Trade, economic geography and the choice of product quality

• Firms determine the quality level of their varieties in a monopolistic competitive market.
• We consider two regions in a trade model and a footloose capital model.
• The larger region produces varieties of higher quality.
• The quality gap increases with larger trade costs and asymmetries in region sizes.
• The home market effect is mitigated when firms choose their product quality.

The present paper studies the effect of the choice of product quality on trade and location of firms. We discuss a model where consumers have preferences for the quality of a set of differentiated varieties. Firms do not only develop and sell manufacturing varieties in a monopolistic competitive market but also determine the quality level of their varieties by investing in research and development. We explore the price and quality equilibrium properties when firms are immobile. We then consider a footloose capital model where capital is allocated to the manufacturing firms in the region offering the highest return. We show that the larger region produces varieties of higher quality and that the quality gap increases with larger asymmetries in region sizes and with larger trade costs. Finally, the home market effect is mitigated when firms choose their product quality.