Is There Policy Induced Quality Reversal in Intra-Industry Trade Between Developed and Less-Developed Countries?

We analyse strategic trade policy with vertical product differentiation where firms from developed and less developed countries compete in both qualities and prices in the domestic market and where the developing country firm has a lower marginal efficiency in producing quality. We concentrate on the case when the domestic market is in a less developed country and when it possesses the characteristics of ‘natural duopoly’. The key issue is under which conditions welfare maximizing trade policy in the form of tariffs can lead to ‘quality reversal’, when the initially low-quality domestic firm jumps up the quality ladder in the anticipation of the optimal trade policy. We then contrast our findings with the related results in the literature.