Commercial Policy with Vertical Product Differentiation

Commercial Policy with Vertical Product Differentiation

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We examine the nature of commercial and domestic policy (tariffs, taxes/ subsidies, and quality restrictions) in a model of vertical product differentiation. A foreign firm competes with a domestic firm in the latter`s market, producing products of varying quality, and competing in prices. We show that a specific tariff on the foreign firm raises overall welfare in the domestic economy, while an ad valorem tariff has a similar effect only when the foreign firm produces the lower quality product. Tariffs on the foreign firm typically induce the domestic firm to upgrade the quality of its product, when it produces the lower quality product. A subsidy is always the optimal policy towards the domestic firm. If quality restrictions are imposed on the foreign firm, the domestic firm upgrades quality, and overall welfare in the domestic economy is once again higher (JEL: F12, F13)