In a world with two countries which differ in size, we study the
impact of (the speed of) trade liberalization on firms' profits
and total welfare of the countries involved. Firms correctly
anticipate the pace of trade liberalization and take it into
account when deciding on their product choices, which are
endogenously determined at the beginning of the game. Competition
in the marketplace then occurs either on quantities or on prices.
As long as the autarkic phase continues, local firms are national
monopolists. ...
In a world with two countries which differ in size, we study the
impact of (the speed of) trade liberalization on firms' profits
and total welfare of the countries involved. Firms correctly
anticipate the pace of trade liberalization and take it into
account when deciding on their product choices, which are
endogenously determined at the beginning of the game. Competition
in the marketplace then occurs either on quantities or on prices.
As long as the autarkic phase continues, local firms are national
monopolists. When trade liberalization occurs, firms compete in an
international duopoly. We analyze trade effects by using two
different models of product differentiation. Across all the
specifications adopted (and independently of the price v. quantity
competition hypothesis), total welfare always unambiguously rises
with the speed of trade liberalization: Possible losses by firms
are always outweighed by consumers' gains, which come under the
form of lower prices, enlarged variety of higher average qualities
available. The effect on profits depends on the type of industry
analyzed. Two results in particular seem to be worth of mention.
With vertical product differentiation and fixed costs of quality
improvements, the expected size of the market faced by the firms
determines the incentive to invest in quality. The longer the period
of autarky, the lower the possibility that the firm from the small
country would be producing the high quality and be the leader in the
international market when it opens. On the contrary, when trade opens
immediately, national markets do not play any role and firms from
different countries have the same opportunity to become the leader.
Hence, immediate trade liberalization might be in the interest of
producers in the small country. In general, the lower the size of the
small country, the more likely its firm will gain from trade
liberalization. Losses from the small country firm can arise when it
is relegated to low quality good production and the domestic market
size is not very small. With horizontal product differentiation (the
homogeneous good case being a limit case of it when costs of
differentiation tend to infinity), investments in differentiation
benefit both firms in equal manner. Firms from the small country do not
run the risk of being relegated to a lower competitive position under
trade. As a result, they would never lose from it. Instead, firms from
the large country may still incur losses from the opening of trade when
the market expansion effect is low (i.e. when the country is very large
relative to the other).
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