International competition in vertically differentiated markets with innovation and imitation: Trade policy versus Free trade∗

The important characteristic of international competition between firms from developed and less developed countries is vertical product differentiation, where firms’ quality choices are strategic decisions. We consider a model with sequential quality choice and the possibility of imitation, and compare positive and normative aspects of this setup in free trade and under strategic trade policy. In particular, we identify conditions under which trade policy can initiate a quality reversal (a change in the quality ladders) and demonstrate that they are closely related to improvements in domestic welfare. Otherwise, commitment to free trade can be an optimal trade arrangement.