Strategic trade policy in a vertically differentiated market

This paper examines a non-cooperative tariff policy game between the home and foreign countries in a vertically differentiated market, taking into consideration the competition mode of two firms. By introducing a "reciprocal trade policy" into an import-competing model, this paper analyzes how these trading countries endogenously choose the strategic trade policy in the presence of tariffs and subsidies. Under Cournot competition, the home country chooses a tariff policy while the foreign country chooses no intervention (free trade). Conversely, under Bertrand competition, both countries adopt strategic trade polices: the home country employs a tariff policy, and the foreign country employs a subsidy policy. However, under Bertrand competition, if both countries choose non-intervention such as free trade, it leads to a high level of welfare of both countries, contingent upon the degree of differentiation in product quality. This result indicates that both countries encounter a prisoner's dilemma. This analysis suggests that establishing free trade agreements between the two countries could resolve the prisoner's dilemma situation when a significant level of differentiation in product quality exists.