Multi-product firms, product quality heterogeneity and trade liberalization

This paper develops a model of multi-product firms with endogenous quality across products within a firm. The model can reconcile the empirical fact that product quality and market size exhibit an inverted U relationship. In our model, on the one hand a larger market has a larger scope of quality differentiation and induces firms to increase quality; on the other hand, market competition is more intense in a larger market, exerting a negative influence on quality. We show that the model without taking quality differentiation into consideration could significantly underestimate the market competition and welfare. Moreover, our numerical analysis suggests that the model without taking quality differentiation into consideration could also significantly overestimate the gains of trade liberalization.