Tariffs, quality reversals and exit in vertically differentiated industries

In a vertically differentiated industry a domestic and a foreign firm first choose the quality of their goods and then compete in quantities, or prices, in the home market. We investigate the cases in which a tariff is chosen before, or after, the firms’ quality decision. These cases are referred to as the ex-ante and the ex-post game, respectively. Optimal ex-post tariffs are positive and ensure that the domestic firm always produces the high quality good. The optimal ex-ante tariff is prohibitive and welfare under domestic monopoly is lower than under ex-post tariffs, unless firms compete in prices and the domestic firm is high quality.The authors would like to thank Jim Markusen and the participants at the meetings in Aix-en-Provence, The International Conference in Industrial Organization (Carlos III), Bellatera (Barcelona), ASSET (Alicante), ETSG (Erasmus) and seminars at Bologna and Vigo universities. The paper was written when Herguera and Petrakis were at Carlos III. The authors would like to thank an anonymous referee, Berthold Herrendorf, and especially the Editor, Jonathan Eaton, for detailed comments that led to a complete rewrite of the paper. Kujal acknowledges support from grants DGESIC [PB98/0024 and CAM 06/0058/2001. Herguera acknowledges support from grant [PB93-236. All remaining errors are our ownPublicad