International trade and investments in a vertically differentiated industry

Abstract

A model of vertical product differentiation is applied to the study of trade and investments between two economies of differing sizes. At the autarky equilibrium, firms in the smaller country are shown to produce lower quality. The choice of the firms between exports and foreign investments when borders open is studied. Intra-industry trade or reciprocal investments arise when the quality gap is not too wide. The strategic role of foreign investments is emphasized. In particular, the establishment of a subsidiary abroad can crowd out both sales by local firms and exports by the co-national firm.