Foreign Competition along the Quality Ladder

Abstract

Abstract We document that firms with low prices are more impacted by low-cost competition. To explain this pattern, we propose an empirical model of trade with random-coefficient demand and endogenous product quality. Unlike commonly used demand systems (e.g., constant elasticity of substitution, nested logit), this model generates rich substitution patterns and implies an ‘escape-competition’ effect: in response to low-cost competition, firms have an incentive to upgrade their product quality. The estimation of the model reveals significant heterogeneity in consumer preferences. Counterfactual experiments suggest that the ‘China shock’ was significantly more damaging to firms at the bottom of the price distribution, and that quality upgrading had a limited role at mitigating the shock.