Vertical product differentiation, minimum quality standards, and international trade

Abstract

This paper develops a two-country, vertically differentiated duopoly model so as to analyse incentives for the formulation of national minimum quality standards in an open economy setting. Markets are segmented and national firms compete in both markets forming an international duopoly. Firms incur quality-dependent variable costs and goods sold domestically and abroad can have distinct qualities, while national quality standards are endogenously determined. International trade links give rise to cross-country externalities that result in inefficient national quality standards, either too lax or too tough relative to the global welfare-maximizing international standard. Trade flows are shown to be lower under Nash equilibrium minimum standards than under world optimum standards. Moreover, if firms specialize in goods of different quality levels, then world optimum standards are unattainable through reciprocal adjustments in national standards, in the absence of lump sum transfers. This suggests limitations in the effectiveness of international negotiations over minimum quality standards.