Import Restraints and Quality Choice Under Vertical Differentiation

We consider the following stage game : A domestic government chooses an import quota, then a domestic and a foreign firm choose their quality level before engaging a price competition in the final stage. We first show that the indirect effect of the quota on the sales of the domestic producer are different depending on whether his product quality is the high or low. In particular, the analysis developed in Krishna (89) has to be amended when vertical, instead of horizontal, product differentiation applies. Despite the non-existence of pure strategy Nash equilibria, we characterise all equilibria of the pricing game and go backward to tackle the quality choice game : for loose quotas, both firms choose Top quality while only one differentiates for tighter quotas. We then put forward the idea that the domestic government should use quotas to reduce the price competition and enable both firms to upgrade to the highest possible quality level to the benefit of domestic consumers. On the contrary, the foreign firm would prefer a very loose quota that generates quality differentiation and larger profits for her.