International trade, product lines and welfare: The roles of firm and consumer heterogeneity

A central prediction of international trade models is that increased integration leads to specialization. This mechanism has been used to gain insight into the location of industries across countries, the reallocation of output across firms as well as the variation of a firm's product range as countries liberalize. Nevertheless, the notion that international trade will lead firms to rationalize their product portfolios and concentrate on their “best” products doesn't always square with reality. In particular, firms in prominent industries have, on occasion, extended their offerings to include a lower quality version/option as international competition increases – expanding rather than contracting their product portfolio. This paper demonstrates that such behavior can be generated in a standard trade model if there is consumer heterogeneity within a country and firms leverage these differences to their advantage. In this setting, increased competition can be associated with either product line reductions or extensions. That is, both types of behavior can arise in equilibrium from ostensibly similar shocks. Since trade costs directly influence the intensity of competition, their variation has important implications for product line design and also the distribution of welfare gains. In particular, product line extensions due to trade liberalization have especially large welfare benefits for low income consumers.