Strategic Trade Policy with Endogenous Product Differentiation

Abstract

In this paper I develop a model of international duopoly, where firms invest in product differentiation. I show that firms have an incentive to free-ride on the investment of their rival, due to an externality generated by product differentiation. A further effect of product differentiation is the market-expansion effect, which induces consumers to increase their aggregate spending in the market. Depending on the strength of the two effects, the investments are either strategic substitutes or strategic complements. I link this result to strategic trade policy and show that the optimal policy depends on the strength of the market-expansion effect.

Keywords: R&D, Duopoly, Product differentiation, Industrial Policy, Strategic trade policy

JEL Classification: F12, F13, F15, L10