Economic Integration and Quality Standards in a Duopoly Model with Horizontal and Vertical Product Differentiation

This paper examines the effect of trade barriers on quality levels in a duopoly model for two countries where products are both vertically and horizontally differentiated. In the absence of quality regulation the producer in the large country produces a higher quality than the producer in the small country. Moreover, the quality levels between the two producers converge in case of market integration i.e. when the trade barrier is reduced. If a common minimum quality standard is introduced, which forces the low quality producer to increase the quality of his product, the high quality producer reacts strategically by lowering the quality of his product. On unregulated markets, market integration increases welfare in both countries if they are almost of similar size. However, if the countries are very asymmetrical with respect to size, market integration may harm welfare in the large country. Introducing a minimum quality standard also has ambiguous effects on welfare.