Endogenous quality and intra-industry trade

The stylized facts of international trade suggest that intra-industry trade predominates precisely where quality enforcement is a serious problem. To explain this phenomenon, I rely on a model of product quality assurance. Intra-industry trade flows between two identical countries are explained, without relying on negatively sloped firm level demand curves, differentiated products or technologically determined firm size. Buyers, knowing only the average market quality, purchase goods whose quality can only be assessed through use and switch firms when dissatisfied with the quality of their purchase. Repeat purchasing provides an incentive to firms to provide the quality anticipated by the buyer. Firms are quantity constrained and enjoy a markup over marginal cost, but cannot adjust price to increase demand. Customers realize that the rent firms receive in equilibrium ensures that an adequate level of quality will be forthcoming. Trade occurs even in the presence of positive transportation costs because firms are quantity constrained and are ex ante purchase indistinguishable to buyers. Production occurs under constant returns to scale and though economies of scale are not inconsistent with they are not necessary for my result. Incorporating this approach in a factor proportions theory of inter-industry trade reproduces many of the important results of the existing literature without requiring Spence-Dixit-Stiglitz preferences and economies of scale technology. For example, even though goods are homogeneous and production occurs under constant returns to scale there exists a link between the volume of trade and relative country size. For a given relative country size the volume of trade is larger the larger the difference in relative factor endowments and the more similar in size are countries the greater is the volume of trade. Demand smoothing provides another rationale for trade in the same good. Firms operate in a stochastic world in which demand fluctuations increase the probability of firm extinction and decrease expected profits as compared to a world with certainty. Firms may choose to engage in intra-industry trade because it reduces the probability of firm death and raises expected profits, even when transport costs are positive. Thus, demand smoothing is a cause of intra-industry trade