metadata: authors: 0: author: Fajgelbaum,Pablo David
1: author: Grossman,Gene M.
2: author: Helpman,Elhanan
count: World
docna: 0: docna: Income distribution, product quality, and
            international trade
docty: Policy Research Working Paper
subtopic: Trade Policy,International Trade and Trade Rules,Rules of Origin,Trade and Services,Transport Services,Trade and Multilateral Issues
teratopic: Transport,Macroeconomics and Economic Growth,Industry
abstracts: cdata!: The authors develop a framework for
            studying trade in horizontally and vertically differentiated
            products. In their model, consumers with heterogeneous
            incomes and tastes purchase a homogeneous good and make a
            discrete choice of quality and variety of a differentiated
            product. The distribution of preferences generates a
            nested-logit demand structure such that the fraction of
            consumers who buy a higher-quality product rises with
            income. The model features a home-market effect that helps
            to explain why richer countries export higher-quality goods.
            It provides a tractable tool for studying the welfare
            consequences of trade and trade policy for different income
            groups in an economy.
repnme: repnme: Income distribution, product quality, and
            international trade
display_title: Income distribution, product
            quality, and international trade
listing_relative_url: /research/2011/10/15284893/income-distribution-product-quality-international-trade
topicv3: Transport m1326661 135,Trade m1326924 698,Trade in Services m1326928 780,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776
publishtoextweb_dt: 2011-10-01T00:00:00Z
historic_topic: Transport,Macroeconomics and Economic Growth,Industry
no_of_pages: 43
author_keys: 0: author_key: 1611801
1: author_key: 606224
2: author_key: 887836
model_extractions: WPS5843 Policy Research Working Paper 5843 Income Distribution, Product Quality, and International Trade _Pablo Fajgelbaum Gene M. Grossman Elhanan Helpman_ The World Bank Development Research Group Trade and Integration Team October 2011
Policy Research Working Paper 5843

# **Abstract**

The authors develop a framework for studying trade in horizontally and vertically differentiated products. In their model, consumers with heterogeneous incomes and tastes purchase a homogeneous good and make a discrete choice of quality and variety of a differentiated product. The distribution of preferences generates a nested-logit demand structure such that the fraction of consumers who buy a higher-quality product rises with income. The model features a home-market effect that helps to explain why richer countries export higher-quality goods. It provides a tractable tool for studying the welfare consequences of trade and trade policy for different income groups in an economy.

This paper is a product of the Trade and Integration Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at grossman@princeton.edu.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Income Distribution, Product Quality, and International Trade<sup>�</sup>

Pablo Fajgelbaum<sup>y</sup> Gene M. Grossman<sup>z</sup> Elhanan Helpman<sup>x</sup>

## JEL Classi...cation Code: F12

Keywords: monopolistic competition, vertical specialization, product quality, nested logit

> �We are grateful to Aykut Ahlatçio1⁄4glu and Gabriel Kreindler for research assistance and to Juan Carlos Hallak, Jonathan Vogel, Yoram Weiss and countless seminar participants for helpful comments and suggestions. Grossman and Helpman thank the National Science Foundation and Fajgelbaum thanks the International Economics Section at Princeton University for ...nancial support. The paper was substantially revised while Grossman was a Visiting Research Fellow in the Development Economics Vice Presidency at the World Bank. He thanks the World Bank for support and the Trade and Integration Team (DECTI) for its hospitality. Any opinions, ...ndings, and conclusions or recommendations expressed in this paper are those of the authors and do not necessarily re‡ect the views of the National Science Foundation, the World Bank Group, or any other organization. yU.C.L.A.

> zPrinceton University

> xHarvard University and CIFAR

1
# 1 Introduction

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, 2011). This suggests a positive association between per capita income and the quality of exports. Also, when a country imports goods in a product category from several sources, the higher-quality goods are imported disproportionately from the higher-income countries (Hallak, 2006). Since wealthier households typically consume goods of higher quality (Bils and Klenow, 2001; Broda and Romalis, 2009), the pattern of vertical specialization has important implications for the distributional consequences of world trade.

In this paper, we propose a new analytic framework for studying trade in vertically-di¤erentiated products. 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 it implies that the welfare consequences of trade vary across income groups in any country. It predicts that richer countries will be net exporters of 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 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 in any country produce goods suited to the predominant tastes of their local consumers and sell them worldwide to others who share these tastes.<sup>1</sup> Our approach complements a ‡ourishing literature that highlights 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 the luxury good, because that good happens to be capital intensive. Similarly, in Flam and Helpman (1987), Stokey (1991), Murphy and Shleifer (1997) and Matsuyama (2000), the pattern of trade follows from an assumption that richer countries have relative technological superiority in producing higher-quality goods.<sup>2</sup> More recently, Baldwin and Harrigan (2011) 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 non-homothetic 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 in horizontally-di¤erentiated goods with discrete choice and non-homothetic preferences and Auer (2010), who models heterogeneity in consumer tastes and explores how international di¤erences in tastes impact the pattern of trade in di¤erentiated varieties.

> 2 See also Fieler (2011), who ...nds in her calibration exercise 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 by referencing the relatively greater incentive that such ...rms have to undertake quality-enhancing investments. Their approach would generate a supply-side explanation for the observed pattern of trade if richer countries are home to a disproportionate share of the high-productivity ...rms.<sup>3</sup> 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 both horizontally and vertically di¤erentiated. Consumers choose among di¤erent quality options for the good 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 that has been developed by McFadden (1978), Anderson et al. (1992) and Verboven (1996a), among others.<sup>4</sup> 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— shared also by earlier work on vertical competition by Gabszewicz and Thisse (1979, 1980) and Shaked and Sutton (1982,1983)— implies that the marginal value of quality is higher for households that have greater income. We add to their speci...cation an idiosyncratic taste component that captures a consumer’s personal valuation of the attributes of each of the di¤erentiated products. With this addition, 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 in explaining bilateral trade ‡ows in work by Hunter and Markusen (1988), Bergstrand (1990), Hunter (1991), and Fieler (2011). Moreover, the horizontal product di¤erentiation validates a market structure of monopolistic competition, which simpli...es the analysis greatly in comparison to the earlier literature with oligopolistic interactions.

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 draw out 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.<sup>5</sup> In our model, patterns of aggregate demand translate into patterns of specialization and trade via “home-market e¤ects.” In a standard competitive model with constant returns to scale, a

> 3 See also Hallak and Sivadasan (2009), Kugler and Verhoogen (2011), and Manova and Zhang (2011), who provide empirical evidence on the relationship 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 Verhoogen (2008) and Khandelwal (2010). The latter two include a vertical dimension of 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.

2
country exports those goods for which there is little local demand and imports goods that domestic consumers especially covet. But, as Krugman (1980) argued, when transportation is costly and production features economies of scale, a large home market lends a competitive advantage to local ...rms. Therefore, countries tend to export the increasing-returns goods that are in great domestic demand.<sup>6</sup> In our model, the demand di¤erences are not a matter of exogenous crosscountry variations in tastes, but rather derive from di¤erences in income distribution in the face of non-homothetic demands. We outline conditions under which a richer country, or one with a more dispersed distribution of income, has a larger home demand for high-quality goods and a smaller home demand for low-quality goods. Under such conditions, more ...rms enter to produce highquality goods in the richer (or more unequal) country, while the opposite is true of ...rms producing low-quality products. Firms at a given quality charge the same ex-factory prices, so the number of producers predicts the direction of trade. Thus, our model can explain, for example, why Germany traditionally has exported 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 products, the delocation of ...rms induced by changes 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 residual income to the homogeneous good. Individuals have idiosyncratic evaluations of the various di¤erentiated products, which also di¤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, costs that vary by quality level, and free entry into the di¤erentiated-products sector. In the monopolistically-competitive equilibrium, each ...rm producing a di¤erentiated product charges a markup over its unit cost that depends on the quality level of its product and a parameter describing the distribution of idiosyncratic tastes. We show in Section 3 for the case of two quality levels that the autarky equilibrium is unique and that it is characterized by positive numbers of producers of both low-quality and high-quality goods. We proceed to examine how changes in population size and the level and spread of the income distribution a¤ect the numbers of producers at each quality level and the welfare of di¤erent income groups.

Section 4 introduces international trade between two 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

> 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 larger countries export more in industries with high transport costs and highly-di¤erentiated products. See Davis and Weinstein (2003) for further empirical evidence of home-market e¤ects in the pattern of trade.

3
the quality level. When shipping costs are su¢ ciently high, as we assume throughout that section, each country produces and trades both low-quality 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 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 our model. 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 extends the model to include more quality levels and more countries. By doing so, we are able to make contact with the recent empirical literature on the pattern of trade in vertically di¤erentiated products. We assume that countries can be ranked from poorest to richest such that the income distributions in any pair of countries satisfy the monotone likelihood ratio property. We show that when two countries are of similar size and trading costs are high, the richer country has positive net exports of all of the highest quality goods and positive net imports of all the lowest quality goods in its bilateral trading relationships with poorer countries. When trading costs are small, each quality level generically is produced in a single country and richer countries produce higher quality goods than poorer countries. In terms of the trade pattern, we ...nd that among countries of similar size, the richer countries export goods of higher quality, which is in keeping with the empirical ...ndings by Schott (2004) and Hummels and Klenow (2005). When trading costs are small, a country imports higher-quality goods from richer trading partners, as Schott (2004), Khandelwal (2010) and Hallak and Schott (2011) ...nd to be true for U.S. imports from various sources.

# 2 The Model

We develop a model featuring income heterogeneity and non-homothetic preferences over goods of di¤erent quality. We describe the model in this section, characterize its autarky equilibrium in the next, and then move on to international trade in Sections 4-7 below.

Each individual consumes a homogeneous good and his optimal choice from a ...nite set of di¤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 constant 4
variable 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 a wage 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 G, so that G (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 variety 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 and by other attributes that a¤ect consumers’idiosyncratic valuations. We denote by Q the ...nite set of available quality levels and index quality by q.

# 2.1 Preferences and Demand

Let j index the individual varieties of the di¤erentiated product and let Jq denote the set of varieties with quality q. In this notation, the variety index identi...es both the quality of the good and its other attributes, so that if j has quality q, then j 2 Jq and j 2= Jq0 for q<sup>0</sup> = q.

Now consider the utility u<sup>h</sup> j<sup>thatanindividualhwouldattainbyconsumingzunitsofthe</sup> homogenous good and variety j 2 Jq of the di¤erentiated product. We assume that where "<sup>h</sup> j<sup>istheindividual’sidiosyncraticevaluationoftheparticularattributesofvarietyj.Each</sup> individual has a vector of idiosyncratic evaluations, one for each of the available varieties; denote this vector by "<sup>h</sup> . The utility function in (1) features complementarity between the quantity of the homogeneous good and the quality of the di¤erentiated product, much as a “standard”utility function (e.g., Cobb-Douglas or CES) features complementarity between the quantities of the various goods in the individual’s consumption basket.<sup>7</sup> The complementarity between quantity and quality implies a greater marginal valuation of quality for those who consume more of the homogeneous good. This property of the utility function generates the non-homotheticity of aggregate demands in our model.<sup>8</sup> Meanwhile, the additive utility component captures the other attributes

> 7 This feature of our formulation is quite common in the earlier literature on vertical competition in oligopoly; see, for example, Gabszewicz and Thisse (1979,1980) and Shaked and Sutton (1982,1983), who use the utility function u = zq (in our notation). We add horizontal di¤erentiation in the form of the idiosyncratic taste component, which greatly simpli...es the analysis.

> 8 In our formulation, the household’s indirect utility function is given by vjh<sup>= q(Ih �pj) + "h</sup> j<sup>,whichisrelatedto</sup> but di¤erent from the speci...cation commonly used to model consumer demand in the recent Industrial Organization (IO) literature. There, researchers typically take vj<sup>h= �h�</sup> j<sup>+�h(Ih �pj)+"h</sup> j<sup>,where �</sup> j<sup>is some attribute of product j</sup>

5
of the product, which the heterogeneous consumers evaluate di¤erently. The horizontal product di¤erentiation validates our assumption of a monopolistically competitive market structure.

We take the " terms to be distributed independently across the population of consumers according to a Generalized Extreme Value (GEV) distribution, which we denote by G" ("). That is, with �q 2 (0; 1) for all q 2 Q. 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-estimable system of demands.<sup>9</sup> Now consider the optimization problem facing an individual with income y<sup>h</sup> and vector of taste parameters "<sup>h</sup> . Of course, this individual simply chooses the quality and variety that yields the highest utility among all available options, i.e., the q and the j 2 Jq that maximize �y<sup>h</sup> � pj� q + "<sup>h</sup> j<sup>,</sup> where pj is the price of variety j. Here y<sup>h</sup> � pj 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 calculations in McFadden (1978) and elsewhere imply that, with " distributed according to a GEV, the fraction of individuals with income y who choose variety j with quality q is given by where is the fraction of consumers that buys variety j among those that purchase a di¤erentiated product with quality q and is the fraction of consumers with income y that opts for a product of this quality. The fraction of individuals that buys a good with quality q varies by income level and with the vector of all

> (such as quality), �<sup>h</sup> are �<sup>h</sup> are parameters that represent the household’s valuation of the attribute � and the marginal utility of income, respectively, and "<sup>h</sup> j<sup>isanidiosyncratictastecomponentliketheoneusedhere.Intheliterature</sup> that follows McFadden (1978), authors have assumed that �<sup>h</sup> = � and �<sup>h</sup> = � for all h, and that "<sup>h</sup> j<sup>hasaGeneralized</sup> Extreme Value distribution. In the literature that follows Berry et al. (1995), authors have assumed that the taste parameters �<sup>h</sup> are �<sup>h</sup> are heterogeneous across households and that "<sup>h</sup> j<sup>hasaType-IExtremeValuedistribution.In</sup> either case, the implied (direct) utility function does not allow for interactions between utility from the numeraire good and that from speci...c attributes of the di¤erentiated product such as “quality”. As Nevo (2011) notes, the separability of (I<sup>h</sup> � pj) and �j is implied by quasi-linear preferences, which may be an appropriate assumption in the partial-equilibrium applications that interest IO economists, but less so for general equilibrium concerns at issue here. In particular, a complementarity between quality of the di¤erentiated product and consumption of the homogeneous good provides a parsimonious explanation for consumption patterns across the income distribution and for the resulting patterns of international trade.

> 9 See also Verboven (1996a) and Train (2003, ch4).

6
product prices, whereas the fraction that buys a particular variety j 2 Jq conditional on the choice of quality q depends only on the prices of the goods in this quality segment.

Readers familiar with the empirical literature on discrete-choice modeling will recognize the implied demand system as a nested logit, with choice over quality levels (the “nest”) and over horizontally-di¤erentiated varieties with a given quality. In that literature, �q is known as the dissimilarity parameter; it measures the degree of heterogeneity in preferences over the varieties in the set Jq.<sup>10</sup> The greater is �q, the smaller is the correlation between "j and "j0 for j and j<sup>0</sup> in Jq (see McFadden, 1978), and therefore the greater are the perceived di¤erences among the various varieties with quality q. It is typically the case that higher-quality products embody richer sets of product characteristics, which expands the scope for horizontal di¤erentiation. If so, the varieties of a lower-quality good will be closer substitutes for one another than the varieties of a higher-quality good. We shall assume that this is the case in what follows; i.e., we adopt Assumption 1 �q is increasing in q.

Variation in the spending pattern across income groups arises solely from variation in the fraction of individuals who purchase the products at di¤erent levels of quality q, as re‡ected by the functions �q(y). It follows that the market share of a good j with quality q varies across income groups according to where is the average quality consumed by all individuals with income y. Equation (5) implies that the fraction of individuals who purchase variety j of quality q rises with income if and only if q > qa (y); that is, if and only if q is above the average quality consumed by individuals in this income group. In particular, in the case of two quality levels, Q = fH; Lg, we have H > qa (y) > L for all y, so that 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 the trade ‡ows.

# 2.2 Pricing and Pro...ts

Firms can enter freely into the di¤erentiated-products sector by choosing any quality level q 2 Q and by employing a ...xed input of fq units of e¤ective labor to develop a particular variety. A

> 10 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 their work, the productivity shocks are assumed to have a Type-II extreme value distribution in which � parameterizes the dissimilarity of productivity levels across goods.

7
producer uses cq units of labor per unit of output to produce a good of quality q. Firms set prices to maximize pro...ts taking aggregate price indexes as given. Entry at each quality level proceeds until the next entrant would fail to cover its ...xed cost. Let nq be the number of ...rms that produce goods of quality q. The demand structure requires the number of varieties in each quality class to be a ...nite integer, but we will take liberty in treating nq as if it were a continuous variable to facilitate the exposition.

A ...rm that produces a variety j of the di¤erentiated product with quality q earns pro...ts of �j = dj (pj � cq) � fq, where dj = N E ��j(y)� is the aggregate demand for variety j 2 Jq and E is the expectations operator with respect to the distribution of income, i.e., E [B (y)] � R B(y)dG(y). Note that demand can be expressed as a function of prices using (2), (3), and (4). If the number of active producers of each quality level is large, then terms in the various sums in (3) and (4) vary only slightly with a ...rm’s own price. We assume that the ...rm ignores this dependence, as is common in models of monopolistic competition. Then a ...rm producing any variety j with quality q maximizes pro...ts by setting the price Evidently, the (absolute) 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 q, the greater is the marginal utility from consumption of the homogeneous good, due to the complementarity between z and q re‡ected in (1). A higher marginal utility from consumption of the homogeneous good makes consumers more sensitive to price di¤erences when choosing among the di¤erent brands in Jq. Second, the greater is �q, the greater are the perceived di¤erences among the various brands with quality q, as we have noted before. This greater degree of product di¤erentiation tends to make demands less sensitive to price changes. These two forces 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 �q=q is increasing in q.

With common prices, the ...rms that produce di¤erent varieties of a good in a given quality segment achieve similar volumes of sales. Let dq be the total quantity demanded of a typical variety with quality q when all goods are priced according to (6). Then where captures the e¤ect of income on demand. The markups of �q=q on sales of dq yield a common pro...t 8
�q to all producers of varieties with quality q, where These functions determine the pro...tability of entry at each quality level. In equilibrium, nq > 0 implies �q = 0 while �q � 0 when nq = 0. In the next section, we will use these free-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 all varieties of the di¤erentiated product also are determined. Together, the ...rms selling goods with quality q capture aggregate sales of nqdq, so that aggregate output of all di¤erentiated products is<sup>P</sup> q2Q<sup>nqdq= N.Thisequalityre‡ectsthefactthateachof</sup> the mass N of consumers buys one unit of some product.

The di¤erentiated-products industry employs a total of<sup>P</sup> q2Q<sup>nq (dqcq + fq)unitsofe¤ective</sup> 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 used in 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 remaining variables determined in the general equilibrium are readily found.

# 3 Autarky Equilibrium

To characterize an equilibrium in a closed economy, we de...ne xq as the quantity that a ...rm producing a brand with quality q must sell in order to break even when it prices according to (6); i.e., Notice that the break-even volume depends only on the magnitude of the ...xed cost and the size of the pro...t margin, as in Krugman (1980). So, (9) will pin down the output per variety for any quality of good that is available in equilibrium.

In an autarky equilibrium, if some positive number of ...rms produce goods with quality q the demand per brand must reach the break-even level. Otherwise, no ...rm producing this quality can pro...tably enter. In other words, if nq > 0, dq = xq, whereas dq < xq implies nq = 0. In any case, the aggregate output of all di¤erentiated products matches the population size N , or We will refer to this equation as the aggregate demand condition. It implies, of course, that nq must be positive for some q 2 Q.

But notice from (7) that as nq approaches zero with nq0 > 0 for some q<sup>0</sup> = q, the demand for a typical brand with quality q grows in...nitely large. This means that a producer of a brand with 9
quality q will certainly be able to achieve the break-even scale when the number of its competitors o¤ering a similar quality is su¢ ciently small. In equilibrium, some positive number of ...rms will be active in every segment of the market.<sup>11</sup> Now that we know that nq must be positive for all q 2 Q, market-clearing for each brand requires xq = dq or Using xq from (9), this system of equations allows us to solve for the number of varieties at each quality level in an autarkic equilibrium:<sup>12</sup> We turn now to the special case with two quality levels, H and L, where H > L; we will return to the more general case with an arbitrary number of qualities in Section 7 below. With only two quality levels, (11) represents a pair of equations that together determine nH and nL. In the appendix we show that these equations have a unique solution, which is characterized by positive values for nH and nL. This establishes Proposition 1 If Q = fH; Lg, there exists a unique autarky equilibrium. In the autarky equilibrium, nH > 0 and nL > 0.

In the remainder of this section, we describe how the autarky equilibrium re‡ects the size of the economy and its income distribution.<sup>13</sup> We also show how the model can be used to examine the welfare 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 implications of trade in the sections that follow.

The size of the economy is captured by the parameter N . As N increases, the demand in each quality segment grows, given the initial numbers of ...rms; see (7). Were it the case that the two quality segments o¤ered similarly di¤erentiated products (�H = �L), the demand expansion would induce equiproportionate entry by both types of ...rms. Inasmuch as high-quality products are more dissimilar than low-quality products by Assumption 1, there must be proportionately more entry of ...rms that produce the former goods relative to the latter; i.e., n^H > N<sup>^</sup> > n^L.<sup>14</sup> As in other contexts, growth in market size causes an expansion in variety of the more horizontallydi¤erentiated products.<sup>15</sup> However, it is readily shown that even the number of low quality varieties must rise in response to market growth (n^L > 0).

> 11 In making this statement, we have ignored the integer constraint. The equilibrium “solution”for some nq 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 nq > 0 for all q 2 Q is well justi...ed.

> 12 Note that the weighted sum of xq from (11) implies (10), which means that only the equations in (11) need be used to solve for the equilibrium numbers of varieties.

> 13 The algebra of the comparative statics that we describe here is derived more formally in the appendix.

> 14 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.

10
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 or equal to y declines. Added income makes consumers more likely to buy a high-quality product across the entire income distribution. Thus, at the initial numbers of ...rms, demand for high-quality varieties grows and that for low-quality varieties shrinks. This shift in demand induces entry of ...rms that ^ ^ produce high-quality goods and exit of producers of low-quality products; i.e., nH > 0 > nL.

Finally, consider an increase in income inequality, as represented by a mean-preserving spread of the distribution G (�). 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, the relative demand for high-quality goods is a concave function of y for given nH and nL. Then, a mean-preserving spread in the distribution of y causes the relative demand for high-quality goods to expand, inducing entry of producers of these varieties and exit of producers of low-quality products. A spread in income distribution in a poor economy (one in which �L(y) > �H (y) for all y) induces a shift in the composition of ...rms toward producers of high-quality products.<sup>16</sup> 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 As market conditions change, 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 that class times the degree of horizontal di¤erentiation (dissimilarity) within the class.

^ From the aggregate demand condition (10), �H ^nH + �LnL = N<sup>^</sup> , where �q = nqdq=N = nqxq=N is the fraction of the overall population that purchases a good of quality q. Using this equation, we can write ^ The ...rst term in the expression for v (y) is a pure scale e¤ect. Holding constant the relative number of high-quality and low-quality products, an expansion of scale bene...ts consumers 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, an increase in the relative number of high-quality products bene...ts those who are more likely

> 16 See the appendix for the details.

11
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 variety of low-quality products is more likely to bene...t a given income group the more dissimilar are the brands of high-quality products and the more similar are the brands of low-quality products.

Now let us examine the distributional implications of the market changes we described above. An increase in population size generates a scale e¤ect that bene...ts all income groups and a composition e¤ect that especially bene...ts the wealthy (since growth in market size generates an increase in the relative number of high-quality varieties when �H > �L). The richest consumers in the economy, who have income ymax, are more likely to purchase the high-quality good than the average consumer and are less likely to purchase the low-quality good, which implies that �H (ymax) =�H > 1 > �L (ymax) =�L. By (13), these wealthy 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— will also bene...t from the expansion in variety in both quality segments, but their gain will be more modest.

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, without changing the output-weighted number of products. With �H > �L, the associated composition e¤ect must bene...t the members of the highest income group (on average). As for the poorest consumers, they too may bene...t if high-quality goods are substantially more dissimilar than low-quality goods, but will lose if �H and �L are quite close in size. Although the low-income individuals are more likely to consume a low-quality product, the contraction of variety in this market segment will not hurt them so much if these goods are relatively similar to one another; meanwhile, the expansion in the variety of high-quality products can be quite advantageous even to these consumers (on average), if the idiosyncratic tastes for the various high-quality products are little correlated. If there are income groups that lose from a change in the composition of products that favors high-quality goods, it will be all groups with income less than or equal to some critical value.

# 4 Trade with Diversi...ed Production

In this section, we introduce international trade. We assume for the time being that there are two countries that di¤er in size and in their distributions of e¤ective labor. We do not allow for any supply-side determinants of the trade pattern— as would arise from comparative cost advantages— in order to focus more sharply on those that derive from di¤erences in income in the face of non-homothetic preferences. We designate the countries as R and P 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. In Section 7, we will extend the analysis to many countries in order to make contact with the empirical evidence cited in the Introduction.

We assume throughout that both (or all) countries have su¢ cient supplies of e¤ective labor relative to the equilibrium labor demands by their producers of di¤erentiated products so that 12
some labor in each country is used to produce the homogeneous, numeraire good. This ensures that the wage of a unit of e¤ective labor is equal to one in both (all) countries.

We assume that the di¤erentiated products are costly to trade.<sup>17</sup> In particular, it takes � q units of e¤ective labor to ship one unit of a variety with quality q from one country to another.<sup>18</sup> As � q grows large, national outputs converge on those of the autarky equilibria. In such a setting, as we now know, both countries produce goods in both quality segments. We will ...nd that such incomplete specialization characterizes the trade equilibrium whenever 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 surely when shipping costs are small.<sup>19</sup> Shipping requirements raise the cost of serving foreign consumers relative to domestic consumers. For a good with quality q, the marginal cost of a delivered export unit is cq + � q, whereas local consumers can be supplied at a cost of cq. The arguments from Section 2.2 now imply that a ...rm producing a variety with quality q maximizes pro...ts by charging foreign consumers the price cq + � q + �q=q, whereas domestic consumers are charged the lower price cq + �q=q (see (6)). In other words, pro...t margins are �q=q for all sales, as ...rms fully pass on their shipping costs to their foreign customers.<sup>20</sup> Demands for domestic goods of quality q in country k re‡ect the prices of these goods, the prices of competing import goods, and the numbers of local and imported varieties at each quality level. Letting d<sup>k</sup> q<sup>representtheaggregatedemandbydomesticconsumersforatypicalgoodofqualityq</sup> produced in country k when all goods are priced optimally, (4) implies where

> 17 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-market e¤ect requires only that transport costs di¤er across sectors.

> 18 Unlike models of monopolistic competition that rely on the CES demand system, our model easily allows for transport costs that are incurred on a per-unit basis. Although we consider this to be more realistic than the popular assumption of “iceberg” transport costs, there is no meaningful di¤erence between the two in our model. In either case, ...rms price their exports at a ...xed markup per unit over the delivered cost.

> 19 It is common in trade models featuring a home-market e¤ect that production is geographically dispersed when transport costs are large, but each good is produced in only one location when transport costs are small; see, for example, Krugman (1991a, 1991b) and Rossi-Hansberg (2005). The implications for the trade pattern are somewhat di¤erent in these two regimes— especially when the number of quality levels and countries is large— which explains why we consider both possibilities.

> 20 If transportation costs instead took the iceberg form— such that the delivery of one unit of a good of quality q to an export market required that �q > 1 units be shipped— then the pro...t-maximizing price for export sales would instead be cq�q + �q=q. The analysis would proceed exactly as in what follows. The ability of our model to accomodate both per unit and iceberg shipping costs re‡ects the fact that, under the nested logit demand system, the optimal gap between price and unit cost is constant and independent of delivered cost. In contrast, models with CES demands imply an absolute markup that is proportional to the delivered cost, in which case per-unit and proportional shipping costs have di¤erent e¤ects on export prices.

13
n<sup>k</sup> q<sup>isthenumberofvarietiesofqualityqproducedincountryk,Nkisthepopulationincountry</sup> k, and E<sup>k</sup> is the expectation with respect to the income distribution there. Notice the similarity between (14) and (7). 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 varieties are less e¤ective competitors. For local ...rms, domestic demand is the same as it would be in autarky with n~<sup>k</sup> q<sup>localcompetitorsproducingqualityq.Theforeign...rmsarediscountedin</sup> this measurement of “e¤ective competitors”by an amount �q 2 (0; 1) that re‡ects the trading cost for goods of quality q as well as the quality and dissimilarity of these products. Also, (4) implies that per capita demand for an imported variety of quality q in country k equals �qd<sup>k</sup> q<sup>=N k;i.e.,itis</sup> a fraction �q of the per capita demand faced by a local ...rm.

A ...rm producing a variety with quality q in either country earns pro...ts per sale of �q=q, considering the ...xed absolute markup it charges over delivered cost. In order to break even, such a ...rm, no matter where it is located, must make sales totalling xq = fqq=�q units, as per (9). In an equilibrium with producers of both qualities in both countries, we must have 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 �q of what a local producer in country ` makes of domestic sales. For these equations to hold for both k = P and k = R it must be that d<sup>R</sup> q<sup>=dP</sup> q<sup>forq=H; L;thatis,...rmsineachcountrymustachievethesamevolume</sup> of domestic sales. Since the size and the income distributions in the two countries may di¤er, the equality must be achieved by adjustment 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 implies xq = d<sup>k</sup> q<sup>(1 + �q)or</sup> The equations in (15) provide four independent relationships, two for country R that jointly determine n~<sup>Rn~RtwoforcountryPthatjointlydeterminen~Pn~PTheseequations</sup> L<sup>and</sup> H<sup>and</sup> L<sup>and</sup> H<sup>.</sup> have exactly the same form as those in (11) that describe the autarky equilibrium, except that xq for the closed economy is replaced by xq= (1 + �q) for the open economy. The proof of Proposition 1 guarantees that (15) has a unique solution with a 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 for the solutions to (15) to represent a legitimate trade equilibrium. We require in addition that the actual number of varieties in each country be positive. Given the values of n~<sup>R</sup> L<sup>,n~R</sup> H<sup>,n~P</sup> L<sup>,andn~P</sup> H 14
that result from the solution of (15), we can solve for n<sup>k</sup> L<sup>andnk</sup> H<sup>usingn~k</sup> q<sup>= nk</sup> q<sup>+ �qn`</sup> q<sup>.Thisgives</sup> A positive solution for n<sup>k</sup> q<sup>forallqandkrequires</sup> which is always satis...ed when �q is close to zero but rarely satis...ed when �q is close to one.<sup>21</sup> This justi...es our claim that a trade equilibrium with incomplete specialization always exists when transport 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 in P, 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-quality and low-quality goods produced in R.

In fact, we know that the export sales by a typical producer of quality q are the same in both locations. Therefore, country R exports more of goods of quality q to P than it imports of that quality if and only if country R has more ...rms producing goods of quality q than does country P. But, from (16), n<sup>R</sup> q<sup>> nP</sup> q<sup>ifandonlyifn~R</sup> q<sup>>n~P</sup> q<sup>.Therefore,wecanidentifytheequilibriumtrade</sup> balance in each quality segment by comparing the e¤ective number of sellers of that quality in the two countries.<sup>22</sup> The pair of equations that determine n~<sup>R</sup> q and n~<sup>P</sup> q<sup>areidenticaltothosethatdeterminethe</sup> autarky numbers of producers of quality q in R and P, except that xq in the latter is replaced by xq= (1 + �q) 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 (G<sup>R</sup> = G<sup>P</sup> ) but country R is larger than country P (i.e., N<sup>R</sup> > N<sup>P</sup> ). We have seen that the larger country has in autarky a greater relative abundance of ...rms that produce high-quality goods, because market growth generates biased entry in favor of the more horizontally di¤erentiated products. It follows that the larger country must have absolutely more producers of high-quality goods in autarky, whereas it may support fewer (or more) producers of low-quality products. These comparisons carry over

> 21 When �q is close to one, the pair of inequalities can be satis...ed only if n~Rq<sup>�n~P</sup> q<sup>,whichhappensonlyunder</sup> exceptional circumstances. For example, N<sup>R</sup> = N<sup>P</sup> and G<sup>R</sup> y<sup>= GP</sup> y<sup>impliesn~R</sup> q<sup>=n~P</sup> q<sup>.</sup>

> 22 Net exports from R to P of goods of quality q are given by

15
to the numbers of e¤ective sellers in a trade equilibrium with incomplete specialization. That is, n~<sup>Rn~Pwhilethecomparisonofe¤ectivenumbersofproducersoflow-qualitygoodscanrunin</sup> H<sup>></sup> H<sup>,</sup> 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<sup>R</sup> = N<sup>P</sup> ) but the income distribution in the richer R ...rst-order stochastically dominates that in poorer P. Then, in autarky, the rich country 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 equilibrium with incomplete specialization, so that n~<sup>R</sup> H<sup>>n~P</sup> H<sup>andn~P</sup> L<sup>>n~R</sup> L<sup>.It followsthat therich</sup> country 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 purchase low-quality goods. Let the countries be of similar size and with similar mean income, but suppose that 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<sup>R</sup> > N<sup>P</sup> and G<sup>R</sup> (y) = G<sup>P</sup> (y) for all y, then R exports on net the high-quality goods but may export or import on net the low-quality goods; (ii) if N<sup>R</sup> = N<sup>P</sup> and G<sup>R</sup> (y) < G<sup>P</sup> (y) for all y, then R exports on net the high-quality goods and imports on net the low-quality goods; (iii) if N<sup>R</sup> = N<sup>P</sup> , �L(y) > �H (y) for all income groups in R and P, and G<sup>R</sup> (�) is a mean-preserving spread of G<sup>P</sup> (�), 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 numbers of 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 not bear 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 the market 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. Access to 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 distributional consequences. For concreteness, consider ...rst a decline in the cost of transporting high16
quality goods.<sup>23</sup> A fall in � H induces an increase in �H . It is clear from (15) that such an increase in �H generates the same outcomes as would a reduction in the ...xed cost of entry for producers of high-quality products, fH . As � H falls, pro...tability rises for ...rms that produce high-quality varieties. The number of e¤ective producers of such varieties rises in each country. This expansion in n~<sup>Rn~Pdemandforlow-qualitygoodsineachcountry,andsothereise¤ectiveexit</sup> H<sup>and</sup> H<sup>reduces</sup> from this market segment. In the new trade equilibrium, there is more e¤ective variety of highquality goods in each country, and less e¤ective variety of low-quality products. The e¤ects of a reduction in the cost of transporting low-quality goods are analogous.<sup>24</sup> What are the welfare implications of these induced changes in the e¤ective numbers of varieties? In a world with costly trade, the average welfare of those with income y in country k increases with Welfare of individuals in country k depends on the e¤ective numbers of varieties available there, with foreign brands carrying less weight than domestic brands due to their higher prices. Di¤erentiating the expression for v<sup>k</sup> (y) and rearranging terms, we can derive an expression for the change in average welfare of an income group analogous to (13), namely where �<sup>k</sup> q<sup>(y)isthefractionofconsumersincountrykwithincomeythatbuysagoodwithquality</sup> q and �<sup>k</sup> q<sup>isthefractionofallconsumersincountrykthatbuysagoodwithqualityq.Thetermin</sup> the ...rst line of (17) is a pure cost-savings e¤ect, analogous to the scale e¤ect in (13). The term in the second line of (17) is a pure composition e¤ect, analogous to the similarly-named term in (13). 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 cost

> 23 The details of the algebra are provided in the appendix.

> 24 It is also evident from (15) that an equiproportionate rise in 1 + �H and 1 + �L has the same impact on the e¤ective number of high- and low-quality products in country k as would a similar percentage increase in that country’s population. From our analysis of the autarky equilibrium, we know that the e¤ective number of high-quality products expands more than in proportion to the increase in 1 + �H and 1 + �L, whereas the e¤ective number of low-quality products can rise or fall.

17
of transporting high-quality goods. As we have seen, such a decline in � H expands the e¤ective number of high-quality varieties in each country, while contracting the e¤ective number of lowquality varieties. The cost-savings e¤ect bene...ts all consumers. Since �H > �L, the composition e¤ect must bene...t the average member of the highest income group in each economy, but it may harm the average member of the lowest income group. It follows that a fall in � H augments the average welfare of the wealthiest consumers in each country, but may bring harm to income groups below some critical level.<sup>25;26</sup> Our analysis also sheds lights on the distribution of the gains from trade. The autarky equilibrium for either country is the solution to (15) with �H = �L = 0. The e¤ects of trade can be found by integrating the increases in �H and �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 of brands 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.<sup>27</sup> 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 � q raises the e¤ective number of brands of quality q and reduces the e¤ective number of brands of quality q<sup>0</sup> , q<sup>0</sup> = q, in both countries. Any reduction in trade costs must bene...t the average member of some income group. If, as a result of a reduction in trade costs, the e¤ective number of high-quality (low-quality) varieties falls in some country, then the highest-income (lowest-income) groups in that country may lose.

In our working paper, Fajgelbaum et al. (2009), we present two numerical examples to illustrate the alternative possible welfare outcomes . For one set of parameter values, the average member of every income group in country R gains from a fall in the cost of shipping high-quality goods. An alternative set of parameter values illustrates the possibility of distributional con‡ict from falling trade costs. In this case, the high-quality products are less dissimilar than in the ...rst example (smaller �H ) and the low-quality products are more dissimilar (larger �L), so that the composition e¤ect is more damaging to the poor. Here, the average member of the median income group in

> 25 There must be some income groups that gain from a reduction in � H . To see this, suppose the opposite were true. Then, the left-hand side of (15) increases for q = L inasmuch as the numerator increases at every y (because n~L falls) and the denominator falls at every y (because average welfare has been assumed to fall). But the right-hand side of (15) is unchanged, which contradicts the requirement for equilibrium in the market for low-quality goods.

> 26 Other reductions in trade costs can be analyzed similarly. For example, declines in � H and � L that increase 1 + �H and 1 + �L by the same proportions must bene...t all income groups if the dissimilarity parameters are almost the same for the two classes of goods; if, however, the high-quality goods are much 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 can harm the poor.

> 27 The proof of this statement follows along similar lines to that used in footnote 25.

18
<!-- Start of picture text --> 1) pyEgyy<br>0.8<br>0.6<br>0.4 P produces{H,L} P produces {H,L}<br>R produces {H, L} R produces {H}<br>0.2 |<br>0.2 0.4 0.6 0.8 1<br>A,<br><!-- End of picture text -->

DN DN DN DN DN DN ~~OE~~ 0 0 Xr
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 shipping costs. As we have seen, when �H and �L are su¢ ciently close to zero, the trade equilibrium is characterized by incomplete specialization in both countries.

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 �q rises toward one, the number of producers of quality q in some country must fall to zero, as is implied by equation (16). For still smaller transport costs, all of the varieties with quality q are produced in a single country. In this section, 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 for both quality levels are literally zero.

# 5.1 The Integrated Equilibrium

Suppose that � H = � L = 0, so that �H = �L = 1. With no supply-side sources of comparative advantage, there is nothing in our model to pin down the location of production. Factor-price equalization 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 nonetheless characterize the integrated equilibrium in terms of the total numbers of brands of each quality that are 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 q is the same in both countries; i.e., n~<sup>R</sup> q<sup>=n~P</sup> q<sup>=nR</sup> q<sup>+ nP</sup> q<sup>forq=H; L.Wecansolvefortheseaggregatenumbersof</sup> varieties using the autarky equilibrium conditions for an economy with population N<sup>R</sup> + N<sup>P</sup> and an income distribution that is the composite of the separate distributions in the two countries. This gives n�H and n�L, the aggregate numbers of high- and low-quality products, respectively, that are produced in the integrated global economy. Armed with these variables, we can calculate aggregate demand in country k for a typical variety with quality q, which we denote by d<sup>�k</sup> q<sup>.Thatis,</sup> The impact of trade with zero transport costs on the welfare of an income group y in country k re‡ects a scale e¤ect and a composition e¤ect, as before. The scale e¤ect— which arises because the integrated economy has a larger population than either separate economy— works to the bene...t of 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 varieties in the integrated equilibrium exceeds the relative number of high-quality varieties in the country’s autarky equilibrium. Otherwise, the composition e¤ect bene...ts the low-income groups in country k. The e¤ect of an opening of trade 20
on the relative numbers of varieties of the di¤erent quality levels re‡ects both the biased nature of growth due to �H > �L, and the demand e¤ects of a change in income distribution from one with the 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 q in country k is to break even, it must attain total worldwide sales of xq = fqq=�q. Each ...rms’sales comprise its home sales— d<sup>k</sup> q<sup>fora...rmincountryk— anditsexport</sup> sales, which are a fraction �q of the domestic sales of a foreign ...rm. For ...rms producing quality q to achieve the break-even volume of sales in both countries given the required relationship between the home sales of one and the export sales of the other requires that domestic sales be common to the two countries; i.e., d<sup>R</sup> q<sup>= dP</sup> q<sup>,aswehavenotedbefore.</sup> But note that the aggregate demand in country k for a typical variety with quality q approaches d�<sup>k</sup> q<sup>astransportcostsgotozero.Theaggregatedemandsoftheintegratedequilibriumaregiven</sup> by (18) and are uniquely determined by parameters of the world economy. Only exceptionally will it happen that d<sup>�R</sup> q<sup>=d�P</sup> q<sup>forq=Horq=L.Inotherwords,onlyexceptionallywillithappen</sup> 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.<sup>29</sup> 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, for example that d<sup>�R</sup> q<sup>>d�P</sup> q<sup>forproductsofqualityq;thatis,thetypicalproducerofagoodwith</sup> quality q makes greater sales in country R than in country P. With positive trade costs and optimal 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 producer of a brand with quality q in country R must exceed those for a producer of that quality in country P.<sup>30</sup> More generally, all production of goods with quality q takes place in the country with the larger domestic market for goods of that quality in the integrated equilibrium. We summarize in

> 29 In the literature on the New Economic Geography, it is common to have diversi...cation for high transport costs but specialization for low transport costs. In these models, if the locations have no inherent productivity or cost advantages, the equilibrium with zero transport costs is indeterminate; see, for example, Rossi-Hansberg (2005). More generally, Krugman (1991a,1991b) was the ...rst to point out an inverted-U shaped relationship between specialization and transport costs when the various locations have inherent advantages. See Aiginger and Rossi-Hansberg (2006) for a fuller discussion of this issue.

> 30 That is, for �q close to one,

and so d<sup>�R</sup> q<sup>>d�P</sup> q<sup>implies�R</sup> q<sup>> �P</sup> q<sup>,where�k</sup> q<sup>isthenetpro...tofatypicalproducerofqualityqincountryk.</sup> 21
Proposition 4 Suppose d<sup>�k</sup> q<sup>>d�`</sup> q<sup>forq2fH; Lg;k; `=R; P;and`=k.Then,for�Hand�L</sup> su¢ ciently close to zero, all goods of quality q are produced in country k.

Let us apply Proposition 4 to some special cases that we have considered previously. Suppose, for example, that G<sup>R</sup> = G<sup>P</sup> and N<sup>R</sup> > N<sup>P</sup> ; i.e., the countries share the same income distribution but di¤er in size. Then, by (18), d<sup>�R</sup> H<sup>>d�P</sup> H<sup>andd�R</sup> L<sup>>d�P</sup> L<sup>,sothelargercountryproducesand</sup> exports all varieties of both the high-quality and low–quality di¤erentiated products. Now suppose instead that N<sup>R</sup> = N<sup>P</sup> while G<sup>R</sup> (�) ...rst-order stochastically dominates G<sup>R</sup> (�). Then d<sup>�R</sup> H<sup>>d�P</sup> H and d<sup>�Rd�Pso the richer country produces all of the high-quality goods while the poorer country</sup> L<sup><</sup> L<sup>,</sup> produces all of the low-quality goods. We record these results in Corollary 1 Suppose that transport costs are small. (i) If G<sup>R</sup> (y) = G<sup>P</sup> (y) for all y and N<sup>R</sup> > N<sup>P</sup> , then n<sup>P</sup> H<sup>=nP</sup> L<sup>=0andonlyRproducesandexportsgoodsofqualityHandL.</sup> (ii) If N<sup>R</sup> = N<sup>P</sup> and G<sup>R</sup> (y) < G<sup>P</sup> (y) for all y, then n<sup>P</sup> H<sup>=nR</sup> L<sup>=0,onlyRproducesandexportsgoods</sup> of quality H, and only P produces and exports goods of quality L.

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 the di¤erentiated product of some quality level or another, where nq is the equilibrium number of varieties of quality q, all produced in R for q = H and all produced in P for q = L, and xq is the break-even quantity of sales per ...rm for producers of goods with quality q 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 producers of 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~<sup>R</sup> H<sup>=nH,n~R</sup> L<sup>=�LnL,n~P</sup> H<sup>=�HnH,andn~P</sup> L<sup>=nL.Also,exportsalesper...rmare</sup> �N<sup>P</sup> � nLd<sup>P</sup> L � =nH for a typical producer of a high-quality good in R and �N<sup>R</sup> � nH d<sup>R</sup> H � =nL for a 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).<sup>31</sup> Suppose now that the cost of transporting high-quality goods falls. This shifts demand toward the (imported) high-quality products in P, without a¤ecting demands in R (at the initial numbers of producers). 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 varieties rises while the

> 31 Details of these equations and their comparative statics can be found in the appendix.

22
e¤ective number of low-quality varieties 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 a reduction 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¤.

# 6 Commercial 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 exit of ...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.<sup>32</sup> 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 income of r = tnLd<sup>R</sup> L<sup>=N R,wheredR</sup> L<sup>istheaggregatedemandforatypical(imported)low-qualityproduct</sup> in country R.

A tari¤ raises the relative price of low-quality goods in country R. Considering both the price hike and the redistributed proceeds, (4) implies that the aggregate demand for a typical low-quality product there becomes The per capita demand for a typical high-quality product in R is Note that r = tnLd<sup>R</sup> L<sup>=N R= t�R</sup> L<sup>> 0, while r�t = �t</sup> �1 � �<sup>R</sup> L � < 0, so the tari¤-cum-redistribution shifts demand in R from low-quality goods to high-quality goods, for given numbers of each type of product. Consequently, the tari¤ induces entry of ...rms producing high-quality goods in R and exit 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

> 32 In this setting with specialization, a tari¤ on all imports in country R is indistinguishable from a tari¤ on imports of low-quality goods.

23
welfare of individuals with income y in country R can be written analogously to (12) as Di¤erentiating the expression for v<sup>R</sup> (y) at t = 0 and using (19) and the market-clearing condition, nqxq = �<sup>R</sup> q<sup>NR + �P</sup> q<sup>NP,wecanexpresstheimpactofasmalltari¤ ontheaveragewelfareofthose</sup> with income y in country R as where �q = nqxq= �N<sup>R</sup> + N<sup>P�</sup> is the fraction of consumers worldwide who buy a di¤erentiated product with quality q. The right-hand side of (20) combines two terms, a composition e¤ect and a redistribution e¤ect. The composition e¤ect should be familiar. It re‡ects the rise in the number of 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 fraction of low-quality goods than the average consumer in the world economy; i.e., �<sup>R</sup> H<sup>(ymax)>�</sup> H<sup>and</sup> �<sup>R</sup> L<sup>(ymax)<�</sup> L<sup>.Therefore,since�H>�L,thecompositione¤ectcertainlybene...tstherichest</sup> income group in country R. However, the poorest income group in that country may well lose from the change in the composition of di¤erentiated products.

The redistribution e¤ect re‡ects the transfers of income implied by the lump-sum redistribution of 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 from these transfers. Indeed, for the richest income group, �<sup>R</sup> H<sup>(ymax)>�R</sup> H<sup>and�R</sup> L<sup>(ymax)<�R</sup> L<sup>and</sup> the members of this group must gain on average from the redistribution e¤ect as well. But notice that the redistribution e¤ect might also bene...t the poor, since H > L. 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 of the di¤erentiated good and quantity of the numeraire good. If the quality di¤erence between di¤erentiated products is large, it may be that ��<sup>R</sup> H<sup>(ymin) =�R</sup> H � H > ��<sup>R</sup> L<sup>(ymin) =�R</sup> L � L, in which case 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 the absence of any terms-of-trade improvement.<sup>33</sup>

> 33 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 1 in Fajgelbaum et al. (2009).

24
# 7 Trade with Many Quality Levels and Many Countries

In this section, we extend our analysis of the trade pattern to the general case with many quality levels and many countries. In so doing, we are able to make contact with the empirical evidence on vertical specialization cited in the Introduction, much of which bears on a country’s relative exports to di¤erent markets or its relative imports from di¤erent suppliers. To address such issues, we need to examine a setting with more than two countries.

We now assume that there is an arbitrary set Q of quality levels indexed by q and K countries indexed by k. We suppose that all countries are of equal size and normalize their populations so that N<sup>k</sup> = 1 for k = 1; 2; : : : ; K. By neglecting variation in country size, we can focus on di¤erences in the level and distribution of income without invoking a taxonomy of cases. Our key assumption in this section is that countries can be ordered unambiguously from poorest to richest. In particular, we will assume that the income distributions in any pair of countries k and k<sup>0</sup> satisfy the monotone likelihood ratio property (MLRP), namely where g<sup>k</sup> (y) � dG<sup>k</sup> (y)=dy is the probability density function for income in country k. In words, Assumption 2 says that when comparing any two countries and any two income levels, the richer country (with the higher country index) has relatively more consumers at the higher level of income. This is a somewhat stronger assumption on the ordering of income distributions than that of ...rstorder stochastic dominance— which we used in the preceding sections— but we shall need it for the statements that follow.

The trading environment is a straightforward extension of the closed-economy model described in Sections 2 and 3. All countries share the same technologies and the same distributions of consumer preferences over varieties. All exports of goods of quality q incur a per-unit shipping cost of � q, regardless of source or destination. These shipping costs give rise to a parameter �q = e<sup>�q�q=�q</sup> such that the e¤ective variety of goods of quality q in country k is given by In country k, the aggregate demand for a local variety with quality q is while purchases of a typical imported variety with this quality are �qd<sup>k</sup> q<sup>.Wedenotetheright-hand</sup> side of (22) by �<sup>k</sup> q �~n<sup>k�</sup> , where ~n<sup>k</sup> is the vector of e¤ective varieties available in country k with typical element n~<sup>k</sup> q<sup>.An important property of these aggregate demands is captured in the following</sup> lemma.<sup>34</sup>

> 34 The proof, which relies on Lemma 2 in Athey (2002) that is orginally due to Ahlswede and Daykin (1978), is

25
Lemma 1 Under Assumption 2, the function �<sup>k</sup> q<sup>(~n)islogsupermodularin(q; k),sothat</sup> The lemma says that if the same e¤ective variety is available in two countries, the relative demand for the higher quality goods will be greater in the richer country.<sup>35</sup> This property of the demand system puts a great deal of structure on the home-market e¤ects, which in turn guide the trade patterns in a world economy satisfying the MLRP in incomes.

As before, we consider in turn the two extreme possibilities concerning the size of transport costs. First, we assume that trading costs are su¢ ciently large that all quality levels are produced in every country. Then we assume that trading costs are su¢ ciently small that every quality level is produced in only one country. In each of these cases, we are able to derive strong predictions about the bilateral trade ‡ows that mirror patterns found in the data.

# 7.1 Large Transport Costs

We know, as before, that all qualities are produced in every country in the autarky equilibrium. Such a pattern of diversi...ed production also obtains in a trade equilibrium when transport costs are su¢ ciently high. We examine now an equilibrium in which every country produces some varieties in all quality segments.

If production of quality q takes place in country k, then total sales by ...rms in this country must match the break-even quantity, xq = fqq=�q. This implies, as in the case with two countries, that all ...rms producing quality q make the same local sales and the same export sales (in total, and in each individual market), no matter where in the world they are located.<sup>36</sup> In the bilateral trade between country k and country k<sup>0</sup> , the latter will be a net exporter of varieties of quality q if and only if there are more varieties with this quality produced in k<sup>0</sup> than in k; i.e., if and only if n<sup>k</sup> q<sup>0> nk</sup> q<sup>.But it is straightforward to show,as we did for the case of two countries, that nk</sup> q<sup>0> nk</sup> q<sup>if</sup> and only if n~<sup>k</sup> q<sup>0>n~k</sup> q<sup>.37To...ndthepatternofbilateraltradebetweenanypairofcountriesforany</sup>

> given in the appendix.

> 35 Note that this statement does not rely on the countries being of equal size. That is, we could instead de...ne �<sup>k</sup> q<sup>(~n)astherighthandsideof(22)multipliedbyN k,andtheinequalitycitedinthelemmawouldstillapply.</sup>

> 36 The break-even conditions require

This implies

> A producer of some variety of quality q in country k exports �qd<sup>`</sup> q<sup>= �</sup> q<sup>dk</sup> q<sup>unitsofthisgoodtoeveryforeignmarket.</sup>

> 37 From the de...nition of e¤ective variety in k and k0 given in (21), subtraction yields

26
quality level, we need only ...nd which country has access to a larger e¤ective number of varieties in the trade equilibrium.

In the appendix we establish the following lemma concerning the relative e¤ective variety of two di¤erent quality levels available in any pair of countries.

Lemma 2 Suppose that some varieties of q and q<sup>0</sup> are produced in countries k and k<sup>0</sup> . Then, under Assumptions 1 and 2, The lemma says that a relatively greater e¤ective number of varieties of a higher-quality good is consumed in a richer country than in a poorer country. Intuitively, if the e¤ective variety were the same in the two countries, then by Lemma 1, the richer country would have the relatively larger domestic market for the higher-quality product. This would mean that producers of the higherquality good could make relatively greater pro...ts in the richer country than in the poorer country thanks to their savings on transport costs. But this implies that there would be incentives for entry of suppliers of the higher quality good in the richer country or incentives for entry of suppliers of the lower quality good in the poorer country. Of course, in equilibrium, all ...rms must make zero pro...ts in all market segments and locations. Under Assumption 1, which ensures that higher quality goods also are more dissimilar, the relative incentives for entry at ~n<sup>k</sup> = ~n<sup>k0</sup> are mirrored in the relative e¤ective numbers of varieties in the trade equilibrium.

Now we can describe the bilateral trade pattern between k and k<sup>0</sup> . Suppose that country k<sup>0</sup> has positive net exports of goods with quality q in its trade with country k. This requires, as we have seen, that there be more e¤ective varieties of q consumed in k<sup>0</sup> than in k; i.e., n~<sup>k</sup> q<sup>0>n~k</sup> q<sup>.But</sup> then Lemma 2 implies that the richer country also consumes more e¤ective variety of quality q<sup>0</sup> for q<sup>0</sup> > q than does the poorer country, which in turn implies that the richer country also has positive net exports of quality q<sup>0</sup> in its trade with the poorer country. More formally, we have Proposition 5 Suppose that all countries are of equal size and all quality levels are produced in all countries. Then, under Assumptions 1 and 2, for every pair of countries k and k<sup>0</sup> , k<sup>0</sup> > k, there exists a quality level q<sup>�</sup> (k; k<sup>0</sup> ) such that country k<sup>0</sup> exports on net to country k all goods with quality greater than or equal to q<sup>�</sup> (k; k<sup>0</sup> ) and imports on net all goods with quality less than q<sup>�</sup> (k; k<sup>0</sup> ).

Proposition 5 generalizes part ii of Proposition 2 to the case of many countries and many quality levels. It provides su¢ cient conditions under which a richer country has positive net exports of all the highest quality goods and positive net imports of all the lowest quality goods in its bilateral trade with a poorer country.

Proposition 5 implies that the average quality of a country’s exports is increasing in k, in keeping with the ...ndings by Schott (2004) and Hummels and Klenow (2005). In fact, the proposition o¤ers a stronger prediction; it suggests that in all bilateral trades, the basket of goods that a richer country exports to a poorer country should be of higher average quality than the basket of goods that ‡ow in the opposite direction.

27
# 7.2 Small Transport Costs

We now consider the opposite extreme case in which transport costs are quite small. As we know, if two countries both produce varieties in the same quality segment, then ...rms in each country must make the same domestic sales.<sup>38</sup> But, in the limit as the vector of transport costs becomes vanishingly small, the domestic sales of each ...rm approach those of the integrated equilibrium. Only exceptionally will the aggregate demands for a given quality level coincide in two countries in the integrated equilibrium. It follows that, generically, varieties of a given quality level are only produced in one country in a trade equilibrium with small transport costs. Moreover, even allowing for exceptional income distributions, any two countries can produce at most one quality level in common.<sup>39</sup> Which quality levels are produced in which countries? The answer is provided in the following proposition, the proof of which appears in the appendix.

Proposition 6 Suppose that all countries are of equal size and each quality level is produced in only one country. Then, under Assumption 2, if country k produces quality q and country k<sup>0</sup> > k produces quality q<sup>0</sup> , then q<sup>0</sup> > q.

The proposition does not rule out the possibility that some countries produce more than one quality level or that others produce none at all. In particular, if there are more countries than quality levels there will be some countries that specialize in producing the homogenous good and that produce none of the di¤erentiated products. But the proposition does indicate that the higher the quality level of a product, the richer is the country that produces it. The result follows from the homemarket e¤ect, which, as in the case with two countries, becomes overwhelmingly strong as transport costs go to zero. Production of a good is concentrated in the country that has the largest home market and richer countries have larger markets than poorer countries for higher quality goods.

Proposition 6 has strong implications for the trade ‡ows. First, the pattern of specialization implies immediately that every country imports higher quality goods from richer countries. This is consistent with the ...ndings by Schott (2004), Khandelwal (2010) and Hallak and Schott (2011) of a positive correlation between the quality of goods imported by the United States and the per capita GDP of the exporting country. Second, richer countries import relatively more from countries that produce goods of higher quality. This result, which is in keeping with the empirical evidence provided by Hallak (2006), follows from the fact that, when transport costs are small, the relative demand for a higher quality good must be greater in a richer country, as indicated in Lemma 1. Third, suppose that a country exports goods in two quality segments, q and q<sup>0</sup> , with q<sup>0</sup> > q. This country will export relatively more of the higher quality goods to the richer market. This too

> 38 The argument is the same as in footnote 36.

> 39 0 0 k Suppose, to the contrary, that countries k and k both produce varieties of quality q and q . Then dq<sup>= dk</sup> q<sup>0and</sup> d<sup>k</sup> q<sup>0=dk</sup> q<sup>00 .Inthelimit,asalltransportcostsvanish(�q!1forallq)thisimplies�k</sup> q<sup>(�n)=�k</sup> q<sup>0(�n)and�k</sup> q<sup>0 (�n)=</sup> �<sup>k</sup> q<sup>00(�n),where�nisthevectoroftotalvarietiesintheintegratedequilibrium.Butthispairofequalitiescontradicts</sup> Lemma 1, so the two countries cannot in fact share in production of these two quality levels.

28
follows from Lemma 1 which implies that, when transport costs are small, the relative demand for the higher quality good must be greater in the richer country. More formally, we have established Proposition 7 Suppose that k<sup>0</sup> > k and that transport costs are vanishingly small. Under Assumption 2, if countries k and k<sup>0</sup> import goods of quality q and q<sup>0</sup> with q<sup>0</sup> > q, then k<sup>0</sup> imports relatively more of quality q<sup>0</sup> .

Notice that this proposition does not require that countries k and k<sup>0</sup> be of equal size, for the reason stated in footnote 35; i.e., the ordering of relative aggregate demands for alternative quality levels in two markets is independent of the sizes of those markets. Proposition 7 yields the following immediate corollary concerning a country’s exports to multiple markets.

Corollary 2 Suppose that transport costs are vanishingly small. If country k produces varieties in two quality segments, it exports relatively more of the higher-quality goods to a relatively richer market.

Finally, consider a country that exports varieties of a given quality to two di¤erent markets. Controlling for the sizes of the importing countries, the exporter’s sales are greater in the country whose income ranking is more similar to its own.<sup>40</sup> This prediction is in the spirit of the Linder hypothesis and the empirical evidence provided by Hallak (2010).

# 8 Concluding 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 non-homothetic aggregate demands for goods of di¤erent qualities. The non-homotheticity in demand re‡ects a complementarity in individual preferences between the quality of the di¤erentiated product and the quantity of a homogeneous good. Consumers have idiosyncratic components in their evaluations of the available varieties of the di¤erentiated 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 and constant-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

> 40 Suppose that k00 > k0 > k and consider the exports of k of some quality q to k 0and k00 when transport costs are small. By Lemma 1;

> where q<sup>0</sup> > q is the quality of some varieties produced and exported only by country k<sup>0</sup> . Since q<sup>0</sup> is produced in k<sup>0</sup> but not in k<sup>00</sup> , d<sup>k</sup> q<sup>00> dk</sup> q<sup>000.Thereforedk</sup> q<sup>0> dk</sup> q<sup>00;i.e.,themarketforgoodsofqualityqmustbelargerink0thanink00.</sup> The same argument applies when k > k<sup>0</sup> > k<sup>00</sup> , once we note that q > q<sup>0</sup> in this case.

29
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 trade equilibrium.

Our model yields predictions about the pattern of trade that are consistent with the empirical evidence. For example, we ...nd that, among countries of similar size, the richer countries export goods of higher average quality. This is in keeping with the empirical ...ndings by Schott (2004) and Hummels and Klenow (2005). When trading costs are small, a country imports higher-quality goods from richer trading partners, as Schott (2004), Khandelwal (2010) and Hallak and Schott (2011) have found to be true in the U.S. bilateral trade data. When a country exports varieties of a given quality to two di¤erent markets of similar size, it exports a greater volume to the country whose income ranking is more similar to its own.

Our framework lends itself readily to welfare analysis. 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 numbers of low- and high-quality products— often bene...ts consumers at one end of the income distribution at the expense of those at the other. We ...nd that, in the absence of supply-side determinants of comparative advantage, trade between countries at di¤erent levels of income tends to bene...t on average the poorer consumers in the richer country and the richer consumers in the poorer country. These income groups gain from integration not only because imports provide a wider variety of choices, but also because trade shifts the composition of available products toward those goods that they are most likely to buy.

Our nested logit demand system is familiar from the empirical literature. For this reason, we believe that it would be possible to estimate key parameters of the model from data on household income and spending. Armed with such estimates and observable data on expenditure patterns, one could utilize our expressions for the average welfare changes in di¤erent income groups to calculate the gains from trade across the income distribution.<sup>41</sup> Finally, our framework is simple enough to allow for extensions and variations. For example, it is straightforward to introduce direct foreign investment as an alternative means for ...rms to serve foreign markets. Then the model could shed light on the spread of Chinese and Indian multinational corporations to other developing countries (see Boston Consulting Group, 2006). We are pursuing such an extension in our ongoing research.

> 41 See Porto (2006) for an ambitious attempt to estimate the distributional impacts of trade policy in a model that includes heterogeneous consumer gains as well as wage and income e¤ects. Porto does not allow for non-homothetic demands, but rather he takes the variation in budget shares for di¤erent households to be an exogenous re‡ection of heterogeneous tastes.

30