Quality and Gravity in International Trade

This paper introduces endogenous quality innovations in a multi-country heterogeneous firm model and derives implications for the gravity equation. Using aggregate trade data and firm-level data, we confirm the theoretical predictions: fixed costs have a lower impact on exports and on the share of exporters in industries with a high degree of vertical product differentiation. Quality innovations change the trade elasticity with respect to fixed costs through the extensive margin, whereas the elasticity with respect to variable costs remains unaffected. We estimate the parameters of our model and simulate a reduction in fixed trade costs. Accounting for quality lowers gains from trade and leads to more heterogeneous effects across industries compared to a model without vertical differentiation.