Sunk Costs and Trade Liberalisation

Abstract

A model of vertical product differentiation is applied to the study of trade between two countries of differing sizes. Firms in the small country choose lower-quality products in autarky. Unlike A. Shaked and J. Sutton (1984), welfare effects of trade are fully analyzed and shown to depend on the degree of sunkness of costs. If firms have not sunk costs, losses from trade may arise for the small country in the short run (when quality is fixed) and for the large country in the long run (when quality is variable). If costs are sunk, both countries always gain from trade. Copyright 1992 by Royal Economic Society.