International Competition in Vertically Differentiated Markets with Innovation and Imitation: Trade Policy versus Free Trade

The important characteristic of international competition between developed and less developed countries is vertical product differentiation, where firms' quality choices represent strategic decisions. Unlike the previous literature, we allow for a leadership in quality choice and the possibility of imitation and learning by the domestic firm. We compare both positive and normative aspects of this setup in the free trade and the strategic trade policy regime and show that the value of leadership may change dramatically when moving from free trade to trade policy. We also identify conditions under which trade policy can initiate the change in the quality ladders (known as quality reversal) and demonstrate that such a policy has a somewhat limited scope to achieve it. Thus, free trade can still be an optimal trade arrangement.