Distributio costs ad real exchage rate dyamics durig exchage-rate-based stabilizatios, Joural of Moetary Ecoomics, 50, Crucii, M. J. ad H. Yilmazkuday 2009: A Model of Iteratioal Cities: Implicatios for Real Exchage Rates, NBER Workig Papers 14834, Natioal Bureau of Ecoomic Research. Herredorf, B. ad A. Valetiyi 2008: Measurig Factor Icome Shares at the Sectoral Level, Review of Ecoomic Dyamics, 11, : Which Sectors Make Poor Coutries So Uproductive, Joural of the Europea Ecoomic Associatio, 10, Hsieh, C. ad P. Kleow 2007: Relative prices ad relative prosperity, America Ecoomic Review, 97, Hummels, D. ad V. Lugovskyy 2009: Iteratioal Pricig i a Geeralized Model of Ideal Variety, Joural of Moey, Credit ad Bakig, 41,

8 Marti, W. ad D. Mitra 2001: Productivity Growth ad Covergece i Agriculture versus Maufacturig, Ecoomic Developmet ad Cultural Chage. Melitz, M. ad G. Ottaviao 2008: Market Size, Trade, ad Productivity, Review of Ecoomic Studies, 75 1, Murphy, D. 2014: Demad Complemetarities ad Cross-Coutry Price Differeces, mimeo. Neary, P. ad M. Mrazova 2013: Not so demadig: Preferece structure, firm behavior, ad welfare, Ecoomics Series Workig Papers 691, Uiversity of Oxford, Departmet of Ecoomics. Ottaviao, G., T. Tabuchi, ad J.-F. Thisse 2002: Agglomeratio ad Trade Revisited, Iteratioal Ecoomic Review, 43, Simoovska, I. 2010: Icome Differeces ad Prices of Tradables, Workig Paper 16233, Natioal Bureau of Ecoomic Research. Tirole, J. 1988: The Theory of Idustrial Orgaizatio. 7

9 Web Appedix Derivatio Pricig Equatio To derive the pricig equatio i 6, we rely o firms markup pricig rules. The markup µ l i = εl i / ε l i 1 ca be calculated easily from the price elasticity i equatio 4 as: µ l i = p l i 2 γ+m t +m p l i 1 γ+m t +m αγ γ+m t +m + γ+m t +m m t p t + m p A.1 Substitutig the expressio for the markup µ l i i equatio A.1 ito the markup pricig equatio, p l i = µl i c l i ϕ l i, leads to the followig equatio: p l 2γ + 2 m t + m i γ + m t + m m t αγ + p t + m γ + m t + m p = γ + m t + m γ + m t + m c l i ϕ l i A.2 Combiig equatio A.2 with a idetical expressio for p l gives: p l 2γ + 2 m t + m i γ + m t + m γ + m t + m c l i γ + m t + m ϕ l i =p l 2γ + 2 m t + m γ + m t + m γ + m t + m c l γ + m t + m ϕ l A.3 Solvig equatio A.3 for p l leads to equatio 5 i the mai text. Fially, substitutig equatio 5 ito equatio A.2 leads to equatio 6 i the mai text. 11 Additioal Derivatios for Mai Model I this sectio we derive the expressio for demad i equatio 3 ad the pricig equatio i 6. We start with the first equatio. Maximizig utility i equatio 1 subect to the budget costrait mt p t qt + m p q + qt 0 = I ad the coditio that demad is positive for all goods geerates the followig Lagragia: L = q0 t m t + α q t + m q 12 γ m t m q t 2 + q m t q t + m m t λ p t q t + m p q + q0 t I + µ t 0C0 t + mt µ t q t + m µ C 11 Additioal derivatios available upo request. q 2 8

10 Maximizig leads to the followig Kuh-Tucker coditios: α γqi l m t q t + m q 1 λ + µ t 0 = 0 λp l i + µ l i = 0; l = T, NT We assume that cosumers have positive demad for all goods. This correspods to: λ = 1 p l i = α γqi l m t q t + m q q0 t = I mt p t q t + m p q > 0 A.4 A.5 A.6 Combiig equatio A.5 with a similar expressio for firm gives: q l = pl i pl γ + q l i A.7 Summig demad i equatio A.7 over all tradables ad o-tradables gives: m t q t + m q = mt p l i p t + qi l + m p l i p + qi l A.8 γ γ m t q t + m q = mt + m p l i 1 m t p t + m p + m t + m qi l A.9 γ γ Substitutig equatio A.9 ito equatio A.5 gives: p l i = α γqi l m t + m p l i 1 m t p t + m γ γ p + m t + m q l i A.10 Solvig for q l m leads to: q l i γ + m t + m = α m t + m + γ p l i + γ γ m t p t + m p qi l α = γ + m t + m 1 1 m t γ pl i + γ + m t + m p t + m γ p A.11 9

11 Next, we derive the pricig equatio i 6. Substitutig equatio 5 ito equatio A.2, both for p t ad p as a fuctio of pl i, leads to: p l 2γ + 2 m t + m i γ + m t + m = αγ + mt αγ + m p l i + γ+mt +m c t 2γ+2m t +m cl ϕ t i ϕ l i γ + m t + m p l i + γ+mt +m 2γ+2m t +m γ + m t + m c cl i ϕ l i + + γ + m t + m γ + m t + m c l i ϕ l i Solvig for p l i ad rearragig leads to equatio 6 i the mai text: p l 2γ + m t + m i γ + m t + m m t αγ + γ+mt +m 2γ+2m t +m = γ + m t + m γ + m t + m + γ + m t + m 1 c t ϕ t + m c m t + m 2γ + 2 m t + m c l i ϕ l i p l i = + αγ + γ+mt +m 2γ+2m t +m m t c t ϕ t 2γ + m t + m γ + m t + m 2γ + m t + m + m c 2γ + m t + m 2γ + 2 m t + m c l i ϕ l i p l i = αγ + γ+mt +m 2γ+2m t +m m t c t ϕ t 2γ + m t + m + m c + γ + m t + m c l i 2γ + 2 m t + m ϕ l i 10

12 Exteded Model Differetial Productivity Growth We first work out the case with differetial productivity growth i homogeeous ad differetiated tradables, still workig with a itegrated labor market. We iclude coutry idices to evaluate the impact of coutry size ad the relative size of the tradables sector. There are J coutries. Each coutry sources tradables from all tradig parters i = 1,.., J ad o-tradables from itself. We have the followig pricig expressios: p t i = αγ + γ+mt +m 2γ+2m t +m 2γ + J m t + m m t c t k k ϕ t k + m c γ + m t + m + 2γ + 2 m t + m c t i ϕ t i ; = 1,.., J p = αγ + γ+mt +m 2γ+2m t +m 2γ + J m t + m m t c t k k ϕ t k + m c γ + m t + m + 2γ + 2 m t + m c A.12 A.13 m t ad m are respectively the umber of tradables ad o-tradables produced i coutry ad m t = J is the umber of tradables sourced from all tradig parters k. We cocetrate m t k o chages i productivity i importig coutry ad keep productivity levels costat i the other coutries. We abstract from the secod compoet of the BS effect, the larger labor share i otradables tha i tradables, sice it has the same impact as the first compoet, differetial productivity growth. So there is oly oe productio factor, labor. Productivity growth i otradables ad tradables is deoted as before by respectively g ad g t. Productivity growth of homogeeous tradables is defied as g h. If the labor market is itegrated across the differet sectors, the relative chage i the price of iput budles wages is equal to g h. The homogeeous good ca still serve as umeraire. If it is freely traded ad coutry is small o the world market, the price of the homogeeous good is give. Therefore, productivity growth i this sector leads to a proportioal fall i wages. 11

13 Log differetiatig the expressios for p t i ad p i A.12 ad A.13 geerates: p t i = p = γ+mt+m 2γ+2m t +m 2γ+m t +m p t i γ+mt+m 2γ+2m t +m p m t c t i ϕ t i 2γ + m t + m g h g t + m m t c t i ϕ t i c g h g g h g t + m c g h g + A.14 g h g A.15 Equatios A.14 shows that the price of tradables rises uambiguously if g h > g t > g. Empirical evidece provides support for these assumptios. As discussed i the mai text, productivity growth of tradables is larger tha productivity growth of o-tradables, g t > g. Marti ad Mitra 2001 fid that productivity growth i agriculture has bee much larger tha i maufacturig i a large cross-sectio of coutries. Iterpretig homogeeous tradables as agricultural goods ad differetiated tradables as maufactures, this implies that g h > g t. With g t > g h > g the chage i the price of tradables is ambiguous. The term i g h g t is egative ad the term i g h g is positive. The first term reflects the fact that productivity growth i differetiated tradables is larger tha i homogeeous tradables, g t > g. This implies that productivity of differetiated tradables falls more tha wages. So, its costs fall. This drives dow the prices of domestic tradables ad through strategic complemetarity this also drives dow the price of imported tradables. The secod term reflects g h > g. The costs of producig o-tradables rise ad this drives up the price of imported tradables through strategic complemetarity. So i this secod case the overall effect is ambiguous ad determied by the size of the productivity differeces, the size of the o-tradables sector relative to the tradables sector ad the size of domestically cosumed tradables relative to imported tradables. We ca observe that for a small ecoomy, the share of tradables sourced domestically is egligible. This implies that the first term betwee brackets vaishes. So, prices of imported tradables will rise as a result eve with g t > g h. Segmeted Labor Markets We ca go oe step further ad assume that the factor markets for differetiated goods ad for homogeeous goods are perfectly segmeted, so that productivity growth i the homogeeous sector does ot drive the price of factor iputs aymore. To determie equilibrium wages w i, we eed to defie a labor market equilibrium coditio. The other edogeous variables are 12

14 determied by the J + 1 J pricig equatios i J + 1 J prices, p t i, p for all i ad all : p t i = αγ + γ+mt +m 2γ+2m t +m 2γ + J m t + m m t w k k ϕ t k + m w γ + m t + m + 2γ + 2 m t + m w i ϕ t ; = 1,.., J i p = αγ + γ+mt +m 2γ+2m t +m 2γ + J m t + m m t w k k ϕ t k + m w γ + m t + m + 2γ + 2 m t + m w A.16 A.17 The labor market equilibrium is give by the followig expressio: L i = J qi t w i ϕ t + qi i w i ϕ i A.18 The expressios for q t i ad q i are give by: J q t i = α 1 γ + m t + m γ pt i + γ + m t + m m t k pt k + m p γ J A.19 q i = α 1 γ + m t + m γ p i + γ + m t + m m t k pt k + m p γ A.20 Substitutig equatios A.19-A.20 ito A.18 gives the followig labor market equilibrium coditio: J α L i = 1 γ + m t + m γ pt i + α + 1 γ + m t + m γ p i + γ + m t + m γ + m t + m J m t k pt k + m p γ J m t k pt k + m p γ w i ϕ i w i ϕ t i A.21 Hece, to simulate the model we solve the J + 1 J pricig equatios A.16-A.17 ad J labor market coditios A.21 for J + 1 J prices p t i ad p ad J wages w i. The umber of firms m t k ad m are exogeously give, i.e. we do ot work with a free etry coditio. This would further edogeize the model. 13

15 Price Relative Productivity Tradables Imported Tradable No-Tradable Domestic Tradable Figure 1: The price of imported tradables, domestic tradables ad o-tradables as a fuctio of relative productivity of tradables As a baselie, we work with 5 idetical coutries, with 20 tradables firms ad 20 otradables firms ad a labor force of 10 i each coutry, i.e. J = 5, m t = m = 20 ad L = 5 for all. Productivity is equal i all coutries ad all sectors, ϕ t = ϕ = 2 for all. Fially, α, γ ad are set respectively at 5, 1 ad 1. To mimic the BS effect, productivity i the tradables sector is icreased i oe of the coutries. 12 Figure 1 displays for the coutry with risig productivity of tradables the average price of imported tradables from all its tradig parters, the price of domestic tradables ad the price of o-tradables as a fuctio of the productivity of tradables relative to o-tradables. We express prices relative to the level where productivity i the two sectors is equal. As expected, the price of domestic tradables falls somewhat, the price of o-tradables rises most ad the price of imported tradables rises as well whe productivity i the tradables sector rises. A icreasig productivity of tradables raises wages ad therefore the price of domestic tradables oly falls slightly as a result of the productivity icrease. As a result of the wage icrease the price of o-tradables rises ad because of strategic complemetarity the price of imported tradables rises i tur. Figure 2 exposes the average price of imported tradables i the coutry with risig productivity as a fuctio of the relative productivity of tradables ad the umber of tradables relative to o-tradables. I the simulatios udereath this figure the umber of o-tradables was reduced keepig the umber of o-tradables costat. The figure clearly shows that the 12 GAMS code is available upo request. 14

16 Import Price of Tradables Relative Number of Tradables Firms Productivity Tradables Figure 2: The price of imported tradables as a fuctio of relative productivity of tradables ad the umber of tradables relative to o-tradables firms icrease i the price of imported tradables is weaker whe the umber of tradables is larger. With a larger umber of tradables, the price icrease of o-tradables has a smaller impact o the price of imported tradables ad the price drop of domestic tradables a larger impact. As a result the average price of tradables does ot rise so much. Figure 3 displays the average price of imported tradables i the coutry with risig productivity as a fuctio of the relative productivity of tradables ad the umber of coutries i the ecoomy. With a smaller umber of coutries the BS effect o the price of imported tradables is agai weaker. The reaso is that with less coutries, the umber of o-tradables is smaller relative to the umber of domestic tradables. Therefore, the drop i price of domestic tradables has a bigger impact ad the rise i prices of o-tradables a smaller impact o the price of imported tradables. 15

17 1.18 Import Price of Tradables Number of Coutries Productivity Tradables Figure 3: The price of imported tradables as a fuctio of relative productivity of tradables ad the umber of coutries 16