Paper #259

Title:

Country asymmetries, endogenous product choice and the speed of trade liberalization

Authors:

Antonio Cabrales and Massimo Motta

Date:

February 1996 (Revised: January 1998)

Abstract:

In a world with two countries which differ in size, we study the impact of (the speed of) trade liberalization on firms' profits and total welfare of the countries involved. Firms correctly anticipate the pace of trade liberalization and take it into account when deciding on their product choices, which are endogenously determined at the beginning of the game. Competition in the marketplace then occurs either on quantities or on prices. As long as the autarkic phase continues, local firms are national monopolists. When trade liberalization occurs, firms compete in an international duopoly. We analyze trade effects by using two different models of product differentiation. Across all the specifications adopted (and independently of the price v. quantity competition hypothesis), total welfare always unambiguously rises with the speed of trade liberalization: Possible losses by firms are always outweighed by consumers' gains, which come under the form of lower prices, enlarged variety of higher average qualities available. The effect on profits depends on the type of industry analyzed. Two results in particular seem to be worth of mention. With vertical product differentiation and fixed costs of quality improvements, the expected size of the market faced by the firms determines the incentive to invest in quality. The longer the period of autarky, the lower the possibility that the firm from the small country would be producing the high quality and be the leader in the international market when it opens. On the contrary, when trade opens immediately, national markets do not play any role and firms from different countries have the same opportunity to become the leader. Hence, immediate trade liberalization might be in the interest of producers in the small country. In general, the lower the size of the small country, the more likely its firm will gain from trade liberalization. Losses from the small country firm can arise when it is relegated to low quality good production and the domestic market size is not very small. With horizontal product differentiation (the homogeneous good case being a limit case of it when costs of differentiation tend to infinity), investments in differentiation benefit both firms in equal manner. Firms from the small country do not run the risk of being relegated to a lower competitive position under trade. As a result, they would never lose from it. Instead, firms from the large country may still incur losses from the opening of trade when the market expansion effect is low (i.e. when the country is very large relative to the other).

Keywords:

Trade liberalization, product differentiation, international trade

JEL codes:

F12, F15

Area of Research:

Microeconomics

Published in:

European Economic Review, 45, (2001), pp. 87-107

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