IIT in Vertically Differentiated Goods and Product Quality

This article illustrates both free and protectionist trade between two countries, differentiated in terms of population density, and where each one of them has a monopoly firm that produces a vertically differentiated good. The two monopolists are involved in intra-industry trade (IIT). At autarky, in each country, only one quality of the good is available. In the free trade equilibrium, the Foreign firm, as the Stackelberg leader, can devise a predatory strategy and sweep out the higher-quality product of the Domestic firm from the market. On the contrary, the Domestic firm as a price leader can drive the lower-quality product out of the market. However, a portion of the total market demand remains unserved. This may generate a cartel of fringes that will serve the untapped market producing horizontally differentiated goods. Under protectionism, in the Cournot game, if a per-unit tariff is imposed on the Domestic firm, its output level and product quality deteriorate while the Foreign firm gains market share with improved product quality. In case of an ad-valorem tariff, the Foreign firm gains at the expense of its domestic counterpart, while there will be a shortage of good-quality products in the market. In the Stackelberg game, both the optimum quantity and quality of the Domestic firm are adversely affected. If the Domestic firm is a price leader, under both the per-unit tariff and ad-valorem tariff, the overall product quality in the market deteriorates. JEL Codes: L2, L13, F12