Empirical studies find a strong positive relationship between a country's per-capita income and price level of final tradable goods. Among alternative explanations of this observation, I focus on variable mark-ups by firms. Mark-ups that vary with destinations' incomes are evident from a clothing manufacturer's online catalogue featuring unit prices of identical goods sold in 24 countries. Such price discrimination on the basis of income suggests that firms exploit lower price elasticity of demand for identical goods in richer countries. In order to capture that, I introduce non-homothetic preferences in a model of trade with product differentiation and heterogeneity in firm productivity. The model helps bring theory and data closer along a key dimension: it generates positively related prices and incomes, while preserving desirable features of firm behavior and trade flows of existing frameworks. Quantitatively, the model suggests that variable mark-ups can account for as much as 50% of the observed positive relationship between prices of tradables and income across a large sample of countries.
The quantitative results of this and other existing structural gravity models depend critically on a single parameter governing the elasticity of trade with respect to trade frictions. Despite its importance, the current literature provides little evidence regarding this parameter for developing nations, which are responsible for a rising portion of world trade. I estimate this value for 129 developed and developing countries for the year 2004 using new disaggregated price and trade flow data. The benchmark estimate for all countries is approximately 7.5 and there is little evidence that the elasticity of trade differs dramatically across developed and developing nations.