Imperfect competition models have generated impressive advances in the theory of international trade. But the analysis of trade between countries with asymmetric conditions has not caught the attention of economists to the same extent. In Discussion Paper No. 1106, Research Affiliate Massimo Motta, Research Fellow Jacques-François Thisse and Antonio Cabrales investigate whether a country supplying low quality products can catch up with a rival country supplying high quality products when both have access to the same technology. Specifically, their main concern is to understand the role of domestic conditions in determining the international success of a firm.

When countries open to trade, firms' products start from an initial quality level dependent on local characteristics of demand. The larger and/or more sophisticated home demand, the higher the quality supplied to domestic customers. Hence, the autarky equilibrium determines the initial conditions of the trade game. Since firms face a larger (international) market and more competition, the autarky choices of quality and price are generally not optimal under trade. But firms have the opportunity to update their quality-price decisions by paying adjustment costs which increase with the difference between the new desired quality and the initial one. In general, firms would like to be the quality leader on the international market since this yields higher profits. Two possible equilibria arise: in the first, the quality leader maintains its position; in the second, leapfrogging occurs. But the latter is only possible if the initial quality gap is not too wide. Furthermore, when the risk dominance criterion is used, only the former equilibrium is generated, a result that holds for both segmented and integrated markets. Qualities, profits and world welfare are higher when firms can price discriminate, that is, in segmented markets.

On the Persistence of Leadership or Leapfrogging in International Trade
Massimo Motta, Jacques-François Thisse and Antonio Cabrales

Discussion Paper No. 1106, January 1995 (IT)