Quality Heterogeneity and Misallocation: The Welfare Benefits of Raising your Standards

Abstract

This paper incorporates product standard regulations into a multi-country general equilibrium framework with firm heterogeneity and variable markups. We model regulations as a fixed cost that any firm selling to an economy must pay, consistent with stylized facts that we present. The fixed cost can improve allocative efficiency by reallocating production towards high-quality firms, who under-produce in the market allocation, and away from low-quality firms least able to bear compliance costs. Importantly, the fixed cost generates a positive externality on the rest of the world as it induces entry of high-quality firms, and it improves the terms of trade of the non-imposing countries. Because of this positive externality, given a level of market access, governments do not choose domestic standards efficiently. The result justifies international cooperation based on the fact that such cooperation can improve welfare. We estimate our model and apply its gravity formulation to quantify the global welfare consequences of altering regulatory policies, the extent of the positive externalities across countries, the effects of cooperation, and the comparison with further tariff liberalization.

Keywords: allocative efficiency, product standards, variable markups, trade policy

JEL Classification: L11, D6, F13