Cost Pass Through In A Competitive Model Of Pricing-to-Market

This paper builds up an extension to the Mussa and Rosen (1978) model of quality pricing under perfect competition. This model incorporates decreasing returns to scale. First, the authors predict that exchange rate shocks are imperfectly passed through into prices. Second, prices of low quality goods are more sensitive to exchange rate shocks than prices of high quality goods. Third, in response to an exchange rate appreciation, the composition of exports shifts towards higher quality and more expensive goods. They test those predictions using highly disaggregated price and quantity US import data.