Vertical product differentiation, minimum quality standards, and international trade policy

This dissertation explores the influences of minimum quality standards and of the threat of entry in a vertical product differentiation model. In the first chapter, I study the influence of minimum quality standards in a partial-equilibrium model of vertical product differentiation and trade in which duopolistic firms face quality-dependent costs and compete in quality and price in two segmented markets. In an unregulated equilibrium, one firm sells high quality whereas the other sells low quality. Under Full Harmonization of standards, there always exists some minimum quality standard that will increase welfare in both regions. Two other alternatives to Full Harmonization are National Treatment and Mutual Recognition. Under either alternative, standards can always be found that increase welfare in both regions. The analysis above is therefore extended to integrate the choice of a particular standard setting alternative by governments and the subsequent setting of standards into the model. This model includes restricting assumptions to capture stylized facts about the EC. Mutual Recognition emerges as one regulatory alternative that always improves welfare in both regions when compared to the case without regulation. It is also the only possible equilibrium outcome of the game. Results obtained in the first chapter imply that there may be particular choices of quality by one firm that could prevent a competitor from attaining positive profits regardless of its quality choice. In the second chapter, I study how the existence of a potential entrant influences a monopolistic incumbent's choice of quality in a model of vertical product differentiation and entry. An incumbent and a potential entrant face fixed setup costs and quality-dependent costs of production and compete in quality and price. With identical quality-dependent costs, the incumbent will always deter entry if possible, i.e. if fixed setup costs are high enough. Quality will be set at a level lower than the optimal quality set if entry was accommodated and lower than or equal to the optimal quality set under monopoly. If entry is not blockaded, quality will be set at a level strictly lower than the optimal quality set under monopoly.