Vertical Strategy with Quality Differentiation in an Import-competing Market

We examine the vertical strategies of home and foreign manufacturers that produce quality-differentiated products. In contrast to previous results that showed vertical separation as the dominant strategy, we find that the home manufacturer opts for vertical separation, while the foreign manufacturer chooses vertical integration under Bertrand competition. This is because the government of the importing country aims to increase consumer surplus by imposing tariffs, which allows the foreign manufacturer to export high-quality products at lower prices. Under Cournot competition, both manufacturers maintain a vertical separation strategy. However, if the quality levels of products are low, both manufacturers obtain higher profits when they choose vertical integration. This leads to a prisoner’s dilemma situation for both manufacturers. In the case of a free trade policy, manufacturers always choose the separation strategy. Under Bertrand competition, integration leads to higher output levels and increases social welfare for the importing country due to the high level of importation of high-quality products, suggesting the tariff policy drive the foreign manufacturer towards integration.