Price, Quality, and International Trade: Theory and Evidence

This paper explores the role of product quality in explaining observed price, production cost and trade patterns. Schott (2004) shows that for narrowly defined product the average unit value of goods imported by the US is increasing in the revenue, skill abundance, and capital intensity of the exporting country. These patterns are difficult to reconcile with a theory in which productivity’s unique impact is to reduce production cost and suggests a role for quality differentiation. I therefore extend the Melitz (2003) model to include vertical product differentiation among heterogeneous firms. In this framework firms can endogenously choose to invest in an expensive technology and face higher unit cost to receive a positive demand shock which allows them to sell more units at any given price. The model leads to endogenous sorting of firms across quality such that, in equilibrium, the most productive firms choose to produce and export high quality varieties that they sell at relatively high prices. Interestingly the model ties down price, cost and quality to a unique exogenous parameter, productivity. I confront the model to the data and find strong empirical support for its main hypothesis and predictions. Obviously one of the main difficulty in exploring the impact of vertical product differentiation is that quality is not directly observable. Using detailed US Census microdata on revenue and quantity for plants in 79 narrowly defined product classes over the period 1972-1997, I construct the time invariant component of demand unexplained by price variation – the empirical counterpart of the theoretical demand shock – and use it to make inference about product quality. The analysis yields three main results: (i) The plant’s demand residual is strongly positively correlated with the unit production cost as well as advertising and new technology expenditures; (ii) The plant’s average unit production cost and price are negatively correlated with its productivity and positively correlated with its demand residual; (iii) The demand residual, in addition to productivity, is an important determinant of the plant’s export status. Overall the theoretical and empirical results strongly suggests that the ability to produce varieties of high quality confers an important competitive advantage to the firm and influences many aspects of its behavior.