Income Distribution, Product Quality, and International Trade

Pablo Fajgelbaum
Princeton University

Gene M. Grossman
Princeton University

Elhanan Helpman
Harvard University

August 2010

Abstract
We develop a framework for studying trade in horizontally and vertically di¤erentiated products. In our model, consumers have heterogeneous incomes and heterogeneous tastes. They
purchase a homogeneous good as well as making a discrete choice of quality and brand of a differentiated product. The distribution of preferences in the population generates a nested logit
demand structure. These demands are such that the fraction of consumers who buy a higherquality product rises with income. We use the model to study the pattern of trade between
countries that di¤er in size and income distributions but are otherwise identical. Trade— which
is driven primarily by demand factors— derives from “home market e¤ects” in the presence oftransport costs. When these costs are su¢ ciently small, goods of a given quality are produced
in a single country. The model provides a tractable framework for studying the welfare consequences of trade, transport costs, and trade policy for di¤erent income groups in an economy.
Keywords: monopolistic competition, vertical specialization, product quality, nested logit
JEL Classi…cation: F12

Grossman and Helpman thank the National Science Foundation and Fajgelbaum thanks the International Economics Section at Princeton University for …nancial support. We are grateful to Aykut Ahlatçio¼
glu and Gabriel
Kreindler for research assistance and to Juan Carlos Hallak, Jonathan Vogel, and Yoram Weiss for helpful comments
and suggestions.

11Introduction

International trade ‡ows reveal systematic patterns of vertical specialization. When rich and poor
countries export goods in the same product category, the richer countries sell goods with higher
unit values (Schott, 2004; Hummels and Klenow, 2005; Hallak and Schott, 2008). This suggests a
positive association between per capita income and the quality of exports. Also, when a country
exports goods in a product category to several destinations, the higher-quality goods are directeddisproportionately to the higher-income markets (Hallak, 2006). Since wealthier households typically consume goods of higher quality (Bils and Klenow, 2001; Broda and Romalis, 2009), thepattern of vertical specialization has important implications for the distributional consequences ofworld trade.
In this paper, we propose a new analytic framework for studying trade in vertically-di¤erentiatedproducts. Our approach features non-homothetic preferences over goods of di¤erent quality, as
is suggested by the observed consumption patterns. It allows trade patterns to depend on the
distributions of income in trading partners and implies that the welfare consequences of trade
vary across income groups in any country. It predicts that richer countries will be net exportersof higher-quality goods and net importers of lower-quality goods under reasonable assumptions
about levels and distributions of national income. Our model implies that, in many circumstances,
trade liberalization bene…ts especially the poorer households in wealthy countries and the richer
households in poor countries.
We provide a demand-based explanation for the pattern of trade in goods of di¤erent quality.
In this respect, our approach is reminiscent of Linder (1961), who hypothesized that …rms inany country produce goods suited to the predominant tastes of their local consumers and sell themworldwide to others who share these tastes.1 Our approach complements a ‡ourishing literature thathighlights various supply-side determinants of trade in vertically-di¤erentiated goods. In Markusen(1986) or Bergstrand (1990), for example, the country with higher per-capita income exports theluxury good, because the luxury good happens to be capital intensive. Similarly, in Flam andHelpman (1987), Stokey (1991), Murphy and Shleifer (1997) and Matsuyama (2000), the patternof trade follows from an assumption that richer countries have relative technological superiority inproducing higher-quality goods.2 More recently, Baldwin and Harrigan (2007) and Johnson (2008)
have incorporated vertically-di¤erentiated products into trade models with heterogenous …rms.
They seek to explain the observation that more productive …rms export higher-priced (and therefore,
1

Mitra and Trindate (2005) also o¤er a demand-based explanation for the pattern of trade in a model with nonhomothetic preferences. However, their model implies that countries will export goods that are little demanded
at home absent any supply-side di¤erences between them. See also Foellmi et al. (2007), who model trade inhorizontally-di¤erentiated goods with discrete choice and non-homothetic preferences.
2
See also Fieler (2008), who …nds in her calibration excercise using a Ricardian framework à la Eaton and Kortum(2002) with two industries and many goods that the industry with a higher income elasticity of demand also has
the greater spread in its productivity draws. As she shows, this gives the country with the higher technology level a
comparative advantage in luxury goods.

1presumably, higher quality) products with reference to the relatively greater incentive that such…rms have to undertake quality-enhancing investments. Their approach would generate a supplyside explanation for the observed pattern of trade if richer countries are home to a disproportionate
share of the high-productivity …rms.3
The demand structure that we exploit has strong empirical roots. We assume that individuals
consume varying quantities of a homogeneous good and a discrete choice of a product that is bothhorizontally and vertically di¤erentiated. Consumers choose among di¤erent quality options of thegood and from a set of distinctive products at each quality level that have idiosyncratic appeal.
The assumed form of the utility function and the distribution of tastes are such that the system of
aggregate demands exhibits a nested-logit structure. We draw on the theory of such demands thathas been developed by McFadden (1978), Anderson et al. (1992) and Verboven (1996a), among
others.4 Since the econometric methods for estimating such models are well developed, our analytic
framework should be readily amenable to empirical research.
We posit a utility function that features complementarity between the quantity of the homogeneous good and the quality of the di¤erentiated product. This property of the assumed preferences
implies that the marginal value of quality is higher for those with greater income, who consume
more of the homogeneous good. Yet consumers have idiosyncratic valuations of each of the di¤erentiated products, which means that a wealthy consumer may fancy a particular low-quality variety
while a poorer consumer favors one of the high-quality products. In the aggregate, the fraction of
consumers that buys a high-quality product rises with income. This behavior generates heterogeneity in income elasticities of demand across di¤erent goods. Such heterogeneity has proven useful inexplaining bilateral trade ‡ows in work by Hunter and Markusen (1988), Bergstrand (1990), andHunter (1991).
The non-homotheticities in demand forge a link between the shape of a country’s income distribution and the pattern and intensity of its trade in vertically-di¤erentiated products. We drawout some of the implications in our analysis, much as do Flam and Helpman (1987), Matsuyama(2000), and Mitra and Trindade (2005). Dalgin et al. (2008) and Choi et al. (2009) show that such
links between income distribution and trade patterns are important in reality.5
In our model, patterns of aggregate demand translate into patterns of specialization and trade
via “home-market e¤ects.”As Krugman (1980) argued, when transportation is costly, a large homemarket lends an advantage to local …rms producing under increasing returns to scale. Therefore,
countries tend to export the increasing-returns goods that are in great domestic demand.6 We derive3
See also Kugler and Verhoogen (2008) and Hallak and Sivadasan (2009), who provide empirical evidence on therelationship between …rm size, …rm productivity, and export unit values.
4
The nested-logit demand structure has been applied to international trade by Goldberg (1995) and Verboven(1996b), and more recently by Khandelwal (2008) and Verhoogen (2008). The latter two include a vertical dimensionof product di¤erentiation in their discussion, but their focus is very di¤erent from ours.
5
Choi et al. (2009) show that country pairs that share more similar income distributions also exhibit more similar
distributions of import prices. Dalgin et al. (2008) …nd a positive correlation in a sample of developed countries
between income dispersion and imports of luxury goods.
6
Hanson and Xiang (2006) extend Krugman’s argument to a setting with many industries that di¤er in transport
costs and the extent of product di¤erentiation. They provide empirical support for the proposition that larger2conditions under which a richer country, or one with a more dispersed distribution of income, hasa larger home demand for high-quality goods and a smaller home demand for low-quality goods.
Under such conditions, more …rms enter to produce high-quality goods in the richer (or moreunequal) country, while the opposite is true of …rms producing low-quality products. Firms at agiven quality charge the same ex-factory prices, so the number of producers predicts the directionof trade. Thus, our model can explain, for example, why Germany exports high-quality cars to
Korea while importing low-quality cars from there.
Our framework provides a tractable and parsimonious tool for studying the distributional implications of changes in transport costs or trade policy. Since di¤erent income classes in a country
consume di¤erent mixes of low- and high-quality products, the delocation of …rms induced bychanges in trading conditions a¤ects the welfare of the various income classes di¤erently. We …nd,for example, that trade liberalization in a rich country tends to favor the lower-income groups there,
who bene…t qua consumers from an expansion in the range of product o¤erings at the low-quality
level and from a transfer of income from groups that consume greater shares of the high-quality
good.
In Section 2, we develop our framework in the context of a closed economy. Each consumer
buys one unit of some di¤erentiated product and devotes all remaining income to the homogeneous
good. Individuals have idiosyncratic evaluations of the various di¤erentiated products, which alsodi¤er in quality. The distribution of taste parameters generates a nested-logit structure of aggregate
demands. We combine these demands with a simple supply model that features a single factor of
production, …xed costs plus constant unit costs that vary by quality level, and free entry into thedi¤erentiated-products sector. In the monopolistically-competitive equilibrium, each …rm producing
a di¤erentiated product charges a …xed markup over its unit cost that depends on the quality levelof its product and a parameter describing the distribution of idiosyncratic tastes. We show in
Section 3 that the autarky equilibrium is unique and that it is characterized by positive numbers of
producers of both low- and high-quality goods. We proceed to examine how changes in population
size and in the level and spread of the income distribution a¤ect the numbers of producers at eachquality level and the welfare of di¤erent income groups.
Section 4 introduces international trade between countries that share similar supply characteristics but di¤er in their levels and distributions of income. We assume that di¤erentiated products
are costly to transport internationally, with per-unit shipping costs that may vary with the quality
level. When shipping costs are su¢ ciently high, as we assume throughout that section, each country
produces and trades both low- and high-quality goods. We examine how country sizes and income
distributions combine to determine the pattern of trade. We also investigate the distributional
implications of a decline in trading costs. When such costs decline su¢ ciently, the production of
goods of a given quality must be concentrated in a single country, as we show in Section 5. For
trading costs close enough to zero, each good is produced in the country that would have the larger
countries export more in industries with high transport costs and highly-di¤erentiated products. See Davis andWeinstein (2003) for further empirical evidence of home-market e¤ects in the pattern of trade.

3home market in a hypothetical, integrated equilibrium. This implies, for example that if countries
are of equal size and the income distribution in one …rst-order stochastically dominates that in
the other, then the richer country produces and exports the higher-quality goods while the poorer
country produces and exports the lower-quality goods.
In Section 6, we study commercial policy. Tari¤s have no e¤ect on ex-factory prices in ourmodel. The welfare e¤ects of a tari¤ derive from a composition e¤ect and a redistribution e¤ect.
The former captures the change in the relative numbers of high- and low-quality products that
results from protection. The latter re‡ects the transfer of tari¤ revenues from import purchasers to
the average consumer. Section 7 o¤ers concluding remarks and an appendix gathers the algebraic
derivations and proofs.

2

The Model

We develop a model featuring income heterogeneity and non-homothetic preferences over goods ofdi¤erent quality. We describe the model in this section, characterize its autarky equilibrium in the
next, and then move on to international trade in Section 4 below.
Each individual consumes a homogeneous good and his optimal choice from a …nite set ofdi¤erentiated products. Both types of goods are produced with labor alone. The homogeneous
good requires one unit of e¤ective labor per unit of output. This good is competitively priced
and serves as numeraire. The di¤erentiated products require a …xed input of labor and a constantvariable input per unit of output. Monopolistic competition prevails in this industry. We assume
that the labor supply is su¢ ciently large relative to aggregate demand for di¤erentiated products
to ensure a positive output of the numeraire good in any equilibrium. Then competition implies awage rate for e¤ective labor equal to one.
The economy is populated by a continuum of individuals who are endowed with di¤erent
amounts of e¤ective labor. This heterogeneity in endowments generates a distribution of income.
We denote the income distribution by Fy , so that Fy (y) is the fraction of the mass N of individuals
with e¤ective labor and wage income less than or equal to y. We assume throughout that every
individual has su¢ cient income to purchase one unit of any brand of the di¤erentiated product,
including the most expensive, at the prevailing equilibrium prices.
Each consumer values only one unit of the di¤erentiated product and thus faces a discrete
consumption choice. Each buys the good that o¤ers him the highest utility, considering the prices
and characteristics of all available products. Varieties are distinguished by their quality level, as
well as by other attributes that a¤ect consumers’ idiosyncratic valuations. We denote by…nite set of available quality levels such that a good with index i 2
the paper, we will takethehas quality qi . For most of= fH; Lg with qH > qL ; i.e., consumers choose from among two quality

levels, opting either for one of the high-quality products or one of the low-quality products. At
each quality level, there is a large number of competing brands that consumers evaluate di¤erently.
So, each consumer chooses not only a quality level, but also a particular item from among the set

4

Qi of brands with quality qi .

2.1

Preferences and Demand

Consider an individual h who consumes z units of the homogenous good and a variety j of thedi¤erentiated product from the set Qi of products with quality qi . We assume that this option
yields the individual utility ofuhi;j = zqi + "hi;j ;(1)where "hi;j is the individual’s idiosyncratic evaluation of the attributes of product j in Qi . Eachindividual has a vector of idiosyncratic evaluations,
one for each of the available brands in eachn oquality class; denote this vector by "h = "hi;jfor i 2and j 2 Qi . The " terms are distributed

independently across the population of consumers according to a Generalized Extreme Value (GEV)
distribution, which we denote by F" ("). That is,F" (") = e

P

i2

hP

j2Qi e"i;j = iii; with 0 <i < 1 for all i 2.

This distribution of taste parameters is common in the discrete-choice literature, following Ben
Akiva (1973) and McFadden (1978), because it generates a convenient and empirically-estimablesystem of demands.7 Notice the interaction in (1) between the quantity of the homogeneous good
and the quality of the di¤erentiated product, which implies a greater marginal valuation of quality
for those with greater consumption of the homogeneous good. This feature of the utility function
captures the non-homotheticity of preferences in our model.
Now consider the optimization problem facing an individual with income y h and vector of taste
parameters "h . Of course, this individual simply chooses the quality and variety that yields thehighest utility among all available options, i.e., the i and j that maximize y hpi;j qi + "hi;j , wherepi;j is the price of the j th variety in the set Qi of goods with quality qi . Here y hpi;j represents

the amount of (residual) income that the individual devotes to spending on the numeraire good
after buying one unit of his most preferred variety of the di¤erentiated product. The calculationsin McFadden (1978) and elsewhere imply that, with " distributed according to a GEV, the fractionof consumers with income y who choose variety j with quality qi is given byi;j (y) =where

jji i (y) ;e pi;j qi = i

jji = Ppi;` qi = i`2Qi eis the fraction that buys brand j among those that purchase a di¤erentiated good with quality qi
7

See also Verboven (1996a) and Train (2003, ch4).

5andi (y) = P!2P

(y pi;j )qi = i
j2Qi ePi(y p!;j )q! = !
j2Q! e!

is the fraction of consumers that opt for a product of this quality. These fractions depend on theprice vector, of course, and the latter fraction varies across the income distribution.
Readers familiar with the empirical literature on discrete-choice modeling will recognize theimplied demand system as a nested logit, with choice over quality levels and brands of a given
quality. In that literature,i

is known as the dissimilarity parameter; it measures the degreeof heterogeneity in preferences over the brands in the set Qi .8 The greater is

i , the smaller is0
the correlation between "i;j and "i;j 0 for j and j in Qi (see McFadden, 1978), and therefore thegreater are the perceived di¤erences among the various brands with quality qi . If di¤erent brands oflower-quality products are better substitutes for one another than di¤erent brands of higher-quality
products, theni will be increasing in product quality.

This ordering seems plausible inasmuch

as higher-quality products typically embody richer sets of product characteristics, which expands
the scope for horizontal di¤erentiation. However, our analysis does not require any particular
relationship between

9i and qi .

Di¤erent income groups allocate their spending similarly among the various brands of a given
quality. Variation in spending patterns across income groups arises solely from variation in thefraction of individuals who purchase a product with quality qi , as re‡ected by the functioni (y).

It follows that the market share of a good of quality qi varies across income groups according to
1 d i;j (y)=dyi;j (y)whereqa (y)

1 d i (y)
= qi
dy
i (y)
X

qa (y) ;(2)

qi i (y)i2Qis the average quality consumed by individuals with income y. Equation (2) implies that the fractionof individuals who purchase brand j of quality qi rises with income if and only if qi > qa (y); thatis, if and only if qi is higher than the average quality consumed by individuals in this income group.
In particular, in the case of two qualities, Q = fqH ; qL g, we have qH > qa (y) > qL for all y, sothat the fraction of individuals who purchase high-quality products rises with income at all income

levels. This is the key property of these non-homothetic preferences that will guide our analysis of
8
Readers familiar with the trade literature will also recognize a similarity between the distribution of preference
shocks here and the distribution of productivity shocks in the Ricardian model of Eaton and Kortum (2002). In theirwork, the productivity shocks are assumed to have a Type-II extreme value distribution in which parameterizes thedissimilarity of productivity levels across goods.
9With this speci…cations of preferences and the distribution of the idiosyncratic taste parameter, the ratio of
fractions i;j (y) = i;j 0 (y), for j; j 0 2 Qi does not depend on the set of varieties available in other quality classes, noron the prices of these goods. This ratio does vary with i , but not with the dissimilarity parameters that apply toother quality groups. On the other hand, the ratio of fractions i;j (y) = i0 ;;j 0 (y), for j 2 Qi and j 0 2 Qi0 depends on
the set of products available in both groups and on the dissimilarity parameters for each.

6the trade ‡ows.
From now on, we will focus on an economy with two qualities of the di¤erentiated product.
Then we can write the fraction of individuals with income y who purchase brand j of quality qi asehP(y pi;j 0 )qi = i

j 0 2Qi epi;j qi = i

ii

hP
i
i;j (y) = P
pi;j 0 qi = i P(y p!;j 0 )q! = ! !
j 0 2Qi ee0!2fH;Lg
j 2Q!

for i = H; L:

Using this expression, we calculate per capita demand for variety j of quality qi ,
di;j

=

Z 1

ymin

=

P

e

i;j (y) dFy (y)pi;j qi = i

j 0 2Qi epi;j 0 qi = i

Z 1

ymin

hP

j 0 2Qi

P!2fH;Lge(y pi;j 0 )qi = ihPii(y p!;j 0 )q! = !
j 0 2Q! e

i ! dFy (y) ,(3)where ymin is the income of the poorest individual in this economy. Evidently, the aggregate demand
N di;j for brand j of quality qi depends on the price of this good and on aggregate indexes of theprices of competing products in each quality class.

2.2

Pricing and Pro…ts

Firms can enter freely into the di¤erentiated-products sector by employing a …xed input fi ofe¤ective labor to produce a good of quality qi . Each active …rm produces a di¤erent brand, using ci
units of labor per unit of output for a good of quality qi . The producers of di¤erentiated products
set prices to maximize pro…ts taking the aggregate price indexes as given. Entry at each quality
level proceeds until the next entrant would fail to cover its …xed cost. Let ni be the number of …rms
that produce goods of quality qi . The demand structure requires the number of brands in eachquality class to be a …nite integer, but we will take liberty in treating ni as if it were a continuous
variable to facilitate the exposition.
A …rm that produces a brand j of the di¤erentiated product with quality qi earns pro…ts ofi;j = N di;j (pi;jci )fi , where di;j is given in (3). If the number of active producers of eachquality level is large, the terms in the various sums in (3) vary only slightly with a …rm’s own
price. We assume that the …rm ignores this dependence, as is common in models of monopolisticcompetition. Then a …rm producing any brand j with quality qi maximizes pro…ts by setting thepricepi = ci +i

qi

for i = H; L:(4)

Evidently, the markup over marginal cost di¤ers for goods of di¤erent qualities. The markup re‡ects
two properties of the class of goods. First, the higher is qi , the greater is the marginal utility fromconsumption of the homogeneous good, due to the complementarity between z and qi re‡ected in(1). A higher marginal utility from consumption of the homogeneous good makes consumers more7

sensitive to price di¤erences when choosing among the di¤erent brands in Qi . Second, the greaterisi , the greater are the perceived di¤erences among the various brands with quality qi , as we havenoted before. This greater degree of product di¤erentiation tends to make demands less sensitive
to price changes. These two forces may work in opposition as they a¤ect price setting; the markup
on high-quality goods will be greater than that on low-quality goods if and only if

H =qH >

L =qL .

With common prices, the …rms that produce di¤erent varieties of a good of a given quality qi
achieve similar volumes of sales. Let di be the quantity demanded per capita of a typical brand in
Qi when all goods are priced according to (4). Then"1
di = EninHH

ni i i (y)L

H (y) + nL

L (y)

#

; for i = H; L;

(5)

where
i (y)

e(y ci )qi

icaptures the e¤ect of income on demand and E is the expectations operator with respect to theR1
distribution of income, i.e., E [B (y)]ymin B(y)Fy (y)dy. The markups of i =qi on sales of N diyield a common pro…ti to all producers of brands with quality qi , wherei (nH ; nL )iN

q i niE"ni i i (y)nHHL

H (y) + nL

L (y)

#

fi ; for i = H; L:(6)

These functions determine the pro…tability of entry at each quality level. In equilibrium, ni > 0
impliesi (nH ; nL ) = 0 whilei (nH ; nL )0 when ni = 0. In the next section, we will use thesefree-entry conditions to characterize an equilibrium in a closed economy. Once the number of …rms
producing at a given quality level is known, sales of each brand of the di¤erentiated products also
are determined. Together, the …rms selling goods with quality qi capture aggregate sales of ni di N ,so that aggregate output of all di¤erentiated products is nH dH N + nL dL N = N .10 This equalityre‡ects the fact that each of the mass N of consumers buys one unit of some product.
The di¤erentiated-products industry employs a total of nH (dH cH N + fH ) + nL (dL cL N + fL )units of e¤ective labor. The di¤erence between aggregate labor supply— which equals N times
the mean value of y— and labor use in the di¤erentiated-products industry gives the labor usedin producing homogeneous goods. The market for homogeneous products clears by Walras’Law.
Therefore, once we solve for the number of …rms of each type in the di¤erentiated-products industry,
the remainder of the variables determined in the general equilibrium are readily found. Accordingly,
we focus in what follows on the determinants of nH and nL .
10Note that ni di = E [ i (y)]; i.e., the per capita demand for all goods with quality qi matches the probability thata random consumer will choose to purchase a good with that quality.

83Autarky Equilibrium

To characterize an equilibrium in a closed economy, we de…ne xi as the quantity that a …rm
producing a brand with quality qi must sell in order to break even when it prices according to (4);
i.e.,
xi =

fi qi

for i = H; L:(7)

i

Notice that the break-even volume depends only on the size of the …xed cost and the size of themarkup, as in Krugman (1980). So, (7) will pin down the output per brand for any quality of goodthat is available in equilibrium.
In an autarky equilibrium, if some positive number of …rms produce goods with quality qi thedemand per brand must reach the break-even level. Otherwise, no …rm producing this quality can
pro…tably enter. In other words, if ni > 0, N di = xi , whereas N di < xi implies ni = 0. In any
case, the aggregate output of all di¤erentiated products matches the population size N , ornH xH + nL xL = N .

(8)

We will refer to this equation as the aggregate demand condition. It implies, of course, that at least
one of nH and nL must be positive.
But notice from (5) that as ni approaches zero with ni0 > 0 for i0 6= i, the demand for a typicalbrand with quality qi grows in…nitely large. This means that a producer of a brand with quality qi

will certainly be able to achieve the break-even volume when the number of its competitors o¤ering
a similar quality is su¢ ciently small. In equilibrium, brands of both qualities will be available toconsumers.11
Now that we know that nH and nL both must be positive, market-clearing for each brandrequires xi = N di orxi = N E"

ni i 1 i (y)nHHL

H (y) + nL

L (y)

#

; for i = H; L.

(9)This pair of equations in turn implies12"

E (nL xL ) L +(nH xH + nL xL ) GH (y)(nH xH )1H

GL (y)

11(nL xL )1

L

GH (y)

# 1

=0,

(10)

In making this statement, we have ignored the integer constraint. The equilibrium “solution” for some ni might
be a fraction, in which case it might not be pro…table for the …rst “whole” …rm to enter in a quality segment.
Moreover, we have assumed that many …rms compete in order to justify our assumption that …rms take price indexes
as given. We will not divert attention to these details, but instead restrict ourselves to parameters for which our
focus on an equilibrium with nH > 0 and nL > 0 is well justi…ed.
12
Note that the weighted sum of xH and xL from (9) implies (8), which means that only two of these three equations
are independent. See the appendix for the derivation of equation (10).

9

nH
G

N

E

E'

G

N

nL

0

Figure 1: Autarky equilibrium

where
Gi (y)

xiii (y) .

We will refer to (10) as the composition of demand condition; it gives a second relationship between
nH and nL , once xH and xL are pinned down by (7).
Equations (8) and (10) have a unique solution, which indeed has nH > 0 and nL > 0. To see
this, substitute (8) into (10), to derive"

E (nL xL ) L +N GH (y)(nH xH )1H

GL (y)(nL xL )1

L

GH (y)

# 1

=0.

(11)

Combinations of nH and nL that satisfy (11) are depicted by the curve GG in Figure 1. These are
the numbers of …rms in the two quality classes that are consistent with equal pro…tability acrossthe two types of …rms, given that the typical …rm in Qi sells xi units and that aggregate sales areequal to N . Equation (11) is satis…ed in the limit as nL = nH ! 0. Moreover, the curve GG iseverywhere upward sloping. This re‡ects the fact that, for given aggregate demand, as nL increases,
the pro…tability of a brand in QL falls by more than one in QH , because the extra low-quality goods
compete more directly with other low-quality goods than with the high-quality goods. To restore
equal pro…tability in the two quality classes, the number nH of producers of high-quality goods
would have to rise in order to maintain the required composition of demand.
As the …gure shows, if the GG curve begins at the origin and slopes upward, it surely mustcross the N N line— which represents equation (8)— and can do so only once.
This establishes
Proposition 1 There exists a unique autarky equilibrium. In the autarky equilibrium, nH > 0 and
nL > 0.

10

In the remainder of this section, we describe how the autarky equilibrium re‡ects the size of theeconomy and its income distribution.13 We also show how the model can be used to examine thewelfare implications of changes in the economic environment for di¤erent income groups. These
properties of the model will aid us in understanding the direction and distributional implicationsof trade in the sections that follow.
The size of the economy is captured by the parameter N . As N increases, the N N curve in
Figure 1 shifts out by the same proportion as the increase in the consumer population. Equation(11) implies that if

H = L , the GG curve shifts out radially by this same proportion, and the^ .14 That is, when the dissimilarity of low and highnew equilibrium is at E 0 , where n^H = n^L = Nquality goods is the same, an expansion in the size of the economy leads to an equiproportionate
increase in the number of goods of either quality level. If

H >L — that is, if low-quality goods

substitute more closely for one another than high-quality goods, as seems most plausible— the GG
curve does not shift quite so far radially as for the case of equal dissimilarity parameters. Then
^ >nn
^H > N^ L , and possibly n^ L < 0. Alternatively, if H < L , the GG curve shifts out radially^ > nby more than the proportional increase in population size, so that n^L > N^ H and possiblyn^ H < 0. In short, growth in market size causes an expansion in the relative number of the morehorizontally-di¤erentiated products.15
Now consider an upward shift in the income distribution in the sense of …rst-order stochastic
dominance; i.e., at every income level y, the fraction of the population with income less than orequal to y declines. This has no e¤ect on the N N curve, but it causes the GG curve to shift tothe left.16 Intuitively, as the economy grows richer, demand shifts toward the high-quality goods,
raising the relative pro…tability of these goods. This induces entry of …rms that produce such
goods and exit of producers of low-quality products. Therefore, when comparing two similarlysized economies, the richer one (in the sense of …rst-order stochastic dominance) will have morevarieties of the high-quality product and fewer varieties of the low-quality product.
Finally, consider an increase in income inequality, as represented by a mean-preserving spreadof the distribution Fy ( ). The e¤ect on relative demand is in general ambiguous, as those at the top
end of the distribution collectively buy more of the high-quality goods while those at the bottom
end do just the opposite. However, if the initial equilibrium is such that a majority of every income
class purchases low-quality products, then the former e¤ect must dominate.17 Thus, a spread inincome distribution in a poor economy (one in which

L (y) >

H (y) for all y) induces a shift in the13

The algebra of the comparative statics that we describe here are derived more formally in the appendix.
We use a circum‡ex to denote a proportional increase; i.e., Z^ = dZ=Z.
15
See Epifani and Gancia (2006) and Hanson and Xiang (2004) for similar results in a di¤erent context.
16
The direction of shift in the GG curve depends upon the pattern of the changes in GL (y) =GH (y) but

14x L
GL (y)= L
GH (y)
xH H

L (y)
H (y)

=

xL L
xH H

e( H +cH qH ) ( L +cL qL ) ey(qL qH )decreases with y. This re‡ects the fact that the fraction of consumers who buy high quality is increasing in income.
17
If L (y) > H (y) for all y, then the term inside the expection in (10) is a concave function of y for given nH
and nL . Therefore, a mean-preserving spread in the distribution of y causes the GG curve to shift to the left in suchcircumstances. See the appendix for the details.

11composition of …rms toward producers of high-quality products.
We can readily examine the implications of these shifts for the welfare of di¤erent income groups.
As McFadden (1978) has shown, the expected welfare among those with income y increases with
v(y)

nHH

L

H (y) + nL

L (y) .

(12)

As conditions change,v^ (y) =^H +H (y) H n^L .
L (y) L n

In words, the change in average welfare at income y weights the changes in the number of products
in each quality class by the probability that a consumer with income y purchases a good of thatclass times the degree of horizontal di¤erentiation (dissimilarity) within the class.
^ , where i = ni di = ni xi =N is the
From the aggregate demand condition (8), H n^H + Ln^L = N
fraction of the overall population that purchases a good of quality i. Using this equation, we canwritev^ (y) =

L

L (y)
L

+

H

H (y)

^+
N

H L

H

H (y)

H

L

L (y)

H

(^
nH

n
^L) .

(13)

L

The …rst term in the expression for v^ (y) is a pure scale e¤ ect. Holding constant the relative numberof high- and low-quality products, an expansion of scale bene…ts individuals at all income levels,
because it increases the number of varieties and therefore increases the likelihood that an individual
will …nd one to his liking.

The second term is a pure composition e¤ ect. For a given scale, anincrease in the relative number of high-quality products bene…ts those who are more likely than
average to consume such a product and harms those who are more likely than average to consume
a low-quality product. An increase in the variety of high-quality products relative to the varietyof low-quality products is more likely to bene…t a given income group the more dissimilar are thebrands of high-quality products and the more similar are the brands of low-quality products.
An increase in population size generates a scale e¤ect that bene…ts all consumers and a composition e¤ect that a¤ects the various income groups di¤erently. Ifgroups gain from population growth. If

H >

H =

^H = n^ L and all income
L, n^H > n^ L . The richL , as seems most plausible, then n

est individuals in the economy are more likely to purchase the high-quality good than the average
consumer and less likely to purchase the low-quality good, so

H (ymax ) = H > 1 >L (ymax ) = L .

These individuals must gain on average from population growth. The poorest consumers— who are
more likely than average to purchase the low-quality good and less likely than average to consume
the high-quality good— may gain or lose.
An upward shift in the income distribution (or a spread of the distribution in a poor economy)
generates a shift in the composition of di¤erentiated products toward high-quality goods, withoutchanging the output-weighted number of products. WithH=

L , the associated compositione¤ect bene…ts the members of the highest income group (on average) and harms the members of
the lowest income group. The former are more likely than average to consume a high-quality goodand so they gain from having a wider variety of choices. The latter are more likely than average

12to consume a low-quality good and so they lose from having fewer choices. If

H >L , the highest

income group again must bene…t, but the lowest income group may do so as well. Although thelatter are more likely to consume a low-quality product, the contraction of variety does not hurtthem so much because the goods are relatively similar; meanwhile, the expansion of variety ofhigh-quality products is advantageous, because these goods are relatively dissimilar. If there arelosers (on average) from a change in the composition of products that favors high-quality goods, itwill be all those groups with income less than or equal to some critical value.

4

Trade with Incomplete Specialization

In this section, we introduce international trade. We assume that there are two countries, R andP, that di¤er only in size and in their distributions of e¢ ciency labor. In other words, we do notallow for any comparative advantage in production. By doing so, we abstract from supply-side

determinants of the pattern of trade in order to focus on those that derive from di¤erences inincome in the face of non-homothetic preferences. The country designations of R and P are meant
to suggest “rich” and “poor,” although we do not insist on any particular relationship between
their sizes or their income distributions except in some special cases.
We assume throughout that both countries have su¢ cient supplies of e¤ective labor relative tothe equilibrium labor demands by their producers of di¤erentiated products so that some labor ineach country is used to produce the homogeneous, numeraire good. This ensures that the wage ofa unit of e¤ective labor is equal to one in both countries.
We assume that the di¤erentiated products are costly to trade.18 In particular, it takesof e¤ective labor to ship one unit of a variety with quality qi

i units
from one country to the other.19 As

i grows large, national outputs converge on those of the autarky equilibria.

In such a setting, as

we now know, both countries produce goods of either quality. We will …nd that such incomplete
specialization characterizes the trade equilibrium whenever the trading costs are su¢ ciently high.
These are the circumstances that we consider now, whereas in the next section we will study
equilibria in which each quality level is produced in only one country, as happens almost always
when shipping costs are small.
Shipping requirements raise the cost of serving foreign consumers relative to domestic consumers. For a good with quality qi , the marginal cost of a delivered export unit is ci +i , whereas

local consumers can be supplied at a cost of ci . The arguments from Section 2.2 now imply that a…rm producing a brand with quality qi maximizes pro…ts by charging foreign consumers the priceci + i + i =qi , whereas domestic consumers are charged the lower price ci + i =zi (see (4)). In otherwords, mark-ups are

i =qi for all sales, as …rms fully pass on their shipping costs to their foreign

18

Davis (1998) has shown that a home-market e¤ect may not exist if di¤erentiated products and homogeneous
goods bear similar trading costs. But Amiti (1998) and Hanson and Xiang (2004) demonstrate that the home-markete¤ect requires only that transport costs di¤er across sectors.
19
Notice that the trading costs here are a certain amount per unit, not “iceberg costs” as is more typically (butunrealistically) assumed in models of monopolistic competition with trade. Iceberg costs could be readily incorporated
into our framework as well.

13customers.
Demands for domestic goods of quality qi in country k re‡ect the prices of these goods, theprices of competing import goods, and the numbers of local and foreign imported brands at eachquality level. Letting dki represent the per capita demand by domestic consumers for a typical goodof quality qi produced in country k when all goods are priced optimally, (3) implies
1dki = k Ek
n
~i

"

n
~ ki
n
~ kH

H

i

i (y)

n
~ kL

H (y) +

L

L (y)

#

;

i = H; L and k = R; P

(14)

where
n
~ ki = nki +i`i ni ,

i qi = ie,nki is the number of brands of goods of quality qi produced in country k, and Ek is the expectation
with respect to the income distribution in country k. Notice the similarity between (14) and(5). Now, domestic brands share the market with both domestic and foreign rivals but, inasmuch
as imports of a given quality bear a higher price due to shipping costs, the foreign brands areless e¤ective competitors. For domestic …rms, demand per capita is the same as it would be inautarky with n~ ki local competitors producing quality qi . The foreign …rms are discounted in thismeasurement of “e¤ective competitors” by an amounti 2 (0; 1) that re‡ects the trading cost forgoods of quality qi , as well as the quality and dissimilarity of these products. Also, (3) implies
that per capita demand for an imported variety of quality qi in country k equals
fractionk
i di ; i.e., it is a

i of the demand faced by a local brand.

A …rm producing a variety with quality qi in either country earns pro…ts per sale of

i =qi ,

considering the …xed mark-up it charges over delivered cost. In order to break even, such a …rm,no matter where it is located, must make sales totalling xi = fi qi = i units, as per (7). In an
equilibrium with producers of both qualities in both countries, we must havexi = N k dki +` `i N di ,` 6= k, k = R; P, i = H; L,

where N k is the population of consumers in country k. The right-hand side of this equation
represents total sales by a …rm located in country k, comprising domestic sales and exports sales,
where the latter are a fraction

i of what a local producer in country ` makes of domestic sales.
P P
For these equations to hold for both k = P and k = R it must be that N R dR
i = N di for

i = H; L; that is, …rms in each country must achieve the same volume of domestic sales. Since thesize and the income distributions in the two countries may di¤er, the equality must be achieved byadjustments in the numbers of e¤ective …rms in each market. In particular, the equality between
the required volume of total sales and the total demand faced by producers in market k implies14xi = N k dki (1 +ki ) or

k

N E

"

n
~ ki
n
~ kH

H

i

1

H (y) +

i (y)

n
~ kL

L

L (y)

#

=

1
1+

fi qi
i

;

i

i = H; L, k = R; P.

(15)

The equations in (15) provide four independent relationships, two for country R that jointly

determine n
~R
~R
~P
~P
L and nH and two for country P that jointly determine n
L and nH . These equations
have exactly the same form as those in (9) that describe the autarky equilibrium, except that xi

for the closed economy is replaced by xi = (1 +i ) for the open economy.

In other words, tradee¤ectively reduces sales per …rm, as far as the solution for the e¤ective number of …rms in eachcountry is concerned. The proof of Proposition 1 guarantees that (15) has a unique solution witha positive number of e¤ective …rms of each type in each country.
It is not enough, of course, that the number of e¤ective …rms in each country be positive forthe solutions to (15) to represent a legitimate trade equilibrium. We require in addition that theactual number of varieties in each country be positive. Given the values of n
~R
~R
~P
~P
L, n
H, n
L , and nHthat result from the solution of (15), we can solve for nkL and nkH using n~ ki = nki +
nki =

n
~ ki
1

~ `i
in
,
2
i

` 6= k, k = R; P, i = H; L.

`i ni . This gives(16)

A positive solutions for nki for all i and k requires
1>iwhich is always satis…ed when

n
~ ki
>
n
~ `i

i ,

` 6= k, k = R; P, i = H; L

i is close to zero but rarely satis…ed when20
i is close to one.

This justi…es our claim that a trade equilibrium with incomplete specialization always exists whentransport costs are su¢ ciently high, but fails to exist (generically) when transport costs are low.
The trade equilibrium with incomplete specialization features intra-industry trade at each quality level. Some consumers in R opt for preferred varieties of the high-quality good produced inP, despite their higher price that includes a charge for shipping. Similarly, some consumers in R
choose to import a favorite foreign variety of the low-quality good. Consumers in P will likewise
import high- and low-quality goods produced in R.

In fact, we know that the export sales by a typical producer of quality qi are the same in both

locations. Therefore, country R exports more of goods of quality qi to P than it imports of that

quality if and only if country R has more …rms producing goods of quality qi than does country P.
P
But, from (16), nR~R~Pi > ni if and only if n
i >n
i . Therefore, we can identify the equilibrium tradebalance in each quality class by comparing the e¤ective number of sellers of that quality in the two20
When i is close to one, the pair of inequalities can be satis…ed only if n
~R
n
~P
i
i , which happens only underP
exceptional circumstances. For example, N R = N P and FyR = FyP implies n
~R
=
n
~
.
i
i

15

countries.21
The pair of equations that determine n~R~Pi and ni are the same as those that determine theautarky numbers of producers of quality qi in R and P, except that xi in the latter is replaced by
xi = (1 +i ) in the former. Therefore, we can use the comparative statics of the autarky equilibrium

to identify the sectoral imbalances of the trade equilibrium with incomplete specialization. For
example, suppose that the countries have the same distributions of income (FyR (y) = FyP (y)) but
country R is larger than country P (i.e., N R > N P ). We have seen that if

H =L , the larger

country has more autarky producers of both classes of goods— in proportion to its larger size.
If instead high-quality goods are more di¤erentiated than low-quality goods ( H >L ), then thelarger country has in autarky an even greater relative abundance of producers of high-quality goods
than its relative superiority in size, but it may support fewer (or more) producers of low-quality
products. These comparisons carry over to the numbers of e¤ective sellers in a trade equilibrium~R~P
L , then ni > ni for i = H and i = L; then the~Plarger country is a net exporter of both high- and low-quality products. If H > L , n~R
H , but
H >nwith incomplete specialization. That is, if

H =the comparison of e¤ective numbers of producers of low-quality goods can run in either direction.
In such circumstances, the larger country is a net exporter of high-quality goods but may be a net
exporter or a net importer of low-quality products.
Now suppose that the two countries are identical in size (N R = N P ) but the income distribution
in the richer R …rst-order stochastically dominates that in poorer P. Then, in autarky, the richcountry has more …rms producing high-quality goods and the poor country has more …rms producing

low-quality goods. These comparisons carry over to the e¤ective numbers of …rms in the trade~R~P~P
equilibrium with incomplete specialization, so that n~R
L . It follows that the rich
L >n
H and nH >ncountry R is a net exporter of high-quality goods and a net-importer of low-quality goods.

Finally, suppose that a majority of consumers at every income level in both countries purchaselow-quality goods. Let the countries be of similar size and with similar mean income, but supposethat the income distribution in R is more spread than that in P. As we have seen before, R has

more producers of high-quality goods and fewer producers of low-quality goods than does P in
autarky. With costly trade, R becomes a net exporter of high-quality goods and a net importer of
low-quality goods.

We summarize our …ndings about the pattern of trade in
Proposition 2 If trade costs are su¢ ciently high, there exists a unique trade equilibrium in which
each country produces both high- and low-quality di¤ erentiated products. In this equilibrium, (i) if
N R > N P and FyR (y) = FyP (y) for all y, and if

L , then R exports on net the high-quality
goods but may export or import on net the low-quality goods; (ii) if N R = N P and FyR (y) < FyP (y)21H

Net exports from R to P of goods of quality qi are given by
iN

P

R
dP
i ni

iN

R R P
di ni

=
=

16

i

1+

xi nR
i
fi qi

i

1

nP
i

i
2
i

i

n
~R
i

n
~P
i

.

for all y, then R exports on net the high-quality goods and imports on net the low-quality goods; (iii)

if N R = N P ,L (y) >

R
H (y) for all income groups in R and P, and Fy ( ) is a mean-preserving

spread of FyP ( ), then R exports on net the high-quality goods and imports on net the low-quality
goods.

Proposition 2 can be understood in terms of the “home-market e¤ect” described by Krugman(1980). Take for example the case in which the countries are of similar size but the income distribution in R …rst-order stochastically dominates that in P. The greater income in R compared to
P provides this country with a larger home market for high-quality goods. If the same numbersof producers of high-quality goods were to enter in both countries, those in R would earn greater
pro…ts than those in P, thanks to their ability to serve more consumers with sales that do notbear shipping costs. In order that producers of high-quality goods in both countries break even,
there must be greater entry of such producers in the rich country, so that their …ner division of themarket o¤sets their local-market advantage. The same is true in the market for low-quality goods,
where producers in P enjoy an advantage due to their closer proximity to the larger market. Accessto a large home market a¤ords a competitive advantage that induces entry and ultimately dictates
the pattern of trade.
We turn now to the e¤ects of a reduction in trade costs, focusing particularly on the dis-tributional consequences. For concreteness, consider …rst a decline in the cost of transporting
high-quality goods.22 A fall in

H induces an increase inH.

To see the e¤ects of this, we use

Figure 2 to determine the e¤ective numbers of sellers in country R; the numbers for country P

are determined similarly. In Figure 2, the GR GR curve is analogous to the GG curve in Figure~R
1; it represents combinations of n~R
L that satisfy (11), when in the latter nH and nL are
H and n~R
replaced by n~R
L , respectively, and xi is replaced by xi = (1 +H and nthe equation23

i ).

The line N R N R depicts

xH
xL
n
~R +
n
~R = N R,
1+ H H 1+ L L

which replaces the N N line of Figure 1.
Now letH rise.

This shifts the N R N R line upward in proportion to the increase in 1 +H.

~ represents an increase in the e¤ective number of high-quality products relative to E
Thus, point E
in proportion to the increase 1 +H . But, as can be seen from (11), the G

more than proportionately to the percentage increase in 1 +R GR curve shifts upward

H . As a result, the new equilibrium

point E 0 has more e¤ective brands of high-quality products and fewer e¤ective brands of low-quality
products than at E. Indeed, it is apparent that an increase in

H induces the same response as a

reduction in the …xed cost of entry by producers of high-quality products, fH . A similar analysis
applied to a reduction in the cost of trading low-quality products would show a rise in the e¤ective
number of low-quality brands and a fall in the e¤ective number of high-quality brands in country
R. Moreover, the analysis is qualitatively similar for country P. Finally, it is evident that if 1 +H

22

The details of the algebra are provided in the appendix.
R R
R R
R
R R
Note that n~R~R
H N dH + n
L N dL = N , while xi = N di +R R
for the N N line follows from combining these two.
23

17

iN

P

dP
i = (1 +i) N

R Rdi for i = H; L. The equation

n~H
GR

NR
E'

~
E
E

GR

~
n
L

NR

0

Figure 2: Trade equilibrium: Reduction inand 1 +

H

L both rise equiproportionately, then the change in the e¤ective number of high- andlow-quality products in country k mimics that for a similar percentage increase in the population
variable, N k . From our analysis of the autarky equilibrium, we know that if

H =L , population

growth generates an equiproportionate increase in the e¤ective numbers of low- and high-quality
products in country k , whereas if

H >L the e¤ective number of high-quality products expands

more than in proportion to the increase in 1+ H or 1+ L while the e¤ective number of low-quality
products may rise or fall.
What are the welfare implications of these induced changes in the e¤ective numbers of brands?
In a world with costly trade, the average welfare of those with income y in country k increases withv k (y) = n
~ kH

H

n
~ kL

H (y) +

L

L (y) , for k = R; P.

Welfare of individuals in country k depends on the e¤ective numbers of brands available there, withforeign brands carrying less weight than domestic brands due to their higher prices. Di¤erentiating
the expression for v k (y) and rearranging terms, we can derive an expression for the change inaverage welfare of an income group analogous to (13), namelyv^k (y) =

k (y)
k (y)
L
H
+
H
k
k
L
H
k (y)
+ kH kL H H k
H

L

h
L

k
H

1\
+ H +

k (y)
L
k
L

k
b
n
~H

k
L
k
b
n
~L

1\
+ L

i

, for k = R; P,(17)k (y) is the fraction of consumers in country k with income y that buys a good with qualityiqi , and ki is the fraction of all consumers in country k that buys a good with quality qi . The term

wherein the …rst line of (17) is a pure cost-savings e¤ ect, analogous to the scale e¤ect in (13). The term inthe second line of (17) is a pure composition e¤ ect, analogous to the similarly-named term in (13).
18The cost-savings e¤ect bene…ts consumers at all levels of income; it re‡ects the fact that, for given
relative numbers of e¤ective brands of each quality, a fall in the cost of trade facilitates entry of new
producers, which expands the range of available varieties and so the probability that a consumer will…nd one especially to his liking. The composition e¤ect impacts di¤erent income classes di¤erently.
An expansion in the e¤ective variety of high-quality goods relative to the e¤ective variety of lowquality goods bene…ts those who are more likely to consume a high-quality product but harms those
who are more likely to consume a low-quality product; and, of course, the likelihood of consuming
a high-quality good rises with income.
Let us return to the e¤ects of a reduction in trade costs. Consider …rst a decline in the costof transporting high-quality goods. As we have seen, such a decline in

H expands the e¤ective

number of high-quality brands in each country, while contracting the e¤ective number of low-quality
brands. The cost-savings e¤ect bene…ts all consumers. If

H

L , the composition e¤ect mustbene…t the average member of the highest income group in each economy, but it may harm theaverage member of the lowest income group. Therefore,H

L su¢ ces for a fall in

H to augment

the average welfare of the most well-o¤ consumers in each country. There may be gains from adecline in

H for all income groups in a given country, or else the gains may be limited to thoseincome groups with y above some critical level.24

Other reductions in trade costs can be analyzed similarly. For example, declines inthat increase 1 +H and 1 +

H and

L

L by the same proportions must bene…t all income groups, if the twoclasses of goods are horizontally di¤erentiated to the same extent ( H =L ); if, however, the high-quality goods are more dissimilar as a group than the low-quality goods, such an equiproportionate
increase in 1 +H and 1 + L must bene…t the highest income group in each country but may harm

the poor.
Our analysis also sheds lights on the distribution of the gains from trade. The autarky equilibrium for either country is the solution to (15) withfound by integrating the increases in

H and

H =

L = 0.

The e¤ects of trade can be

L from zero to their actual levels.

This generates

a cost-savings e¤ect that bene…ts all consumers. It also generates a composition e¤ect that may
bene…t some income groups at the expense of others. If the e¤ective number of brands at both
quality levels rises as a result of trade, then all consumers must gain. If the e¤ective number ofbrands of some quality level declines, then income groups that buy this good with a probability
that exceeds the economy-wide average may lose. Although trade may not bene…t every income
group, it always bene…ts some such groups.25
We summarize our discussion of the distributional consequences of a reduction in trade costs in
Proposition 3 In a trade equilibrium with incomplete specialization, a decline in the trade cost
24
Even if H < L there must be some income groups that gain from a reduction in H . To see this, suppose theopposite were true. Then, the left-hand side of (15) increases for i = L inasmuch as the numerator increases at everyy (because n~ L falls) and the denominator falls at every y (because average welfare has been assumed to fall). But theright-hand side of (15) is unchanged, which contradicts the requirement for equilibrium in the market for low-quality
goods.
25
The proof of this statement follows along similar lines to that used in footnote 24.

19

i raises the e¤ ective number of brands of quality qi and reduces the e¤ ective number of brands ofquality qj , j 6= i, in both countries. Any reduction in trade costs must bene…t the average member ofsome income group. If,as a result of a reduction in trade costs, the e¤ ective number of high-quality(low-quality) brands falls in some country, then the highest-income (lowest-income) groups in thatcountry may lose.
We conclude this section with numerical examples that illustrate some of the points we havemade. Figure 3 shows a case in which all income groups gain from a fall in the transport cost for
high-quality goods. To generate this …gure, we have assumed that income in each country has a
R = yPR
displaced Gamma distribution, with ymin
min = 1, ymedianP
5:15, and ymedian

2:38.26 In theleft-hand panel, the …gure shows the e¤ective numbers of high- and low-quality varieties in R as
H is raised from zero to 0.8, while27
L is held constant at 0.5.

The right-hand panel shows theaverage welfare among those with the lowest income in R and among those with the median income

there. In drawing the …gure, we have normalized the (average) welfare level for each income groupto equal 100 whenH = 0.

The rich gain proportionately more than the poor from a fall inHthanks to the composition e¤ect that re‡ects the rise in the e¤ective variety of high-quality goods
and the fall in the e¤ective variety of low-quality goods. Nonetheless, even the poorest consumers
bene…t from a fall in transport costs in this case. The …gures for the poor country P (not shown)
are qualitatively similar.

Figure 3: Increase in

H : All consumers gain

Figure 4 illustrates the possibility of distributional con‡ict. This …gure uses the same distributions of income in the two countries as above, but it depicts a case in which the high-quality
products are less di¤erentiated (and the low-quality products more so) than before, so that thecomposition e¤ect is more damaging to the poor.28 Here, the median income group in country R
26
The example takes N R = N P = 1000, qH = 1:05, qL = 0:9, H = 0:7, L = 0:5, L = 0:5, fH = 5, fL = 1:5,
cH = 0:3, and cL = 0:05: The distributions of income are such that y 1 has a Gamma distribution in each country,with a coe¢ cient of variation equal to 1 in each case. We take the scale parameter in R to be 6 and that in P to be
2, so that mean incomes are 7 and 3, respectively.
27
For H > 0:8 in this example, P specializes in the production of low-quality goods.
28
The parameters for Figure 4 are N R = N P = 1000, qH = 0:9, qL = 0:75, H = L = 0:6, L = 0:5, fH = 20,

20

gains from a reduction in the cost of trading high-quality goods, but the lowest income group in R
loses. Again, the …gures for the poor country look qualitatively similar.

Figure 4: Increase in

H : Rich gain but poor lose

Finally, Figure 5 illustrates the patterns of specialization for di¤erent values of

H and

L . The…gure is drawn for the same parameters as underlie Figure 3. In this case, the countries are similarin size but consumers in R are richer than their counterparts in P . When both trading costs arereasonably large, so that

H and

L are small, both countries are incompletely specialized, much as

they are in autarky. A su¢ cient reduction in the cost of trading the high-quality goods, holdingL…xed at a reasonably low level, generates an equilibrium in which the poor country P produces only
low-quality goods, while the rich country R produces both high- and low-quality goods. Similarly,a su¢ cient reduction in the cost of trading low-quality goods, holding

H at a reasonably low level,

results in an equilibrium in which R produces only high-quality goods while P produces goods inboth quality classes. If the cost of transporting both goods is su¢ ciently small, each class of goods

is produced in a single location. We study this latter type of equilibrium in greater depth in thenext section.

5

Trade with Specialization

In a trade equilibrium, high transport costs allow …rms in each country to enter pro…tably inboth quality segments of the market for di¤erentiated products. Even if there are relatively many
foreign producers of a given quality level, local …rms can enter to sell to local customers thanks
to the protection a¤orded by the high transport costs. As we have seen, when

H

and

L are

su¢ ciently close to zero, the trade equilibrium is characterized by incomplete specialization in bothcountries.
As transport costs fall, it becomes more di¢ cult for …rms in a smaller market to overcome
the disadvantage of their lesser local demand. Eventually, as

i rises toward one, the number of

producers of quality qi in some country must fall to zero, as is implied by equation (16). For still
fL = 1:5, cH = 0:3, and cL = 0:05:

21

Figure 5: Patterns of specialization

smaller transport costs, all of the varieties with quality qi are produced in a single country. In thissection, we study trade equilibria with specialization of this sort. We are particularly interested
in the limiting equilibrium, as transport costs approach zero. We will see that this equilibrium is
unique and has a readily understood pattern of trade. Before beginning this analysis, however, it
will prove useful to have a brief discussion of the integrated equilibrium, when transport costs forboth quality levels are literally zero.

5.1

The Integrated Equilibrium

Suppose thatH =L = 0, so thatH =L = 1.

With no supply-side sources of comparativeadvantage, there is nothing in our model to pin down the location of production. Factor-priceequalization and zero transport costs means that the di¤erent goods can be produced in various
combinations in the two countries, without consequence for any aggregate variables or anyone’s
welfare level. Although we cannot say anything about the pattern of trade, we can nonethelesscharacterize the integrated equilibrium in terms of the total numbers of brands of each quality thatare produced and the average welfare of the di¤erent income groups.
In the absence of trade costs, the e¤ective number of varieties with quality qi is the same inRPboth countries; i.e., n
~R
~P
i = n
i = ni + ni for i = H; L. We can solve for these aggregate numbersof varieties using the autarky equilibrium conditions for an economy with population N R + N P
and an income distribution that is the composite of the separate distributions in the two countries.
This gives nH and nL , the aggregate numbers of high- and low-quality products, respectively, thatare produced in the integrated global economy. Armed with these variables, we can calculate per22capita demand in country k for a typical brand with quality qi , which we denote by dki . That is,
dki =

"
1 k
E
ni
(nH ) H(ni ) ii (y)H (y) + (nL )

L

L (y)

#

.

(18)

The impact of trade with zero transport costs on the welfare of an income group y in country kre‡ects a scale e¤ect and a composition e¤ect, as before. The scale e¤ect— which arises because theintegrated economy has a larger population than either separate economy— works to the bene…tof all income groups in both countries. The composition e¤ect bene…ts the high-income groups
in country k if the relative number of high-quality brands in the integrated equilibrium exceeds
the relative number of high-quality brands in the country’s autarky equilibrium. Otherwise, thecomposition e¤ect bene…ts the low-income groups in country k. The e¤ect of an opening of tradeon the relative numbers of brands of the di¤erent qualities levels re‡ects both the biased nature of
growth whenH 6=

L , and the demand e¤ects of a change in income distribution from one withthe properties of the local economy to one with the properties of the global economy.

5.2

Trade Equilibrium with Small (but Positive) Trade Costs

Now we are ready to characterize the trade equilibrium when transport costs are positive but small.
If a …rm producing quality qi in country k is to break even, it must attain total worldwide salesof xi = fi qi = i . Each …rms’sales comprise its home sales— N k dki for a …rm in country k— and its
export sales, which are a fraction

i of the domestic sales of a foreign …rm.

For …rms producing

quality qi to achieve the break-even volume of sales in both countries given the required relationshipbetween the home sales of one and the export sales of the other requires that domestic sales be
P Pcommon to the two countries; i.e., N R dR
i = N di , as we have noted before.

But note that the per capita demand in country k for a typical variety with quality qi approaches
dki as transport costs go to zero.

The per capita demands of the integrated equilibrium are givenby (18) and are uniquely determined by parameters of the world economy. Only exceptionally will
P P
it happen that N R dR
i = N di for i = H or i = L. In other words, only exceptionally will it

happen that …rms in both countries producing a given quality can break even when transport costs
are su¢ ciently small. Otherwise, goods of a particular quality are produced in a single country,
while a potential entrant at that quality level in the other country …nds insu¢ cient demand (at its
optimal price) to cover its …xed costs.
Which country produces each class of goods when trade costs are small? To answer this question,
we look at national demands for products of a given quality in the integrated equilibrium. Suppose,
P P
for example that N R dR
i > N di for products of quality qi ; that is, the typical producer of a goodwith quality qi makes greater sales in country R than in country P. With positive trade costs andoptimal pricing, each …rm’s exports are a fraction of sales by a local producer in the destination

market. It follows that when transport costs are su¢ ciently small, pro…ts per …rm for a producerof a brand with quality qi in country R must exceed those for a producer of that quality in country23

P.29 More generally, all production of goods with quality qi takes place in the country with thelarger domestic market for goods of that quality in the integrated equilibrium. We summarize in
Proposition 4 Suppose N k dki > N ` d`i for i 2 fH; Kg; k; ` = R; P; and ` 6= k. Then, for

H andL su¢ ciently close to zero, all goods of quality qi are produced in country k.

Let us apply Proposition 4 to some special cases that we have considered previously. Suppose,for example, that FyR ( ) = FyP ( ) and N R > N P ; i.e., the countries share the same income
P
R R
P P
distribution but di¤er in size. Then, by (18), dR
i = di for i = H; K. Therefore, N dH > N dH
P P
and N R dR
L > N dL , so the larger country produces and exports all varieties of both the high-quality and low–quality di¤erentiated products. Now suppose instead that N R = N P while FyR ( )PRP…rst-order stochastically dominates FyR ( ). Then dR
H > dH and dL < dL , so the richer country

produces all of the high-quality goods while the poorer country produces all of the low-quality
goods. We record these results in
Corollary 1 Suppose that transport costs are small. (i) If FyR (y) = FyP (y) for all y and N R >P
R = N P and
N P , then nP
H = nL = 0 and R exports goods of quality qH and qL . (ii) If NR
FyR (y) < FyP (y) for all y, then nP
H = nL = 0, R exports goods of quality qH , and P exports goodsof quality qL .

We can also readily examine the e¤ects of a fall in trading costs in an equilibrium with specialization by quality level. Suppose, for example, that only R produces high-quality goods while only
P produces low-quality goods, as when the countries are of similar size and the income distribution

in R …rst-order stochastically dominates that in P. Since every consumer buys one unit of thedi¤erentiated product of some quality level or another,nL xL + nH xH = N R + N P ,(19)

where ni is the equilibrium number of varieties of quality qi , all produced in R for i = H and all
produced in P for i = L, and xi is the break-even quantity of sales per …rm for producers of goods

with quality qi as before. This linear relationships implies that a change in trade costs that induces
entry at one quality level in the country where that quality is produced also forces exit of producersof the other quality level, in the other country.
Next we can use (14) to calculate per capita domestic sales for each type of …rm, recognizing that n~R~R
H = nH , nL =29That is, for~P
L nL , nH=~P
H nH , and n
L= nL . Also, export sales per …rm are

i close to one,
R
i

i

qi

N R dR
i +

P P
di

fi

R R
di + N P dP
i

fi

iN

and
P
i
P P
so N R dR
i > N di implies

R
i >

P
i , where

i

qi

iN

k
i is the net pro…t of a typical producer of quality qi in country k.

24

NP 1

R 1
nL d P
L =nH for a typical producer of a high-quality good in R and N

nH d R
H =nL fora typical producer of a low-quality good in P. The fact that total sales by each type of …rm must
attain the break-even level gives us two more equations for nH and nL , one of which is redundant
given (19).30
Suppose now that the cost of transporting high-quality goods falls. This shifts demand towardthe (imported) high-quality products in P, without a¤ecting demands in R (at the initial numbersof brands). The shift in the composition of demand induces additional entry by producers of high-quality goods in R, while some producers of low-quality goods in P are forced to exit the market.

Then, in both countries, the e¤ective number of high-quality brands rises while the e¤ective numberof low-quality brands falls. From (17), we see that the wealthiest consumers in both countries must
gain, while the poorest consumers in both countries may gain or lose. The consequences of areduction in the cost of shipping low-quality goods are analogous— the variety of low-quality goods
expands and that of high-quality goods contracts in each country, to the bene…t of poor consumers
and the possible detriment of those who are well-o¤.

6Commercial Policy

We turn to the impact of commercial policy. With …xed markups over delivered costs, tari¤s do
not alter the terms of trade. All welfare e¤ects of tari¤s emanate from the induced entry and exitof …rms producing at di¤erent quality levels and from the shifts in the distribution of income that
result from the disposition of tari¤ revenue.
The novel e¤ects of tari¤s in our model are well illustrated in a simple setting in which transportation costs are positive but close to zero and each quality class is produced in only one country.
We assume that R produces all varieties of high-quality products while P produces all varieties of
low-quality products and examine a speci…c tari¤ of t per unit that is introduced in country R.31

In this setting with non-homothetic demands, the manner of redistribution of government revenues
in‡uences the e¤ects of tari¤s on aggregate demand. For concreteness, we assume that tari¤s are
redistributed to consumers on an equal per-capita basis. Each consumer receives additional incomeRof r = tnL dR
L , where dL is the per-capita demand for a typical (imported) low-quality product incountry R.

A tari¤ raises the relative price of low-quality goods in country R. Considering both the pricehike and the redistributed proceeds, (3) implies that the per capita demand for a typical low-quality
product there becomes
dR
L =

"
1 R
E
nL
(nL ) L(r t)qL
L (y) e(r t)qL + (n ) H
rqHH
L (y) eH (y) e(nL ) L30#.

Details of these equations and their comparative statics can be found in the appendix.
In this setting with specialization, a tari¤ on all imports in country R is indistinguishable from a tari¤ on importsof low-quality goods.
31

25

The per capita demand for a typical high-quality product in R is
"
1
dR
ER
H =
nH
(nL ) LrqH
H (y) e(nH ) H(r t)qL + (n ) HH
L (y) eR
Note that r = tnL dR
L = t L > 0, while r

t=

t 1

R
L

rqH
H (y) e#.

< 0, so the tari¤-cum-redistribution

shifts demand in R from low-quality goods to high-quality goods, for given numbers of each typeof product. Consequently, the tari¤ induces entry of …rms producing high-quality goods in R andexit by …rms producing low-quality goods in P.

How does the tari¤ a¤ect the welfare of di¤erent income groups in country R? The average

welfare of individuals with income y in country R can be written analogously to (12) asv R (y) = nHH

rqH+ nLL L (y) e(r t)qL .
H (y) eDi¤erentiating the expression for v R (y) at t = 0 and using (19) and the market-clearing condition,ni xi =RN R +i

P N P , we can express the impact of a small tari¤ on the average welfare of thoseiwith income y in country R asv^R (y) jt=0 =
where

i

H L

H

R (y)
H
H

= ni xi = N R + N P

L

R (y)
L

(^
nH

n
^L) +

L

R R
H L

R (y)
H
qH
R
H

R (y)
L
qL
R
L

dt

(20)

is the fraction of consumers worldwide who buy a di¤erentiatedproduct with quality qi . The right-hand side of (20) combines two terms, a composition e¤ ect anda redistribution e¤ ect. The composition e¤ect should be familiar. It re‡ects the rise in the numberof high-quality varieties and the fall in the number of low-quality varieties induced by the tari¤.
The richest income group in R buys a greater fraction of high-quality goods and a smaller fractionof low-quality goods than the average consumer in the world economy; i.e.,R (ymax ) <
L

L . Therefore, if

H

R (ymax ) >H

H and

L , the composition e¤ect certainly bene…ts the richest income

group in country R. However, the poorest income group in that country may well lose from thechange in the composition of di¤erentiated products.

The redistribution e¤ect re‡ects the transfers of income implied by the lump-sum redistributionof tari¤ revenues. The tari¤ transfers income from those who chose to purchase an imported, lowquality product to those who choose to purchase a domestic, high-quality product. The rich are
more likely to buy a high-quality product than the poor, so they are most likely to bene…t fromthese transfers. Indeed, for the richest income group,R (ymax ) >
H

R and
H

R (y
max ) <L

R andL

the members of this group must gain on average from the redistribution e¤ect as well. But noticethat the redistribution e¤ect might also bene…t the poor, since qH > qL . This is because the tari¤transfers income from those in any income class who happen to prefer one of the low-quality varieties
to those in that same class who happen to prefer one of the high-quality varieties. The latter group
has a higher marginal utility of income due to the complementarity in preferences between quality

26

of the di¤erentiated good and quantity of the numeraire good. If the quality di¤erence betweendi¤erentiated products is large, it may be thatR (yRmin ) = H
H

qH >

R (y
R
min ) = L
L

qL , in whichcase the redistribution e¤ects of a small tari¤ serves to bene…t even the poorest income group in R.
Indeed, the combined composition and redistribution e¤ect can be positive for those with income
ymin , in which case a tari¤ would raise the average welfare of every income group in R, despite theabsence of any terms-of-trade improvement.32

7Concluding Remarks

We have developed a tractable model of trade in vertically- and horizontally-di¤erentiated products.
The model features discrete quality choices by consumers who di¤er in income levels and nonhomothetic aggregate demands for goods of di¤erent qualities. The nonhomotheticity in demand re‡ects
an assumed complementarity in individual preferences between the quality of the di¤erentiatedproduct and the quantity of a homogeneous good. Consumers have idiosyncratic components intheir evaluations of the di¤erent varieties of a given quality of product. The distribution of taste
parameters in the population generates a nested-logit system of product demands.
We have embedded such consumers in a simple, supply-side environment. Goods are produced
from labor alone, with constant returns to scale in the homogeneous-good industry and …xed andconstant-variable costs for the varieties of the di¤erentiated products. The number of varieties at
each quality level is determined by free entry in a monopolistically-competitive, general equilibrium.
Transport costs impede trade between countries that di¤er in size and in their income distributions
but are otherwise similar. In this setting, a large home market for goods of a given quality confers
a competitive advantage to …rms located there, which renders them as net exporters in the tradeequilibrium.
We have used this framework to study the pattern of international trade. We …nd, for example,
that the re‡ection of country size in the trade pattern depends on the extent of horizontal productdi¤erentiation at each quality level. If low- and high-quality goods are equally di¤erentiated, thenthe larger country among two with similar distributions of income will be a net exporter of bothtypes of di¤erentiated products. But if varieties of high-quality goods are more dissimilar thanvarieties of low-quality goods, the small country may be a net exporter of the latter. When two
countries have similar populations, the one that is richer (in the sense of …rst-order stochastic
dominance) will be a net exporter of high-quality goods and a net-importer of low-quality goods.
This prediction of the model is consistent with patterns observed in the data by Schott (2004),
Hummels and Klenow (2005), and Hallak and Schott (2008).
Our framework lends itself to analysis of the incidence of changes in the trading environment.
We can decompose the welfare impact on a particular income group of, for example, reductions
in trading costs into a cost-savings e¤ect and a composition e¤ect. The former tends to bene…t
all consumers, whereas the latter— re‡ecting the induced change in the relative number of low32

A small tari¤ raises the average welfare of all income groups, for example, when the parameters take the values
that were used to generate Figure 3.

27and high-quality products— often bene…ts consumers at one end of the income distribution at theexpense of those at the other.
We have also investigated the impacts of tari¤ policy. In our setting, tari¤s have no e¤ect on
the terms of trade. They generate a composition e¤ect while redistributing income across income
groups. For example, a tari¤ in a country that imports low-quality goods transfers income fromlower income groups— who disproportionately consume goods of lesser quality— to higher income
groups, who do the opposite.
Our framework could readily be extended in several directions. First, it would not be di¢ cultto incorporate several quality classes and additional countries. Then, the model could be used toaddress Hallak’s (2006) …nding that when a country exports goods in a product category to several
destinations, the higher-quality goods are directed disproportionately to the higher-income markets.
We can show, for example, that a unique exporter of a high-quality good will sell more to a richer
country than to a poorer country of similar size. Second, we could introduce direct foreign investment as an alternative means for …rms to serve foreign markets. Then the model might shed lighton the spread of Chinese and India multinational corporations to other developing countries (seeBoston Consulting Group, 2006). Finally, the close a¢ nity between our analytical framework andthe empirical literature on discrete-choice demands makes the model ripe for empirical application.
We hope to pursue these lines in future research.

28

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31

8

Appendix

8.1

Derivation of (10)The pair of equations in (9) implies"#"#
nLL 1 L (y)nHH 1 H (y)
1
1
E
=
E
xL
xH
nLL L (y) + nHH H (y)nLL L (y) + nHH H (y)
or
E

"

1
L 1
L (y)
xL nL

nLL L (y) + nHH

1

1
H
xH nH

H (y)

H (y)

nLL L (y) + nHH

H (y)

#

= 0.

The term in square brackets can be written asnLL L (y) + nHH

H (y)
1
H 1
H (y)
xH nH

1
L 1
L (y)
xL nL

(nL xL ) L xL L L (y) + (nH xH ) H xH H

=

=

! 1

"

1

(nL xL ) L(nL xL )L+(nH xH ) H

xH H

H (y)

(nH xH + nL xL ) xH H

H (y)
1 L

xL L L (y)1(nH xH )

1

! 1

H (y)

H

xL L L (y)(nL xL )

xH H

H (y)

# 1

1

(nL xL ) L.

Since nL xL must be …nite, the expectation will be zero if and only if (10) is satis…ed.

8.2

Comparative Statics of the Autarky Equilibrium

De…ne(y; nH ; nL )"(nL xL )L+

N GH (y)1(nH xH )H

GL (y)

1(nL xL )L

GH (y)# 1

so that (10) implies E [ (y; nL ; nH )] = 0. Since GH (y) =GL (y) is increasing in y, @ =@y > 0. Note alsothat @ =@nH > 0 and @ =@nL < 0

8.2.1

Population size

Divide the numerator and denominator of the expression in square brackets in the de…nition of~ (y; nH ; nL ; N ), where ni = ni =N . That is,de…ne ~~ (y; nH ; nL ; N )"(nL xL )

L

N

L

+

GH (y)
1(nH xH )

H

N L

H

GL (y)

1(nL xL )L

GH (y)by N , to# 1~ ( ) is homogeneous of degree zero in nH , nL , and N . With (8), this implies n^ . If^L = n^H = N~ is increasing in both nL and N . With (8), this implies n^ <n^L < N^H .
H > L,

If

H =

8.2.2

L,

First-order stochastic dominance

The fact that @ =@y > 0 implies, with (8), @ =@nH > 0 and @ =@nL < 0 that nH rises and nL falls as theincome distribution shifts to the right.

32

8.2.3

Mean-preserving spread

A mean-preserving spread in Fy ( ) will increase nH and decrease nL if
calculate@1= (nL xL ) L (nH xH )@y0

Since [GL: (y) =GH (y)] = (qL
@2
@y 2

2

GL (y)GH (y)

1

nL xL + N

GL (y)GH (y)H

N (nH xH )0qH ) [GL: (y) =GH (y)] we have1

2 (nL xL ) L (nH xH )=H(y; nH ; nL ) is concave in y. We

1+ (nL xL ) L (nH xH )H

3

GL (y)GH (y)

nL xL + N

GL (y)GH (y)

nL xL + N

H

2(1

H)

(nL xL ) L (nH xH )2
1H

N (nH xH )qH )GL (y)GH (y)2

GL (y)GH (y)

2

(qL

2

N (qL

qH )

Therefore, @ 2 =@y 2 < 0 if and only if
nH xH =

1

nL xL + N < (nL xL ) L (nH xH )H

GL (y),GH (y)

which implies that @ 2 =@y 2 < 0 if and only if
1<
Therefore, if

8.3

nLL
(nL xL ) L GL (y)=nHH(nH xH ) H GH (y)

L (y)

,

H (y)

L (y) >H (y).

L (y) > 1=2 for all y, a mean-preserving spread will increase nH and decrease nL .

Comparative Statics of Trade Equilibrium with Incomplete Specializationk

Let us de…nek~ kL analogously toy; n~ kH ; ny; n~ kH ; n~ kL

where Gi (y)[xi = (1 +

2

6 k
eL
4 n
i

i )]

( ), namely

L

xL
1+ L

N GH (y)+nekH 1+xHHki (y), so that E [1

Hn
ekL 1+xL L

GL (y)1

L

GH (y)

3 1
7
5] = 0 for k = R; P: Now we use

xH
xL
n
ek +
n
ek = N
1+ H H 1+ L Lkto solve for n~ kH and substitute into Gi (y) and

k

(y)

2

6 k
= 4 n
eL
2

6 k
= 4 n
eL

L

xL
1+ L

L

( ) to derive

N GH (y)

+
N

+
N

n
ekL 1+xL L

nekL 1+xL L
1

H

1

L (y)

H

L

xL
1+ L

L (y)

N GH (y)
1
n
ekL

33

L

xL
1+ L

xH
1+ H

n
ekL 1+xL L
H

1

H (y)

L

xH
1+ H

3 1
7
5

H

xL
1+ L

H (y)

L

.

3 1
7
5

It follows that d k =d H < 0 and therefore d~nkL =d H < 0.
Now consider an equiproportionate increase in 1 + H and 1 +k(y) = NL

2

4 nkL xL

L+

xH
(1+ L ) LN
(1+ H ) H

L1
nkH xH

H

H

H

xL

k
k
L . De…ne ni = ni =N (1 +

H (y)
1

nkL xL

L (y)L

It is clear from this equation that an equiproportionate increase in 1 +e¤ect on nki as an increase in N .

8.4i ), so that

H

L

xH H

and and 1 +

H (y)

3 1
5

.

L has the same

Equilibrium Numbers of Brands with Small Trade Costs

The aggregate demand condition isnL xL + nH xH = N R + N P = N W .
The zero-pro…t conditions imply
N P EP"#nLL 1 L (y)"( L nL ) L+ L N R ER
( H nH ) H H (y) + nLL L (y)
nHH
"
#
"
1
( H nH ) H
H (y)
P P
N
E
+ N R ERH
( H nH ) H H (y) + nLL L (y)
nHH

1

L (y)

H (y) + ( L nL )
1

nHH

L

L (y)

H (y)

H (y) + ( L nL )

L

L (y)

#
#

= xL
= xH :

We multiply the …rst of these equations by xH and the second by xL , and subtract, to derive
P

P

N E

" 1

xL nL

L

1

L (y)

nHH

H

H

1

1
H
xH nH

H (y)

H

H

H (y) + nL

L

L (y)

#

R

R

+N E

" 1

xL nL

L

1

L

L

nHH

1
H
xH nH

L (y)

H (y) + nL

L

L

L

1

H (y)

L (y)

#

= 0.

Now we can follow similar steps to those used in the derivation of (10). Note that the …rst term in square
brackets is the same as the term in square brackets in that derivation, except that we have HH H (y) inplace of H (y). Therefore, we can replace N W using the aggregate demand condition and rewrite the …rst
term in square brackets as"(nL xL )L+

N W xH H
1(nH xH )H

xL L L (y)H (y)1(nL xL ) L xH H

(nL xL ) L

1

H (y)

# 1

.

(nL xL ) L

1

H (y)

# 1

.

H

H

H

H

Similarly, the second term in the square brackets can be written as"(nL xL )L+

N W xH H
1(nH xH )H

xL L LL L (y)

H (y)
1

L

(nL xL )xH H

Therefore, the composition-of-demand condition can be written as
N P EPhPi+ N R ER

34

h

R

i

=0

where
P

R

=

=

"

"

nL +

nL +

NW
xH n1HxH n1H

H

H

L (y)

H (y) H
n1L L xL H (y)H

N W H (y)Ln1L
L (y) LLH

H

xL H (y)# 1# 1Note that d k =dnL < 0, which implies that the equilibrium is unique. Moreover, d P =d H < 0 and
d R =d H = 0. Therefore, dnL =d H < 0.

35