Product Quality and Market Size: Price Competition Between a Large and Small Country

In a two-country world for a product which in the absence of trade is provided by a monopoly in each country, opening trade effectively creates a world duopoly rather than two separate country monopolies. Suppose the goods produced in the competing countries differ in quality because the firm's home market sizes differ and quality is chosen before trade opens. Our results suggest that consumers benefit in free trade both from the choice of qualities and from the price competition. Social surplus for both countries is higher in trade than autarky—and although normally firms lose due to the increased competition, occasionally one of the firms may actually gain in trade. The competition between firms means that the trade price is less than the autarky price, but sales increase, sometimes enough to offset the price effects.