Trade in Vertically Differentiated Goods under Duopoly

Abstract

We explore the possibility of free trade between two countries, differentiated in terms of the market size and where each of them has a monopoly firm that produces a vertically differentiated good. The two monopoly firms are involved in intra-industry trade. At autarky, in any one country, only one quality of the good is available. However, strict convexity of the monopolist’s cost function yields the possibility of two different qualities being produced by each of the two firms. In the free trade equilibrium, the foreign firm, as the Stackelberg leader, can devise a predatory strategy and sweeps out the higher-quality product of the domestic firm from the open market. On the contrary, the home firm as price leader can drive the lower quality product out of the market.