Trade of Vertically Differentiated Products, Quality Improvement, and Welfare

This paper constructs a simple model to explain how trade in vertically differentiated products affects the welfare of the trading countries when product quality can be selected by firms. We specifically devise a model showing that when trade expands a market, firms will intensively invest in R&D activities to build higher quality into their goods and thus benefit the entire region. We find that trade does not increase the variety of goods but increases their cost due to their higher quality. We conclude that quality improvement is the main mechanism that helps countries gain from trade in vertically differentiated goods.