«Quality in Open Markets: How Larger Leads to Less»

Transcription

1 TE 505 Jne 014 «Qality in Open Marets: ow Larger Leads to Less» M.. Calmette, M. Kilenny, C. Lostalan, I. Pechox and C.Bernard

2 Qality in Open Marets: ow Larger Leads to Less M.. Calmette (TE 1, M. Kilenny (NCAP, C. Lostalan (TE, I. Pechox (TE, C. Bernard (TB Astract: We show how a large contry s entrance on world marets can lead to lower and less ality diversity availale to consmers rather than more. In or model, atary ality is directly proportional to the willingness to pay for ality and home maret size, and inversely proportional to the cost of ality. We formalize strategically interacting firms, and identify the context in which a low-ality prodcer can lead, driving high-ality prodcers ot of the maret despite the existence of cstomers willing to pay for higher ality. We discss the feasiility of this predatory strategy y an emerging contry. It is more liely in contexts where the emerging exporter is mch larger. Introdction Jagars, Porsches, BMWs, in 01 aot eleven percent of the new vehicles sold in the UA were lxry cars lie these. They were oght y people willing and ale to pay for high ality goods. Other people prchased less expensive vehicles prodced y other ato maers. The fact that some prodcers specialize in serving high-end cstomers while others specialize in spplying low-priced goods has een rationalized y indstrial organization and international trade theorists for some time. Recently, however, a new pattern has emerged. In some retail marets, despite the existence of cstomers willing to pay for ality, lxry goods are no longer availale. Althogh the fll spectrm of vertically-differentiated goods was availale in the recent past, now only low-ality versions are offered. In this paper we attempt to explain why a maret may ecome dominated y only low-price, low-ality goods despite no redction in the nmer of consmers willing to pay for high ality. Over three decades of literatre exists concerning world marets for vertically-differentiated goods, also nown as intra-indstry trade. A large part of this literatre is ased on indstrial organization, e.g.: Gaszewicz and Thisse (1979, haed and tton (198, Motta (1993, Crampes and ollander (1995, and agelam, Grossman, and elpman (011. A canonical model y Motta, Thisse and Carales (1997 consists of two firms in two contries, each prodcing a good identified y a ality index, strategically competing for a share of the gloal maret in a two-stage game. Consmers are characterized y their tastes and their willingness to pay for ality. Qality is costly to prodce. In the first stage firms simltaneosly choose the ality to spply. In the second stage they compete in a noncooperative Cornot or Bertrand game. In atary, the ality choice that maximises profits 1 Corresponding athor : Marie-rançoise Calmette Tolose chool of Economics/ ondation Jean-Jaces Laffont / IDEI Université Tolose I Capitole 1 Allée de Brienne Tolose / tel : / marie-francoise.calmette@tse-fr.e 1

3 depends on the home maret size and consmers willingness to pay for ality relative to the costs of spplying ality. The literatre provides three main implications aot what happens when contries open to trade. One, oth firms respond to maret incentives to change the ality they spply on the gloal maret. Two, in eilirim the two firms never chose to spply the same ality, as that wold drive oth firms profits to zero. Three, there are mltiple stale eiliria. It is not possile to predict whether the firm in the contry that has the lower ality in atary will contine to spply low ality gloally, or if it will leapfrog to spply the high ality prodct, or vice-versa. These reslts are consistent with the indstrial organisation literatre. Motta, Thisse and Carales (1997 assme that the willingness to pay for high ality differs etween the contries and that changing ality reires incrring fixed costs. This is why the contries specialize in a different ality good in atary. When the contries open to trade, intra-indstry two-way trade occrs, allowing high ality-loving consmers in oth contries to otain high ality goods, and low price cstomers in oth contries to otain low price goods. ree trade ths leads to more ality diversity in local marets, not less. And leapfrogging on the spply side occrs only if the difference etween the two contries willingness to pay for high ality is sfficiently small. The importance of domestic demand conditions in determining the patterns of international trade has een recognized since Linder (1961. Linder hypothesized that sppliers tailor their prodcts to the tastes of domestic prchasers. To the extent that the mix of tastes elsewhere are similar, there will e intra-indstry trade with other regions. Krgman (1980 highlighted the home maret size effect in a monopolistically competitive context. Porter (1991 emphasized the importance of domestic demand for high ality to prepare firms to compete in international marets. The aility to prodce high ality goods has een noted as a condition for export sccess and economic development (Kremer 1993, Grossman and elpman, This cold e nderstood as a prescription for leapfrogging. In contrast, China has ecome a maor exporter to gloal marets in many prodct lines withot switching to high ality. sted and Nishioa (01 report that initial Chinese exports were laor-intensive, low ality manfactred items sch as clothing, footwear, and toys. According to Berger and Martin (011 the vale of Chinese exports more than adrpled in the eight years etween 000 and 007. By 009, China had ecome the world s largest gloal exporter. The entrance of China as a low-cost, low-ality spplier in world marets drove the domestic prodction of low price, low ality goods ot of some contries economies. Bt no-one expected it to drive high price, high ality goods ot of oth prodction and marets as well. In sm, the existing international trade and indstrial organization theories indicate that as long as consmers have differentiated tastes and willingness to pay for ality, firms have incentives to differentiate spplies to satisfy gloal maret demands. The implication that free trade leads to greater ality diversity in each local maret is also a conseence of the assmption that firms play a non-cooperative game in two stages, with simltaneos decision maing at each stage. Bt the relative sizes of trading contries today casts dot on this simltaneos play assmption. In a world where firms in some contries face hge domestic marets, it may e more realistic to assme that sch firms assert their aility to lead, forcing smaller contry rivals to follow their (ality, price offer. or example, why shold a Chinese firm engage in a non-cooperative simltaneos game on a level-playing field when it

4 exports to the Astralian maret? Given a Chinese firm s hge domestic maret, large economies of scale and low nit prodction costs, why woldn t a Chinese firm ehave as a leader, forcing the Astralian firm to adapt its strategy in response? This is what we analyze in this paper. We propose a model consisting of two contries, one small t implicitly rich, with a share of consmers willing to pay for higher ality, as well as higher laor costs and lower fixed costs for prodcing high ality goods. The other contry is very large, has low laor costs, low willingness to pay for ality, and a high fixed cost to prodce high ality goods. Giving these assmptions, in atary the large contry firm prodces a lower ality than the small, rich contry firm. The difference in home maret size is the first essential difference etween or model and the existing literatre. The second essential difference is stified y the first assmption aot relative size. Becase of the low-ality prodcing contry s large home maret size, it can credily lead. We formalize a tacelerg-lie game. We show that a large contry can choose the ality and antity that forces the small contry firm to exit the maret. Or model ths rationalizes how a low ality prodct spplied y a large contry can captre an entire maret. We analyze the feasiility of this aggressive predatory strategy, demonstrates that it maximizes profit, and investigate the staility of the eiliria of the game. We show that the ataric characteristics of the large contry are primordial. A large domestic maret is essential. Even if contries have the same cost characteristics and face the same willingness to pay for ality, only a sfficiently large contry s firm can sccessflly follow a predatory strategy. If the domestic maret is large enogh, the low ality-prodcing contry can export its atary ality, wholly avoiding the costs of adapting ality to compete for st a share of the other contry s maret. This contrasts with the existing finding in the literatre that firms always have incentives to adapt the ality of their spplies to the gloal maret when they open to trade. rthermore, when the small contry/high ality prodcing firm raises its ality in an attempt to relax the competition on its own maret, it s gloal maret revene is not sfficient to cover costs. igh ality prodction shts down. The paper is organized as follows: in the next section we present the model and the atary sitation. ection 3 formalizes the open maret sitation. Assming the large contry leads, we formalize a tacelerg game in section 4, focsing on the (ality, antity strategy that nllifies the profits of the high ality prodcer, which we call a predatory strategy. We analyze the feasiility conditions for the predatory strategy in section 5, emphasizing the implications of relative size. In section 6 we compare the profitaility of the predatory strategy to the profitaility of the eiliria in the non-cooperative simltaneos game. The last section concldes.. The model and the atary sitation We model two contries, ( ome and ( oreign. In contry (,, consmers indexed y a taste for ality θ are niformly distrited over the interval [0, ] with density. On the spply side, firms incr a adratic prodction cost C c and a fixed cost K that is adratic in ality: prodces a single ality of a good. K. Ths in atary, in each contry, a monopoly firm 3

5 Consmers either y one nit or none at all. Consmers of type θ will y one nit only if their net consmer srpls is positive, that is, only if θ -p 0, where p is the price of the good of ality. When only one ality A is availale, consmers with θ higher than p A θˆ JA y one nit of the good. In atary, maret demand in each contry is ths: A p A D A,,. A In sm, there are for differences etween the two contries: 1 the willingness to pay for ality is lower in oreign than in ome <. oreign is larger: >, in contrast with the exiting literatre, e.g., Motta, et al., (1997. We normalize 1. 3 it follows that the marginal cost of prodction, c, is lower in than. Normalizing that cost to zero implies C 0, C > 0. 4 the fixed cost to prodce a different ality is lower in ome: 0 < <. These for assmptions descrie contry as a relatively small developed contry, with higher wages, more sophisticated consmers, and lower prodct line switching costs (de to, for example, pre-existing R&D or more flexile or prodctive infrastrctre. Meanwhile, contry is a ig emerging contry, with a relative andance of laor and ths lower wages, as well as a large poplation of ssistence consmers. Given the fixed cost of ality, to maximize profits firms will prodce only one ality. Profits are given y: A A π A ( A A C K. Maximizing π A with respect to A and A we find that: A A, ( A c and A ( 16c 3c (1 16 Given c 0 the atary ality choice (1 y simplifies to: A. ( 8 4

6 Clearly, s profit-maximizing ality is increasing in and, and decreasing in, the fixed cost of ality This implication contrasts with the sal explanation that emerging economies export low ality goods strictly ecase their laor is low-priced. Prodcing lower ality goods is also a rational otcome where domestic consmers have a low willingness to pay for ality, the contry is relatively small, and the fixed costs of higher ality are high. inally, recall that consmers with θ higher than θˆ JA p A A will y one nit of a good. Ths for a given poplation, the firm in the contry where consmers have a higher willingness to pay for ality prodces a higher ality, sold at a higher price. This is a another significant implication of asymmetric home maret size. When there is a difference in the nmer of consmers in each ality range (density astracting from any differences in consmers willingness to pay for ality ( nor difference in the fixed cost of ality (K, or, the atary ality prodced y the firm in the larger contry will e higher. Ths, to formalize the sitation in which the larger contry prodces the lower ality prodct in atary, we se (1 and ( to otain the conditions on relative to, c, and sch that in atary, prodces a lower ality than : ( 16c 3c 1 < < (3 or the remainder of this paper, we assme parameters vales consistent with this condition. 3. ree Trade When the two contries open to trade, oth low and high ality versions may e availale to consmers in each contry. In each contry the consmer indifferent etween ying the higher or the lower ality is indexed y: ~ p p θ Ths in each contry, the domestic demand for the higher ality (overscored D is: p p D, (4 While demand for the lower ality (nderscored D is: D p p p, (5 When free trade is possile, each firm faces a new set of demands de to the different willingness to pay for ality ecase, and, a different nmer of consmers at each willingness to pay ecase. The firms may have incentives to adst ality to spply the gloal maret. Bt to do so they mst pay a fixed cost to change ality. ome athors assme that this adstment cost depends on the difference etween the atary and open maret ality. Unfortnately with 5

7 this assmption, as Motta, et al, 1997 explain, it is impossile to find analytical reslts for the eiliria of the game; nmerical simlation is reired. In models where it is assmed that firms have constant marginal costs, e.g., Venales (1990 and Motta et al (1997, firms segment the maret in prices, then maximize the gloal profit y choosing to spply one ality to oth marets. Others, following Brander and Krgman (1983, assme that firms choose prices to maximize profits separately on oth marets, which can lead to reciprocal dmping. In order to focs on ality choice we rle ot dmping. And or assmption that prodction costs are adratic rles ot segmenting the maret in prices. Becase of the fixed cost of ality, firms choose to spply a single ality on oth maret places. They also choose the antity to prodce that maximizes their gloal profit. rom (4, the gloal maret demand for high ality prodcts facing the firm is given y: p p p p (6 given normalized to 1, and assming oth alities are availale in oth marets. imilarly, from (5, the gloal maret demand for low ality prodcts facing the firm is: p p p ( 1 (7 The corresponding free trade prices when oth versions of the good are transacted are ths: p p ( ( 1 1 Recall that demand for the high ality good in contry is positive only if Given (8 and (9, we otain that p (8 (9 p >. ~ p p θ,, and the necessary (1 condition for positive demand for the high ality good in contry is <. It follows that there is difference in the willingness to pay for ality at which two-way trade will not occr, that is, althogh may import low ality versions from, it will not export high-ality versions to. In the following we assme parameter vales consistent with positive demand for high ality goods among contry consmers, i.e., two-way trade. 4. The Predatory trategy Or oective in this paper is to nderstand how high ality goods cold disappear from a developed contry s maretplace. We now that this otcome is not rationalized y assming a sitation in which firms play a two-stage non-cooperative game, as in the existing literatre. As we shall show, the oserved otcome is rationalized if we assme that the larger contry 6

8 7 ehaves as a tacelerg leader, to achieve a predatory oective. Taing into accont the small contry firm s est response, the firm in commits to spply the ality and antity on the gloal maret sch that when the small contry firm adapts ality, its profits are nonpositive, reslting in the ltimate closre of the -firm. The game we formalize proceeds in two stages. imilar to the tacelerg game, anticipating the -firm s est response, the -firm commits to spply the ality and antity that shold nllify the -firm s profits. In the second stage, the -firm chooses the new ality and antity that maximizes their profit. As sal, this game is solved y acward indction. irst solve the profit maximization prolem of the -firm, as anticipated y the -firm. Assming that the -firm will adapt ality ( A, -firm profit is: ( ( c p π With free trade and oth goods consmed in oth contries, the open maret price p is given y (8. Rearranging, profit is: ( 1 c π (10 The -firm is assmed to choose the ality and antity that maximize π. The first order conditions with respect to imply that: (1 ( (11 Expressing π in terms of this expression for we have: (1 4 ( (1 4 ( (1 1 c π (1 The firm also chooses the prodction antity that maximizes its profit. Let λ ( 0 > λ. The first order condition with respect to the profit maximizing antity is: 0 (1 (1 3 ( 3 ( (1 4 c λ π Of the three soltions for, the one consistent with a negative second derivative is: ( (1 16 ( c λ (13 Analyses of this game assming ome does not adapt reslts in theoretical open maret otcomes inconsistent with the oserved otcome we see to explain: (i for ( - too large, ome serves the domestic maret only, t free trade still leads to wider ality choice in ome; (ii at lower ( -, there is a threshold at which ome also serves only the domestic maret, and (iii at larger, there is leapfrogging, also leading to higher ality in the open maret than in atary. Details availale from the athors on reest.

9 Eations (11 and (13 express the -firm s profit-maximizing response in terms of the ality and antity choice variales of the -firm (and the relevant parameters. Note that one otains the same reslts y first maximizingπ with respect to. Now, solve the predatory strategy prolem of the firm. What pair (, nllifies π? Denote λ and express the vale fnction for π in terms of as given y(13. This reslts in an expression for π in terms of the parameters (, c, as well, as λ and s choice of. ind the vale of λ that nllifies the -firm s profit y eating π (,, c,, λ, to 0: λ 18 1 (1 (( 1 c (1 ( ( 1 With this vale of λ in (13, the expression for is: 1 [9 9 ( c (1 8 ( 1c (1 1 ( 34 8 ( 1c (1 ] (13 c (1 G It follows that λ, where G 18 1 (1 (( 1 c (1 ( ( 1 c (14 (1 In sm, this is a game in which the -firm is ale to drive the -firm profits (1 to zero y offering G. A nmerical example is given in Appendix 1. Clearly, when the -firm offers the (, sch that G eps, the -firm s revenes will not cover costs, and it will e driven ot of the maret. 5. The feasiility conditions for a predatory strategy The predatory strategy y the firm in is to set. G (14. Under what parametric conditions can the -firm sccessflly implement this strategy while prodcing the lower ality version of the good? If the -firm adapts ality (, given or normalizations its profit is π ( p. Using (9 to express the open maret price of the low ality good, we have: ( π 1 (15 A 8

10 Alternatively, if the -firm simply specializes in and exports its atary ality, then it avoids the cost of adapting ality: ( A π (15 1 irst alternative: oreign firm exports its atary ality Proposition 1: The emergent contries ale to play a predatory strategy y exporting their atary ality mst have a high density of poplation. The density of the poplation mst e higher when the rich contry consmers willingness to pay for ality is higher. The -firm can drive the -firm ot of the maret y proposing a pair G where G depends on the characteristics of the contries (14. The higher is the willingness to pay for ality in the rich contry (the higher is and the lower is the cost of prodction in the rich contry (the lower is c, the larger is G, and the more difficlt it is for an -firm to sccessflly follow a predatory strategy. When the firm exports its atary ality when it ehaves as a leader when it opens to trade, it is constrained y the trade-off formalized in (14. The lower its atary ality, A, the higher antity,, mst e to conform with A G. Nevertheless, its prodction cannot exceed the gloal maret size: (16 Max ( In conseence, the minimm atary ality in contry consistent with a predatory strategy is: G min A (17 rom ( we have that ( A. This allows s to express the maret density,, 8 necessary for a sccessfl predatory strategy y the firm exporting its atary ality. By sccessfl predatory strategy, we mean π 0 (10, and that the -firm s profits (15 are higher than nder any other strategy. It follows from (17 and ( that in order for the firm to play the predatory strategy, mst e sfficiently large, i.e., it mst e that: G(8 >. (18 ( We illstrate via simlation how the minimm predator size (or density,, varies as c and vary in igre 1. Consider 3, 5, c 3, 0. 8 and These vales of the parameters are consistent with (3. igre 1 illstrates the feasiility of the predatory strategy when the - firm exports its atary ality at different levels of, 9

11 igre 1. Atary ality in oreign, A, compared to the minimm ality choice reired for a sccessfl predatory strategy (Min A with respect to oreign size, assming 5, 3, c 3, 0.8, 0.3. The steeper (red line in igre 1 illstrates that oreign atary ality is directly proportional to its size, as explained in the second section of this paper. The shallower line (le represents how the minimm ality consistent with an implementale predatory strategy smmarized y G. On and nder the shallower π A varies with respect to line, 0. With the illstrated parameter vales, the -firm will not ehave as a predator exporting its atary ality when it is small, p to. 4. At larger size, oreign s atary ality ( exceeds the minimm ality that satisfies (17 for a sccessfl predatory strategy. This nderscores or finding that the emerging contry mst e sfficiently large (aot three times larger, depending on the other parameters to implement the predatory strategy. The main reslt is that among emergent contries that have the same cost of ality, cost of prodction, and their own consmers willingness to pay for ality, only the large emergent contries-- with sfficiently high -- are ale to implement a profit-maximizing predatory strategy while exporting their atary ality. Alternatively, when rich contry consmers are willing to pay even more for ality (higher vales of, the minimm ality of exports from the emergent contry ( min A for a sccessfl predatory strategy mst also e higher. rthermore, the higher is the willingness to pay for ality in the rich contry,, relative to, the larger the emergent contry mst e for it to scceed with a predatory strategy. This is illstrated y comparing igres and 1. igre is generated sing the same parameters as igre 1, except that 7 in igre. Note also that (3 is satisfied throgh 10

12 < 14. igre shows the higher size of ( 4. 5 consistent with a sccessfl predatory strategy in s atary ality when the difference in the willingness to pay for ality is larger. igre. Atary ality in oreign, A, compared to the minimm ality reired for a sccessfl predatory strategy (Min A with respect to oreign size ; assming 7 (all else the same as in igre 1 econd alternative: the oreign firm adapts ality to spply the gloal maret Proposition : The emergent contry playing a predatory strategy will chose to adapt ality to the new open maret when differences etween contry willingness to pay for ality and in poplation are sfficiently small. Nevertheless if differences in poplation are large, the emergent contry firm can sccessflly corner the maret while exporting its atary ality. Let s consider now the alternative that the oreign firm adapts and exports the ality A while satisfying G. In this case the oreign firm incrs the fixed cost of ality, and π is defined as in (15. Using the vale of λ which nllifies the ome firm s profit, the corresponding vale of G (13, and setting λ in (15, the vale of π depends on the parameters 11

13 (,, c, and is only a fnction of. We find the level of ality that maximizes the π oreign firm s profit y satisfying the first order condition 0. 3 or parameter vales 3, 5, c 3, 0. 8 and 0. 3, igre 3 illstrates oreign firm s profit nder the predatory strategy as a fnction of density, comparing adapt ality to the don t adapt ality alternative. igre 3. -firm profits nder the predatory the adapt ality and don t adapt alternatives with respect to density, given 5, 3, c 3, 0.8, 0.3. At low levels of the oreign firm maximises profit y adapting ality to the new open maret (the red crve. At larger the oreign firm maximises profit y exporting its atary ality (s the le crve. Given the parameter vales illstrated, the alternatives are eally profitale at.9. Aove that size, exporting the atary ality is more profitale. acing a large nmer of consmers with a low willingness to pay for ality in oreign, the oreign firm has insfficient incentives to incr a fixed cost of switching to higher ality to sell to the ome contry consmers. Consider how this reslt varies with respect to. When the willingness to pay for ality in ome,, is higher, it is more difficlt for the oreign firm to implement a sccessfl predatory strategy. Bt there is still a oreign size at which the predatory strategy dominates. As shown in igre 4, with 7, vales of other parameters eing the same, the predatory strategy is not profitale at all for <. or < < 5., the oreign firm has the incentive to adapt ality and serve more ome consmers. The size effect dominates after > 5.. Aove that size the -firm most profitaly exports its atary ality in a predatory strategy. 3 Details of the calclations are availale on reest to the athors. 1

14 igre 4. oreign firm profits nder alternative predatory strategies (adapt, not adapt with respect to, given parameters 7, all else eal to igre 3. In this section we have shown that a predatory strategy model rationalizes the oserved exclsively low ality goods on an open maret following the entrance of a very large, relatively poorer contry. The size of the emergent contry is ey, as is the relative willingness to pay for high ality. When the emergent contry is small, as we shall show in the next section, its most profitale strategy is to play a non-cooperative game. That reslts in the more diverse ality otcomes that have een common in the past on open marets. When the emergent contry is more than thrice the size of its trade partner (depending on other parameters, it maximizes profit y implementing a predatory strategy in which it simply exports its atary ality when it opens to trade. The threshold size is increasing in the willingness to pay for ality in the ome contry, t there is always a sfficiently large size at which the predatory strategy is the most profitale. The est response to the predatory strategy in ome leaves the high ality firm with zero profit (or lower, ltimately driving it ot of the maretplace. The ltimate otcome is exclsively lower ality goods after the emergence, compared to efore. This is the otcome oserved in some marets (e.g., clothing since China emerged on gloal marets. 6. Comparison with the simltaneos non-cooperative Cornot Game In this section, for prposes of comparison we consider the sitation where the monopoly firms in the two contries play a non-cooperative game when they open to trade, as in the existing literatre (e.g., Motta, et al (1997. In the first stage they simltaneosly choose alities and and in the second stage they compete in antities and. According to the existing literatre, depending on the vales of the parameters,, c, and, there 13

15 may e mltiple Nash eiliria, inclding leapfrog eiliria (where the low ality prodcer switches to a higher ality than the high-ality rival. Assming oth adapt ality to the open maret, as in the existing literatre, the firms profits are as sal, given y eations (10 and (15. We solve y acwards indction. irst, find the prodction antities that maximize their respective profits. The first order condition soltions consistent with a negative second derivative are: ( ( and (4c (1 4 ( (4c (c (1 (1 4 stitting these expressions into π and π we otain: ( ( c (1 ( π (1 ( 4c (1 4 (19 And (( ( c (1 π (1 ( 4c (1 4 (0 At the first stage, the firms simltaneosly choose the ality to spply to maximize these profit fnctions. The first order condition soltions consistent with negative second derivatives are the Nash eiliria of the game. 100 Don t adapt 50 Adapt Non Coop igre 5: oreign firm profits as a fnction of for oth predatory strategy alternatives and the non cooperative strategy, 3, 5, c 3, 0. 8 and 0. 3 Compare the oreign firm s profits from a non-cooperative game strategy to its profit from the alternative predatory strategies. The analytical soltions are prohiitively difficlt. We can, however, identify sperior strategies via simlation, assming vales for the parameters 14

16 ( 3, 5, c 3, 0. 8 and 0. 3, and investigate how the strategy ranings vary with respect to the parameters, especially the oreign maret size or density,. In igre 5 the oreign firm s profit as a fnction of from oth alternative predatory strategies is compared to profits when it participates in a simltaneos non-cooperative game. igre 5 shows that at low levels of the oreign firm maximises profit y playing the noncooperative game. When its size or density is larger than 1.9, the oreign firm maximises profit with the predatory strategy alternative in which it adapts ality. At levels of higher than.9, it is most profitale for the -firm to implement the predatory strategy with a low atary ality, as shown in the previos section. As seen, this threshold size is directly proportional to the difference in the willingness to pay for ality. This is illstrated in igre 6. When is raised to 7, all else eal, the predatory strategy is not profitale elow 5.. owever, once again, even with a significant difference etween the willingness to pay for high ality, the effect of that difference is ltimately overwhelmed y the difference in size. In igre 6 the size effect dominates after > 5.. Aove that size the -firm can most profitaly export its atary ality in a predatory strategy. Note also that when 7, the -firm predatory strategy alternative adapt is dominated at all vales of. Non coop Don t adapt Adapt igre 6. oreign firm profits with respect to nder oth predatory strategy alternatives and the non cooperative strategy; 3, 0.3, c 3, 0.8, 7. Conclsions This paper provides theoretical explanations for what has occrred in many developed contries since China emerged on gloal marets. We have proven how a large contry s low-ality exports can dominate an entire maret, not only where low-price, low-ality goods are demanded, t also where there is a nmer of consmers willing to pay for high ality. We have shown how large can lead to less. 15

17 China s exports of low ality manfactred prodcts sch as clothing, footwear, and toys have een docmented y Amiti and rend (010 and sted and Nishioa (01. Or model shows that an emergent s contry ality is inversely proportional to the cost of ality and directly proportional to its size. The finding agments the typical explanation that emerging economies export low ality goods strictly ecase their laor is low-priced. The importance of emergent contry size, Proposition 1, helps explain why China has managed to dominate some marets while other low-laor cost contries have not. Proposition clarifies how a very large emerging contry s lower ality exports can drive high-ality prodcers ot of the maret, despite the existence of cstomers willing to pay for higher ality. These findings are nprecedented in the literatre, t widely oserved in open marets for some goods. We have shown how free trade can lead to less ality diversity rather than more. We have shown that a predatory strategy model rationalizes the oserved exclsively low ality goods on an open maret following the entrance of a very large, relatively poorer contry. The size of the emergent contry is ey, as is the relative willingness to pay for high ality. When the emergent contry is not too mch larger than its trade partner, we have shown that its most profitale strategy is to play a non-cooperative game (section 6. Ths, when the contries opening to trade are relatively similar in size, the otcome to e expected is more ality diversity, inclding high ality, on the open maret. That otcome has occrred, especially in the past. This also explains why the previos literatre analyzed intraindstry trade in vertically differentiated goods assming similarly-sized contries a noncooperative game maret strctre. owever, when the emergent contry is very large, we have shown that it maximizes profit y implementing a predatory strategy in which it exports its atary ality when it opens to trade. The est response to the predatory strategy in the relatively smaller contry can leave its high ality prodcers nale to cover costs, ltimately driving them ot of the maretplace. Again, the size of the emergent contry s domestic maret is essential. The size at which a predatory strategy can scceed is directly proportional to the trading partner s willingness to pay for ality, t there is always a sfficiently large size at which the predatory strategy is most profitale for the emerging contry. The ltimate otcome is exclsively lower ality goods on the open maret, compared to efore its emergence. This is the otcome oserved in some marets (e.g., clothing since China emerged on gloal marets. While or analyses have provided plasile answers to these estions, we have also opened new lines of iniry for ftre research. As noted earlier, since 009 China has een the world s largest exporter. It may e that no single set of assmptions aot size, costs, preferences, and maret strctre can explain China s sccess on gloal marets. or example, in What s o pecial aot China s Exports? Rodri (006 noted that althogh China exported relatively low ality goods twenty years ago, more recently China has een exporting goods that are three times more sophisticated than what wold e normally expected for a contry at its income level (Rodri, 006. It has dominated in marets for high-tech goods sch as cell phones, liid crystal displays, integrated electronic circits, and laptop compters. In fact, y 009, China spplied 85 percent of the imported laptops on the U maret (Berger and Martin, 011. Meanwhile there has een an explosion in Chinese demand for these prodcts as well. 16

18 Or model provides a point of departre for ftre research in a few ways. One, domestic maret size can e even more important than costs or wages, i.e., incomes, in explaining the ality of goods exported y emerging contries. This is empirically testale. Two, the lower are the costs of switching to higher ality, the more liely is leapfrogging. This is the case in China today with respect to high tech prodction. Three, in this paper we have astracted from leapfrogging, ecase when emerging contries leapfrog the otcome is more ality, not less, which is not the otcome we have soght to explain. We already now that leapfrogging is more liely the more similar are the trading partners with respect to willingness to pay for ality. Clearly it cold e interesting to analyze the otcomes of or predatory model allowing for leapfrogging and alternative ality switching costs. Appendix I. Example of a ccessfl Predatory trategy As an example, consider 5, 3, 0. 3, 0. 8, c 3 and 3. With these vales of the parameters we can see from (1 and ( that in atary, the ome firm prodces high ality and the oreign firm prodces the lower ality: and P ; and P A A Note that the oreign firm is ale to serve half of its maret when the ome firm offers A If the oreign firm offers a gloal antity and a ality sch than. G (see(14, then the est response of the ome firm is to offer a different (higher ality and the antity that maximizes its profit, given y eations (11 and (13. A A Ptting these optimal vales in (10 with. G, we otain π 0. What happens to the ome firm? It is ale to offer, according to (11, (13 and (8, a antity. 93 and ality , at the price p Note that ome firm has raised the ality and decreased the price of its good (relative to atary in response to competition from the oreign firm. The antities that the ome firm cold offer on each maret (see (6 are p p p p.33 and ~ p p (Note that sing (8 and (9, we otain θ so we do not need to (1 now p and to otain these reslts. The corresponding revenes from each maret are R and R owever, having chosen to adapt ality, the ome firm mst pay the fixed cost ( as well as prodction costs ( c The reslting profit π 0. 17

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