same way with the homogeneous good Z .
3.1 Households
Preferences are assumed to be a Cobb-Douglas nest of the homogeneous Z-
good and the differentiated X -good. The price of Z serves as the num´eraire. Ui
describes the utility function of a representative household in country i, where
μ denotes the fixed expenditure share for differentiated products and σ > 1 is
the elasticity of substitution between differentiated product varieties:
Ui
Xic
Xμc (Ziii + Zjji) μ ,
(l^ Пп ∖ σ—1 —1
1j + hi Xhj) σ
σ-1
σ-1 X χ V σ --- -1
+ hj XX^ σ + vi J + vj (Xj )σ-
(1)
Transportation of the differentiated X -good across the border is subject to
iceberg transport costs (τ) for the shipment of each unit. Z-goods, in contrast,
are costlessly tradeable.
For each firm type and location, the utility maximization of consumers yields
demand for a single variety of manufactures
Xji = Ppki} σpσ- 1 μE ∀ i ∈{ 1, 2} ∧ ∀ k ∈{n,h}
Xkii = (j´ -σ Piσ-1 μEi ∀ i = j ∈{ 1, 2} ∧ ∀ k ∈{h,v}
Xj = (PVji}-σ pσ- 1 μEi ∀ i = j ∈{ 1, 2}
Xnji = (Pnji)' Pk- 1 μEi ∀ i = j ∈{ 1, 2}∙ (2)
Ei represents the total expenditures of consumers in country i. The price index
Pi of differentiated goods consumed in country i can be written as
Pi
ni (Pki) 1-σ + nj (Pnji¢ 1 -σ + hi (Pki´ 1 -σ
1
(j ∖ 1 —σ i zτ. s^izτ 1—
Pai) + vi (Pvji ¢ + vj (Pυvii ¢
(3)
Expenditures for X and Z are allocated as follows:
Xic
μEi
Pi ,
(4)
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