Trade with Horizontally and Vertically Di¤erentiated Goods

This paper explains the mechanism through which trade liberalization a¤ects the composition of intra-industry trade and \u85rmschoices of investment in quality di¤er-entiated goods. Equilibrium of a two-stage game is characterized, in which quality producers choose investment levels in stage 1, and subsequently, all \u85rms compete in quantities in stage 2. A trade model involving two countries with ad valorem tari¤s yields that quality levels rise and the share of trade in vertically-di¤erentiated goods also rises when tarri ¤ protection is lowered and the relative market size of the two countries exceeds a certain threshold. 1 1 Introduction. In the background of signi\u85cant reductions in tari ¤ and non-tari ¤ barriers over the past three or four decades, intra-industry trade has accounted for the largest share in the bilateral trade between industrialized countries. Although numerous empirical studies document this increased importance and show that the majority of its growth is due to trade in qualit