Abstract
We examine the nature of commercial and domestic policy (tariffs, taxes/ subsidies, and quality restrictions) in a model of vertical product differentia tion. A foreign firm competes with a domestic firm in the tatter's market, pro ducing products of varying quality, and competing in prices. We show that a specific tariff on the foreign firm raises overall welfare in the domestic econo my, while an ad valorem tariff has a similar effect only when the foreign firm produces the lower quality product. Tariffs on the foreign firm typically induce the domestic firm to upgrade the quality of its product, when it produces the lower quality product. A subsidy is always the optimal policy towards the domestic firm. If quality restrictions are imposed on the foreign firm, the domestic firm upgrades quality, and overall welfare in the domestic economy is once again higher. (JEL: F12, F13) * Correspondence Address: Ashish Vaidya, Department of Economics & Statistics, California State University at Los Angeles, 5151 State University Drive, Los Angeles, CA 90032, U.S.A; We would like to thank Giacomo Bonanno, Robert Feenstra, and participants at the Economic Theory Seminar Series in the Department of Econom ics, University of California at Riverside, as well as at the Department of Economics Seminar Series at CSLA for very helpful comments. We are responsible for any remaining errors. ©1996 Institute for International Economics, Sejong Institution. All rights reserved. This content downloaded from 207.46.13.128 on Wed, 07 Sep 2016 06:42:15 UTC All use subject to http://about.jstor.org/terms Ramana Polavarapu and Ashish Vaidya 231
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