Economic Integration and Quality Standards in a Duopoly Model with Horizontal and Vertical Product Differentiation

This paper examines the effects of trade barriers on quality levels in a duopoly model for two countries with one producer in each country. The products are both vertically and horizontally differentiated. In absence of quality regulation, the two producers determine prices and quality levels in a two stage game. The firms choose the quality level in the first game, and their prices in the second game. The Nash equilibrium illustrates that the producer in the large country produces a higher quality than the producer in the small country. However, a reduction of the trade barrier twists the quality levels in favour of the small country. Furthermore, in case of implementation of a minimum quality standard, which forces the low quality producer from the small country to increase the quality level, the producer from the large country reacts strategically by lowering the quality level of his product. On the unregulated markets, integration increases welfare in both countries if they are almost of similar size. However, if the countries are very asymmetrical with respect to size, market integration may harm welfare in the large country. Welfare effects by introduction of minimum quality standards are also ambiguous depending on the parameters of the model.