The unit values of internationally traded goods are heavily influenced by quality. We model this in an extended monopolistic competition framework where, in addition to choosing price, firms simultaneously choose quality. We allow countries to have non-homothetic demand for quality. The optimal choice of quality by firms reflects this non-homothetic demand as well as the costs of production, including specific transport costs as in the “Washington apples” effect. We estimate quality and quality-adjusted prices for 185 countries over 1984-2011. Our estimates are less sensitive to assumptions about the extensive margin than are “demand side” estimates. We find that quality-adjusted prices vary much less across countries than do unit values, and surprisingly, that the quality-adjusted terms of trade are negatively related to countries’ level of income.
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