Vertically Differentiated Cournot Oligopoly: Effects of Market Expansion and Trade Liberalization on Relative Markup and Product Quality

We model an oligopoly where firms are allowed to freely enter and exit the market and choose the quality level of their products by incurring different set-up costs. Using this framework, we study the mix of firms in the long-run Cournot-Nash equilibrium under different cost structures and the effects of market size on market outcomes. Specifically, we consider two alternative specifications of cost structure. In the first specification, quality upgrading requires a large increment in the set-up cost or R&D investment. Under this cost structure, we show that in the Nash equilibrium, each firm specializes in a single quality level, and an increase in the market size leads to (i) an increase in the fraction of firms that specialize in the high quality product, (ii) an increase in the market share of the high quality product, and (iii) a reduction in firms' markups and in markup dispersion. Under the second type of cost structure where quality upgrading only requires higher marginal cost, we find that all firms will produce both types of product, and the value share of the high-quality product increases as the market expands, but in quantity terms, the market share of the high quality product does not change. Finally, we find that trade liberalization has broadly similar effects to that of a market expansion, but the supply of the high-quality product from the smaller economy may decrease.