ecent vertical product-differentiation models provide a basis for the analysis of international trade issues which arise when countries differ in terms of product qualities, technology, costs, market size and income. Research suggests that, owing to such asymmetries, national industries will either be market leaders or lag behind in the international market place in terms of their product qualities. This, in turn, provides a reason for national governments to intervene to alter the situation in their favour.

In Discussion Paper No. 1522, Iñigo Herguera and Stefan Lutz analyse this possibility in the context of a model in which a more efficient domestic firm competes with a less efficient foreign firm in the domestic market, and where the foreign firm initially produces and sells products of a higher quality. The domestic firm could make higher profits by offering higher quality but, as the current outcome is a market equilibrium, it is unable to do so. Herguera and Lutz show that, given this situation, it is possible for the national government to set minimum quality standards that will facilitate both the domestic firm ‘leapfrogging’ its foreign competitor in terms of quality and the foreign competitor exiting from the market, thus raising domestic welfare. The result suggests that decision-makers should be aware of the possible radical effects of their domestic policies. The authors point out that a more complete understanding of leapfrogging would necessitate an analysis of firms’ strategic actions and profits.

Minimum Quality Standards as Facilitating Devices: An Example with Leapfrogging and Exit
Iñigo Herguera and Stefan Lutz