Strategic Trade Policy and Vertical Product Differentiation: intra-industry trade between developed and developing countries

We analyse the effects of simple strategic trade policy in a duopoly with vertical product differentiation where firms from a developed and less developed country compete in both qualities and prices in the domestic market. The distinction between the developed and developing country firm is captured through the difference in the marginal efficiency in production of quality, where the latter has lower marginal efficiency than the former. We concentrate on the case when the domestic market is in a less developed country and when it possesses the characteristics of a "natural duopoly". That is, the size of the market is such that only two firms can survive in it. We analyse under which conditions welfare maximising trade policy in the form of tariffs can lead to so-called quality reversal, that is, to the situation in which an initially low quality domestic firm will jump up the quality ladder in anticipation of the optimal trade policy. We then contrast our findings with related results concerning quality reversal in the relevant trade literature.