Firm Heterogeneity, Endogenous Quality, and Traded Goods Prices

Abstract A model with endogenous quality and firm heterogeneity is developed. Firms can invest in quality, and quality investment is relatively skill intensive. The model is used to account for two findings in the empirical literature on traded goods prices, lacking a formal explanation in the theoretical literature thus far. First, the model provides a theoretical explanation for Schott's ( Quarterly Journal of Economics 2004, 119, 647) empirical finding that relatively skill‐abundant countries export higher priced goods. Firms in these countries invest more in quality and therefore sell higher quality, higher priced goods. Second, the opposite effects of importer market size on traded goods prices at the firm level (positive) and at the aggregate level (negative) identified in the empirical literature can be explained with the model. In a larger market, the incentive to invest in quality is larger for each firm, leading to higher firm‐level prices. Due to a selection effect, also less productive firms selling goods of lower quality can export to larger markets, implying lower aggregate prices.