Country Asymmetries, Endogenous Product Choice and the Speed of Trade Liberalization

In a world with two countries which differ in size, we study the\nimpact of (the speed of) trade liberalization on firms' profits\nand total welfare of the countries involved. Firms correctly\nanticipate the pace of trade liberalization and take it into\naccount when deciding on their product choices, which are\nendogenously determined at the beginning of the game. Competition\nin the marketplace then occurs either on quantities or on prices.\nAs long as the autarkic phase continues, local firms are national\nmonopolists. When trade liberalization occurs, firms compete in an\ninternational duopoly. We analyze trade effects by using two\ndifferent models of product differentiation. Across all the\nspecifications adopted (and independently of the price v. quantity\ncompetition hypothesis), total welfare always unambiguously rises\nwith the speed of trade liberalization: Possible losses by firms\nare always outweighed by consumers' gains, which come under the\nform of lower prices, enlarged variety of higher average qualities\navailable. The effect on profits depends on the type of industry\nanalyzed. Two results in particular seem to be worth of mention.\nWith vertical product differentiation and fixed costs of quality\nimprovements, the expected size of the market faced by the firms\ndetermines the incentive to invest in quality. The longer the period\nof autarky, the lower the possibility that the firm from the small\ncountry would be producing the high quality and be the leader in the\ninternational market when it opens. On the contrary, when trade opens\nimmediately, national markets do not play any role and firms from\ndifferent countries have the same opportunity to become the leader.\nHence, immediate trade liberalization might be in the interest of\nproducers in the small country. In general, the lower the size of the\nsmall country, the more likely its firm will gain from trade\nliberalization. Losses from the small country firm can arise when it\nis relegated to low quality good production and the domestic market\nsize is not very small. With horizontal product differentiation (the\nhomogeneous good case being a limit case of it when costs of\ndifferentiation tend to infinity), investments in differentiation\nbenefit both firms in equal manner. Firms from the small country do not\nrun the risk of being relegated to a lower competitive position under\ntrade. As a result, they would never lose from it. Instead, firms from\nthe large country may still incur losses from the opening of trade when\nthe market expansion effect is low (i.e. when the country is very large\nrelative to the other).