Vertical Product Differentiation, Minimum Quality Standards and International Trade

This paper extends a well-established vertical product differentiation model to an international duopoly with two segmented countries, where firms compete in quality and price. The framework is used to analyse governments` incentives for unilateral minimum standard-setting as well as the scope and effects of cooperative agreements in minimum standards. Endogenous national standards result from a standard-setting game between governments whose objective function is to maximise national welfare. Cross-country externalities can be are either positive or negative, depending on the quality of traded goods. Four unregulated Nash equilibria in minimum standards are shown to exist, two symmetric and two asymmetric, which correspond to the four different combinations of externalities that may arise between the two countries: symmetric positive externalities, symmetric negative externalities, or asymmetric positive and negative externalities. Unilateral minimum standards can be inefficiently high or low relative to world optimum symmetric standards and operate as non-tariff barriers to trade. Harmonisation of minimum quality standards through cooperation is both feasible and mutually beneficial in the symmetric case, but the scope for mutually beneficial cooperation is significantly restricted when countries are asymmetric and lump-sum transfers are not possible. The resulting cooperative standards are asymmetric and do not maximise world welfare.