Product Quality, Firm Heterogeneity and Trade Liberalization

Abstract

This paper develops a framework for studying the general equilibrium effects of endogenous quality upgrading, a new margin of trade, on the welfare impact of trade liberalization. Unlike Fajgelbaum et al. (2011) which studies the effect of non homothetic preferences on output quality and welfare, the model extends Melitz (2003) by introducing endogenous quality differentiation and focuses on supply-side aspects. Among other results, in general equilibrium, trade liberalization decreases the share of high-quality varieties in exports and the average productivity of exporters. These changes affect average export price in opposite ways. Nevertheless, trade liberalization in the quality extended model increases consumers’ welfare by more than in the benchmark model.

Keywords: Product Quality, firm heterogeneity, trade liberalization, welfare

JEL Classification: F1, F12