An intra-industry trade model in a vertical differentiation framework

We developed a partial equilibrium model in which intra-industry trade arises as a result of utility maximization of consumers and profit maximization of firms. The driving force for intra-industry trade is non-homothetic preferences of consumers. We utilized a vertical differentiation framework, in which consumers have the same tastes for quality but different income levels determining their non-homogeneous choices. All firms in all countries have access to the same production technology, and there are no differences in factor endowments. Intra-industry trade arises as a result of each firm specializing on a certain segment of the market in all countries. We solved the model numerically for a two-country two-firm setup. In this setup, firms choose their product quality level and their price by maximizing their profits in a two-stage optimization problem. They also decide whether to export to the foreign market or to concentrate only on the domestic market in a standard two-by-two game. With introduction of non-zero transportation costs, trade volumes in both directions decrease. Transportation costs are shared between consumers and firms according to the marginal demand in the domestic versus in the foreign country. This model supports Krugman’s home market effect: In case of non-zero transportation costs, firms want to locate their production site in the country where there is higher marginal demand for their product.