\documentclass[12pt,epsf]{article}

\newcommand{\comments}[1]{}

\renewcommand\floatpagefraction{.9}
\renewcommand\topfraction{.9}
\renewcommand\bottomfraction{.9}
\renewcommand\textfraction{.1}
\setcounter{totalnumber}{50}
\setcounter{topnumber}{50}
\setcounter{bottomnumber}{50}

\usepackage{hyperref} \hypersetup{breaklinks=true, pagecolor=white,
colorlinks=
true, linkcolor=black, hyperfootnotes= false, urlcolor=blue }
\urlstyle{
rm}
\usepackage{verbatim}
\usepackage{graphicx}
\usepackage{amsmath}
 \usepackage{amssymb}


% \reversemarginpar
%  \topmargin  -.3in
%  \oddsidemargin -.1in
%  \textheight  8.5in
%  \textwidth 7in
%  \baselineskip 16pt



         \begin{document}

 

\titlepage

%\begin{raggedright}

 \parindent 24pt

 \parskip 10pt

\begin{small}


\begin{center}

 %\begin{Large}

 {\bf    A    Model of  Trust in Quality  and   North-South Trade   }


%\end{Large}


 \bigskip

April 12, 2016    \\

\bigskip

Eric Rasmusen \\

\bigskip

{\it Abstract}

\end{center}

  \vspace*{-12pt}

 Why do some countries produce higher quality goods than other
countries?   This article suggests that one reason is self-
perpetuating
reputations, modelling the idea with a Klein-Leffler reputation model
embedded in a   general equilibrium model of trade.   Reputation
differences are particularly interesting because  reputation is  a
form
of ``social capital'' that is   amenable to modelling. Like product
differentation, it  can  explain why  countries might  trade even if
their technologies and endownments are identical, why  firms could
profit from exports  even if the foreign price is no higher than the
domestic one,   and why governments like to have   ``high-value''
sectors. Ideally, a developing country would shift its own producers
to
a high-quality equilibrium; if that is not possible, the next best
thing
is to import experience goods and  substitute to  home production of
goods for which reputation is not important.

\bigskip

\bigskip

\begin{small}

\noindent
  \hspace*{20pt} Dan R. and Catherine M. Dalton Professor, Department
of
Business
Economics and Public Policy, Kelley School of
Business, Indiana University. BU 438, 1309 E. 10th Street,
Bloomington, Indiana, 47405-1701. Office: (812) 855-9219.
Fax:812-855-3354. \href{mailto:erasmuse@indiana.edu}{
erasmuse@indiana.edu},  \hspace{5 pt} \url{http://www.rasmusen.org}.
 Copies of this paper can be found at
 \url{http://www.rasmusen.org/papers/trade-rasmusen.pdf}.

\noindent
 JEL codes: F10, L15.   Keywords: trust, reputation, development,
social
capital,  product quality, comparative advantage.

\noindent
  I thank David Greenstreet, David Hummels, Peter Neary,  Manu Raghav,
and those
attending  the IU BEPP
Brown Bag Lunch and the Midwest International Economics meetings and a
workshop at Oxford University  for
their comments, and  Allen
Chang, Barick Chung,  Adam Rees, and Benjamin Warolin for research
assistance.




\end{small}

\end{small}

\newpage


\noindent
  {\bf 1.  Introduction}


  Why quality differs among exporters has been studied in many  models
of international trade.  Since    Linder (1961), a common theme has
been
that   proximity  to buyers is a source of comparative advantage, so
that countries whose consumers have a high preference for quality will
not only consume high-quality goods but produce and export them.
More
recent versions of this idea include  Murphy \& Shleifer (1997), which
uses a one-factor, two-good model to make the point that because
richer
countries  have a stronger preference for  high-quality goods,  we
will
see efficient differences in quality between goods consumed in
different
countries; and  Hallak (2005) and Choi, Hummels \& Xiang (2006),
which
model  the idea in such a way that he   can empirically measure how
incomes and quality flows interact.

As an alternative,     comparative advantage might be based on
differences in technologies.  In   Flam \&   Helpman (1987), a model
of
North-South trade, the North has a technological advantage in
producing
high quality, but products are differentiated and both high and low
quality are  produced and traded in equilibrium.  This approach raises
the question, surveyed in    Keller (2004),    of why technologies
would
differ across countries. Or, it may be that quality happens to be
linked
to endowments of particular factors such as capital  or skilled
labor--
or even, conceivably, unskilled labor, which may  be the cheapest way
to
find and eliminate defects.\footnote{A rather different view of
quality
is as    a characteristic of intermediate goods,    in  Grossman \&
Helpman's  1991   {\it Innovation and Growth in
the Global Economy}  and   models that
follow it.  There, intermediate goods vary in quality, and innovation
and technological diffusion allows that quality to increase, good by
good.}

 Empirical studies  show that  quality does matter. Schott (2004) and
Hummels \& Klenow (2005)  find that  prices per unit of various goods
vary considerably across exporters and are correlated with the
exporters' incomes and endowments of capital and skilled labor,
confirming what casual observation would suggest. Hallak (2006) points
out that countries with higher prices for a class of good also have
higher shares in the  export markets in which they sell  Navaretti  \&
Soloaga (2001) find  that European transition economies import
equipment
at  lower average prices than does the United States.  Hummels \&
Klenow
(2005) use changes in prices over time to extract information on
whether
product quality has changed; roughly speaking, if prices rise but
quantities do not, we might deduce that quality has risen. There also
exists a voluminous literature in marketing and international business
on ``country of origin effects''; for a survey, see Papadopoulos  \&
Heslop (2002),and for more recent references, see  Pappu,
Quester
\&  Cooksey (2007). This takes a more psychological approach, trying
to
determine at what stage of the buying process and to what extent
consumers see country of origin as important, and how that interacts
with brand name. An example is  Johansson \& Nebenzahl   (1986), which
uses questionnaires to find out how closely consumers link brands to
countries and how much they would pay for cars of a given brand built
in
a particular country. Consumers were willing to pay 14\% more compared
for a Buick made in Germany  than for one made in the U.S.A.,  but
16\%
less for one made in Mexico.   These findings confirm that quality is
an
important element in international trade, and work continues on trying
to measure   quality.  Another example, much-cited, is Roth  \&  .
Romeo
(1992), which  surveys consumes in Ireland, Mexico, and the United
States to see how perceptions of different country's product qualities
vary across type of product.

     The present paper   constructs  a theoretical model of product
quality, but will take a  different line of attack. Rather than
looking
at differences in countries' consumption preferences, technologies, or
endowments, I will focus on the problem of whether firms can persuade
customers of the high quality of their
  experience goods, goods whose quality the consumer cannot verify
before purchase. The quality of insurance   or   a consultant's
services
must be taken on trust, since it  cannot be verified till   after the
purchase  and for some buyers may never be verifiable. Why, then,
would
any  buyer believe a seller's  claim that his high prices are
justified
by  high quality, when the supposed high level of  quality cannot be
verified?

 This is an aspect of  quality  that has been of central importance in
the industrial organization literature since the Lemons model of
Akerlof
(1970).   Typically, models in this literature have assumed that firms
are heterogeneous in their technologies for producing high quality and
that advertising or some other expenditure signals a firm's type to
consumers. Farrell (1986), Milgrom \& Roberts (1986), Bagwell \&
Riordan
(1991) and Rasmusen \& Perri (2001)  all take this approach.  Here, I
will assume that all firms are     identical, because I wish to show
how
differences in reputation and trust can generate trade between
otherwise
identical countries. In this, I will follow a line of research begun
by
the model of reputation in   Klein \& Leffler (1981) and continued in
Shapiro (1983), in which firms acquire a good reputation by selling
high
quality at a low price for a long enough period of time; Allen (1984),
in which firms have both a positive fixed cost of entry and increasing
marginal cost; and Rogerson (1987), which synthesizes those two ideas.
I
will use  a  simple  formalization based on Rasmusen (1989) so that I
can embed reputation into a simple  general equilibrium model of one
factor, two products, and two countries where production is repeated
for
many periods.

 Klein  and Leffler's idea is that buyers know that a seller with a
good
reputation wants to  preserve that reputation as a valuable asset, and
hence can be trusted.
As a solution to the problem of unobservable quality, trust   is an
old
idea.
  As Macaulay   pointed out as long ago as 1963,     businesses rely
not
on the courts but on relationships and reputation in the ordinary
course
of dealing.  A firm honors its commitments, not just in letter but in
spirit, because it wants to keep its good reputation. Klein \& Leffler
(1981) put this in economic terms. If a firm can charge a premium for
a
high-quality product, then even if it could get away with cutting
corners in the short run because courts cannot enforce subtle cheating
in quality, it will choose to deal honestly with its customers. The
reason need not be simple integrity: it can be the result of selfish
profit maximization. If the firm does cheat, it will lose repeat
business, and if it can charge a price high enough to earn economic
profits from its reputation and it cares enough about future profits
it
will refrain from taking the  short-run gain from cheating.  Buyers,
knowing this, are willing to pay a premium price, which is what gives
the firm its economic profit. This, however, is just one possible
equilibrium, one set of self-fulfilling expectations. Another
equilibrium is for buyers not to trust promises of quality and to
refuse
to pay premium prices. The sellers, in turn, then have no incentive to
provide high quality.


   We will   go straight to the model in the next section, first
laying
out the assumptions of the simple general equilibrium model, next
showing how a reputation equilibrium could arise in a single product
market.  I will then return to the    model of trade and reputation
and
explore its implications.  Having explained the model, I will be able
to
explain how it differs from other  models of trust and quality  such
as
Acemoglu,    Johnson \&   Robinson (2002),  Basu \& Chau (1998),
Berkowitz, Moenius  \&
Pistor (2003),   Chisik (2003), Moenius   \&  Berkowitz (2004),
Haucap,
Wey \&  Barmbold (2000), and  Levchenko (2006).


\bigskip

 \noindent
 {\bf 2. The   Model  }


Firms use one  factor of production, labor,  in two countries,   the
North and the South.        The $F$ firms in each country compete in
pricesL: each chooses its price simultaneously, as in Bertrand
competition.     A firm can produce two kinds of goods: the simple
good,
with subscript 0 (our numeraire);   and the experience good,
subscripted
$l$ or $h$ depending on whether its  quality is low or high.
Ownership of labor and firms  is evenly distributed across the
population in each country.  Transportation costs
are  zero for produced goods but   labor cannot be moved.


Technologies are the same in both countries.
Each unit of the simple good  or the low-quality good costs one unit
of
labor to produce  in either North or   South,   but each  unit of the
high-quality experience good costs $\phi>1$.


If  $x_0$ is consumption of the simple good and $x_l$ and $x_h$ are
the
consumptions of   the experience goods, a consumer's utility in a
given
period is assumed to be
\begin{equation}\label{e1}
U =x_0^{\alpha }  (x_l+ \theta  x_h)^{\alpha   }
\end{equation}
 where $ \alpha < 1$     and  where $\theta > \phi   $ is the relative
value of high quality. Low and high-quality experience goods are
perfect
substitutes for each other  in the sense that their only difference in
the utility function is  the multiplier $\theta$.

 Production is repeated in each of an infinite number of periods, with
quality    and prices chosen anew each period. The discount rate   is
$r$ in both countries. Consumers buying in period $t$  cannot observe
quality  before purchase, but they  do observe the quality  that each
firm sold in period $(t-1) $.

 Prices are denoted by  $p_0 \equiv 1$ for the simple good,  as a
normalization, and $p_l$ and $p_h$ for the low and high-quality
experience goods.



The North has    1 unit of labor and the South
has    $S$.  Most of this article will make the ``large North''
assumption that
\begin{equation}  \label{q2a}
 S  \leq  \frac{2(\phi + (\phi-1)r)(\phi-1)}{2 \phi + + (\phi-1)r +
1}.
\end{equation}
   a condition which, as explained below,  will imply that  the
North's
prices become the world
prices under free trade.   I make this assumption for simplicity of
exposition. Section 6 explains what happens in the opposite case,
when
the North is ``small''.


\bigskip

 \noindent
 {\bf 3.  Optimistic and Pessimistic Equilibria   }


In equilibrium, the  simple good and one of the experience goods will
always be produced, since the fact that otherwise utility would fall
to
zero in equation (\ref{e1}) means there will be demand for both even
at
very high prices, as formalized below.    If consumers could observe
quality before purchase,  firms would produce high quality, not low
quality. Its price would be $p_h=\phi$ under price competition,
because  it costs $\phi$ times as much labor to produce as the simple
good does.

   Under the model's assumption that consumers cannot observe
present-
period quality before purchase,  firms would all produce low quality
if
there were just one period instead of an infinite number of periods.
Regardless of what consumers expect, it is cheaper for the firm to
produce low quality, and hence choosing low quality would be  a
dominant
strategy.


  We will start by explaining how multiple periods can  lead to high
quality and then apply the idea to  different countries.  Consider a
partial-equilibrium model in which firms produce either low quality at
cost 1 or high quality at cost $\phi>1$ and consumers (with fixed
consumption of the numeraire good)  have reservation
prices of 1 for low quality and $\theta> \phi$ for high quality. Firms
compete in prices. Consumers can  observe quality after purchase  but
not before, the game is repeated an infinite number of periods, and
the
discount rate is $r$.

 The  model is    a mathematized  version of   Klein \& Leffler
(1981)'s
verbal idea. They aimed to  explain   two things: (1) why some firms
produce high quality instead of low,  even though consumers cannot
tell
quality before purchase, and (2) why  firms that produce high quality
charge a price higher than cost, even under Bertrand competition.

  A subgame perfect Nash equilibrium of a game is a combination of
strategies for each player such that at any point in the game  a
player
who expects the other players to follow the strategies   the
equilibrium
specifies for them  has no incentive to deviate from the strategy it
specifies for him. Thus, different expectations may be able to support
different equilibrium  strategy combinations. Here, because the
interaction is repeated an infinite number of times, multiple
equilibria
do exist.   We will focus on two equilibria: the ``pessimistic'' and
the
``optimistic''.

 In  a pessimistic equilibrium,   a firm's  strategy is to produce low
quality.
A consumer's strategy is to pay at most a price of 1, regardless of
the
claims the seller makes about quality.  Firms choose the price $p_l=
1$,
equal to cost because of competition.


  These strategies form a subgame perfect Nash equilibrium for the
repeated
game. No firm has an incentive to produce high quality, since no
consumer would
pay any higher price. If a firm did produce high quality once,
consumers
would
be surprised, but the equilibrium calls for the firm to return to
producing low
quality in the next period, so the consumers would not be willing to
switch to
paying a higher price for that firm's goods. They would regard the
deviation as
a fluke  not to be repeated.



In the optimistic equilibrium,  on the other hand,   a   firm
produces high quality and sells at a price $p^*$ to be explained
below,
unless it deviated from equilibrium and produced low quality in the
past
(in which case it produces low quality). Consumers buy the good  from
a
firm if and only if its price  equals   $p^*$  and the firm has never
produced low quality.


In this equilibrium, a   firm's punishment  for deviating and
producing
low quality is that
   consumers believe it will produce low
quality in the future and    switch to another firm. For this to be a
punishment, however, the firm's profits must be lower if it sells zero
than if it sells a positive amount, which requires that the price
$p^*$
be greater than cost. The exact value of $p^*$
 is derived as follows.  Denote the present
discounted  value per unit of sales by  a firm with a reputation for
high quality
by $V$. If the firm produces high quality today, it keeps its good
reputation,
and  the present value of profits per unit sold  is, assuming cash
flows
occur
at the  beginning of  periods,
 \begin{equation} \label{e220}
   V=    (p^*- \phi)
  + \left( \frac{1}{1+r} \right) V,
 \end{equation}
 where the first term is the  current period's profit and the second
term is the
discounted value of  capitalized future profits.
 Solving  for $V$, we  get
\begin{equation} \label{e221}
   V=     \frac{(1+r)(  p^*- \phi)   }{  r}
 \end{equation}
If the firm produces low
quality  the present value of its profits is
 \begin{equation} \label{e230}
 (p^*-  1 )  + \left( \frac{1}{1+r} \right)(0),
 \end{equation}
 since it will lose its reputation. For the firm to choose high
quality
it must
be true that
  \begin{equation} \label{e24a}
    \frac{(1+r)(  p^*- \phi)   }{  r}   \geq    p^*-  1
  \end{equation}
 Competition among firms turns this  weak inequality into an equality,
  \begin{equation} \label{e27x}
  p^*  =   \phi  + (\phi -1)r
 \end{equation}

  For consumers to be willing to buy    high quality
instead of    not buying anything, we also  need $p^* \leq \theta$.
That
requires
\begin{equation} \label{e28a}
 p^*=  \phi  + (\phi -1)r   \leq \theta.
 \end{equation}
  If this is not true (because $r$, the discount rate, is  too high or
$\theta$,
the valuation of high quality, is too low),  the optimistic
equilibrium will not exist.

   The optimistic equilibrium is pareto-superior to the pessimistic
equilibrium. In the pessimistic equilibrium of this partial-
equilibrium
model, consumers have zero surplus
and firms have zero profits. In the optimistic equilibrium, consumers
have positive surplus (if $p^*<\theta$ strictly) and firms have
positive
profits.


Let us define ``optimistic expectations'' for the players in a game
as
expecting that  the  pareto-optimal equilibrium will be the one played
out in the game between a particular firm and its customers, and
``pessimistic expectations''  as expecting    the  pareto-worst
equilibrium. Let us define a ``good reputation'' for a firm as the
expectation, based on its past behavior and its incentives,  that it
will produce high quality.
   We will assume that  expectations  about a firm's behavior  do not
change if it begins to export its product.

We will briefly  analyze  two reasons that a firm might have a good
reputation.
Both  apply only if $p^*<\theta$, because otherwise only the
pessimistic
equilibrium exists.

First, a country  may have ``trust''.  All players have  optimistic
expectations and all firms are expected to produce high quality  in
accordance with the optimistic equilibrium.  Firms have no incentive
to
deviate from this equilibrium, and so will keep their  good
reputations.

Second, a firm in  a country  may be able to  use ``reputational
investment''.  All   players believe that a firm  in that country
which
invests amount   $A$ in acquiring a reputation will  produce high
quality  in accordance with the optimistic equilibrium.

   If a firm has a good
reputation, consumers expect it  to produce high quality. Given that
expectation,
high quality is in  the firm's  best interest.   If a firm
has a bad reputation, it is expected to produce low quality. Given
that
expectation, low quality is in the firm's best interest.     A   firm
with a bad reputation would like to have a good reputation and sell
high
quality at a
high price, but it  cannot do so unless consumers change their
expectations.
Consumers, too, would like to be able to trust a firm to sell high
quality, but if the firm  has a  poor reputation   they rightly
distrust
it.

 ``Trust'' is  purely a matter of expectations and is  exogenous to a
firm. It is a matter of culture or history-- of what is called social
capital. A nation blessed with high trust will be richer than one with
low trust, but there is no easy way to switch from one trust level to
another.

``Reputational investment'' is endogenous to the firm, and refers to
any
investment that creates a good reputation for a particular firm. This
investment  might   be advertising, it might be observable sunk costs
that make consumers believe the firm  will want to preserve its
reputation for the future, or it might be the sale of  high quality at
a
low price for some period of time by  a firm  that starts with a poor
reputation.

 Whichever form investment takes, investment's ability to    generate
a
good reputation is an assumption, not a necessary consequence of there
being multiple periods.  Without this assumption, it remains an
equilibrium for consumers to continue to have pessimistic expectations
even if they observe some firm investing large amounts  to try to
acquire a good reputation. If consumers think the firm's effort is a
waste of resources, it will be.  The firm will  then not  have  any
incentive to produce high quality after its investment, and the
consumers' pessimistic beliefs will be confirmed. Depending on
expectations,  reputational investment might be effective in  one
country and ineffective in the other.

Reputational investment   introduces  a   complication. If firms   use
investment  to acquire reputations, the number of   firms producing
high
quality becomes endogenous.
The  equilibrium   involves  a firm's decision of whether
to  invest amount $A$  to acquire a good reputation.  The firm must
trade off the immediate cost $A$ against the flow of profits from
selling at $p^*$. That flow value is $V$ from equation (\ref{e220}),
where by substituting (\ref{e28a}) for $p^*$ we get
\begin{equation} \label{V-equation}
   V=    (1+r)(\phi -1)
 \end{equation}

Thus, if  there are $X$   consumers and they are split equally among
high-quality firms, the  greatest number of firms for which investment
is profitable is $M$, where   $M$ is the biggest integer such that:
\begin{equation} \label{e1ab}
{\displaystyle Profit(M)=   -A+ \bigg( \frac{X}{M} \bigg)  \bigg(
(1+r)(\phi -1)  \bigg)    \geq 0.}
\end{equation}

  If $N>M$, only some firms will acquire reputations and their
lifetime
profits will be positive only   because of the integer problem.   If
$N<M$,   all firms will  acquire reputations,  and  their lifetime
profits will be positive because sales per firm will be higher and  a
firm's investment  will not dissipate its future profit stream.

  These explanations for differing reputations are separable from the
rest of this model, however.  Reputations can be entirely arbitrary,
since they are really just self-fulfilling rational expectations
equilibria. If consumers believe a firm will produce high quality, it
has incentive to do so. If a few firms in an industry are lucky enough
to acquire such reputations, those are the firms that will survive and
come to dominate the market. We may imagine that  the  North had some
firms which did this, driving out the pessimistic-expectations
Northern
firms, but the South did not, and so retains pessimistic-expectation
firms.


\bigskip





\noindent
{\bf  4.  North and South under Autarky  }

Now let us return to  general equilibrium, starting with the case of
autarky.   From equation (\ref{e28a}), the quality-guaranteeing price
is:
\begin{equation}
 p^* = \phi  + (\phi -1)r
\end{equation}

 Three patterns of production are possible, depending on the level of
$p^*$ and   expectations.

\bigskip

\noindent
(1)  Autarky quality might be low in both countries.  If
$p^* >  \theta$,  we will see shortly,  the level of price which
would
lead a firm to choose high quality is greater than the value of high
quality to the consumer, so that price could not be charged in
equilibrium. Trade, of course, would make no difference, and this is
an
uninteresting case.  Or, it might be that expectations are pessimistic
in both countries, even if  $p^*  \leq   \theta$


\noindent
(2)   Autarky quality might be high in the North and low in the South.
This happens  if   $p^* < \theta  $   but   expectations are
optimistic
in the North  and pessimistic in the South.  It is also possible to
have
autarky quality high in the South and low in the North, if the
expectations are reversed.


\noindent
 (3) Autarky quality might be high both countries, because
$p^*  \geq \theta$  and expectations are optimistic in both countries.


  \bigskip





If consumers in a country believe   claims that the  experience good's
quality is high, they    solve the  following problem in each period:
 \begin{equation}\label{e1a}
\stackrel { Maximize }{x_0, x_l, x_h } \;\;\;\;\;\; U=  x_0^{\alpha }
(
x_l+
\theta  x_h)^{\alpha   }  \;\;\;\;\; {\rm such \; that\; \;\;\;} x_0
p_0
+ x_l p_l +
x_h p_h = income,
\end{equation}
  which has the first order conditions:
  \begin{equation}\label{e2}
\frac{ \alpha  U}{ x_0 }  -\lambda p_0 =0, \;\;\;\;\;\;
 \frac{    \alpha     U}{    x_l+ \theta  x_h }  -
\lambda p_l =0, \;\;\;\;\;\;
 \frac{ \theta
\alpha     U}{    x_l+ \theta  x_h }  - \lambda p_h =0
  \end{equation}

 \noindent
If it is optimal to consume all three goods  then:
\begin{equation} \label{threegoods}
 \lambda =     \frac{ \alpha  U}{ x_0 p_0 } = \left( \frac{
1} {p_l} \right) \left( \frac{   \alpha     U}{ (   x_l+ \theta
x_h ) } \right) =\left( \frac{ \theta }{p_h} \right)\left(  \frac{
\alpha
U}{ (   x_l+ \theta  x_h ) }\right)
  \end{equation}

  A consumer   consumes both    experience goods only in the knife-
edge
case that   $\frac{1}{p_l} = \frac{\theta }{p_h}$. Otherwise  utility
maximization has a corner solution.  Only low quality will be consumed
if $\frac{1}{p_l} > \frac{\theta }{p_h}$, and only high quality if the
inequality is reversed.   Consumers can rationally believe that
quality
is high only if $p_h \geq p^*$, so if that inequality is false, only
the
pessimistic equilibrium exists and quality is low, which is case 1
above.
Otherwise, depending on expectations, from  equation
(\ref{threegoods})
we   get either:
 \begin{equation}\label{consumption1}
  x_0 =
p_l    x_l
\end{equation}
or:
 \begin{equation}\label{consumption2}
  x_0 =      p_h  x_h
\end{equation}
All this  holds true for either North or South.



Consider case (2), in which the North has high quality and the South
has
low quality.    In both countries,  $p_0= 1, p_l =1$, and $w=1$. High
quality is not  produced in the South. In the North  high quality is
produced, at the price   $p^* =   \phi  + (\phi -1)r$.


 In the South,  firms produce only low quality, whatever they may
claim
(because expectations are pessimistic) so
  $x_l>0$ and $x_h =0$. We can rewrite   equation (\ref{consumption1})
as:
 \begin{equation}\label{e9rewrite}
x_0 (South)    =   x_l.
 \end{equation}

 Since there are $S$  units of labor in
the South, $x_0 + x_l =S$, and:
\begin{equation}\label{e10}
 x_0 (South) =
\frac{S}{ 2 }, \;\;\;  \;\;\; \;\;\;      x_l (South) = \frac{S}{ 2 }
 \end{equation}

 Utility of a Southerner with  one unit of income is:
 \begin{equation}\label{e11}
  U (South)   =  \left( \frac{1}{ 2 } \right)^\alpha  \left(  \frac{1}
{
2}+0 \right)^\alpha   =   \frac{1} { 4^{ \alpha}   } \end{equation}


\bigskip

In the North,   $p_0= p_l=w=1 $ and $ p_h=p^*$.  High
quality is maintained by reputation, since  $ p_h=p^*< \theta$  and
there is either trust  or    firms invest $A$ in reputation.
Thus, $x_l=0$ and $x_h >0$.  Equation (\ref{consumption2}) becomes:
\begin{equation} \label{shares}
  x_0     =  p^* x_h
 \end{equation}

The North has one unit of
labor  and the wage is $w=1$, so  labor income is 1 per capita, as in
the South. The North also has profits, though, of   $(p^*-\phi)x_h$,
because  high price $p_h=p^*$ does not reflect a real production cost.
The amount $(p_h -\phi w)$ is profit,  not extra labor needed for
higher
quality. Thus,
for the North  the budget constraint, $p_0x_0 +  p_h x_h = income$ is:
 \begin{equation}\label{e9}
x_0 +   p^* x_h =1 + (p^*-\phi)x_h
 \end{equation}

Combining   equations (\ref{shares}) and  (\ref{e9})  yields:
\begin{equation} \label{highprice}
 x_h (North)  = \frac{1}{p^* + \phi}
\end{equation}
 where   $p^*$ can be written in terms of the primitive parameters as
$p^* = \phi + (\phi-1)r. $ Combining (\ref{highprice}) with equation
(
\ref{shares}), yields consumption of the simple good:
 \begin{equation}\label{e6}
 x_0
(North)  =  \frac{p^*}{p^* + \phi}
  \end{equation}





 Utility  of a Northerner with one unit of income would be:
  \begin{equation}\label{e7}
U (North)   =   \left( \frac{p^*}{p^* + \phi}  \right)^\alpha  \left(0
+
(\theta )  \left(
\frac{1}{p^* + \phi} \right)
\right)^\alpha
 \end{equation}

 The North's utility is higher than the South's for two reasons.
First,
the North
consumes more of the simple good. The South  consumes
$1/2$ per capita of the simple good, while the North consumes   $x_0
(North)  =  \frac{p^*}{p^* + \phi}$, a larger amount  because
$ p^* >\phi$. Second, the North's utility  of  $    \left(
\frac{\theta}{p^* + \phi}
\right)^\alpha$ from its high-quality consumption is greater than the
South's utility $(1/2)^\alpha$  from its low-quality consumption,
because $\theta >p^*$. The North does better in both components of
utility.


The North has higher utility per capita even if
  trust is low  there and firms must use resources in  reputational
investment. In the worst case, where there is no integer problem, the
entire industry profit is eaten up  by the investment, so the budget
constraint, equation  (\ref{e9}),  becomes:
 \begin{equation}\label{e9a}
x_0 +   p^* x_h =1 + 0
 \end{equation}
From equation  (\ref{shares}), $x_0 = p^* x_h$, so:
 \begin{equation}\label{e9b}
x_0  = \frac{1}{2} \;\; and \;\;  x_h = \frac{1}{2p^*}
 \end{equation}

 Northern consumption per capita of the simple good is then no higher
than Southern, but consumption of the experience good enters the
Northerner's utility function as
$\left(\frac{\theta}{2p^*}\right)^\alpha$, which is greater than the
Southerner's $\left(\frac{1}{2 }\right)^\alpha$. Even when profits are
zero, the North's utility is higher, because  consumers are better off
buying high quality at $p^*$ than     low quality at $p_l=1$.



Though there is no differences in factor endowments or production
functions,
under autarky the South's consumption of the high-quality experience
good is
even more inefficient than the North's---zero, despite lack of any
technological barrier to production. Consumers do not trust Southern
firms to
produce high quality, and that distrust is self-confirming.




For reasons unrelated to  the lack of free trade,    the
North   does not attain the first best.
  The price of the  high quality
good  exceeds its marginal cost.   As a result, too much of the simple
good is
 produced and consumed relative to   the high-quality   good. The
outcome is
nonetheless   better   than if the high-quality   good were not
produced
at all.


\bigskip

 \noindent
  {\bf 5.  Opening Up Trade}

Now let us imagine that  the autarky just described is destabilized by
the unexpected opening of free     trade between North and South.
\footnote{If the opening of free trade is expected, the autarky
equilibrium will be different. More firms will advertise, knowing they
would not recover their investment if the North were the only market
but
anticipating the profits they will earn once they can start exporting
to
the South.}   Prices will equalize between the countries  since
transportation costs are zero.  Since the production function does not
have diminishing returns, production is constrained only by the amount
of labor available.  One of the countries will specialize in one of
the
goods, using up its entire labor supply producing it. The marginal
rate
of transformation in the other country, which produces both goods,
will
determine the world price, which   will  thus equal one of the two
country's
autarky price levels.  Since the North is larger, it is the North's
price
that will become the world price in this model.\footnote{I have worked
out the small-North case but have not included details here.   If
the North is small, the North specializes in the experience good, the
South produces both goods. The North's experience good has a price
high
enough  above the South's that  consumers are indifferent about which
they consume. The main difference from the large-North case is that
trade leaves the South's welfare unaffected. As in the large-North
case,
the North benefits from trade.  }  The
effects are summarized in
Proposition 1.

\bigskip
\noindent
 {\bf Proposition 1}. {\it After trade opens between North and South:

(1)   The new world prices of the simple good and the high-quality
good will be $p_0 =1$ and  $p_h=p^*>\phi>1$. The North will continue
to
produce both goods and will export the high-quality good to the South.
The South will produce only the simple good, ending production of the
low-quality good, and will export some of the simple good to the
North.


 (2) Consumer welfare will rise in both North and South. Profits will
rise in the North and will remain zero in the South. Northern
consumption per capita of both goods will be higher than Southern
consumption.  }



 The remainder of this section will show why Proposition 1 is true.


The South's prices have changed to  equal to the North's  so its
consumption proportions  change to equal the North's too.    The
South's
budget constraint     is, since it has $S$ units of labor:
 \begin{equation}\label{e16a}
  x_0 + p^* x_h \leq income = S
\end{equation}

\noindent
 Combining this with equation (\ref{consumption2})'s $x_0= p^* x_h$,
total
consumption   in the South is:
  \begin{equation}\label{e16}
 x_0
(South)  =     \frac{S}{ 2 }        \;\;\;\;  x_h (South)   =
 \frac{S}{2 p^*}
\end{equation}
   The South's utility has risen, because its consumption of the
simple
good is unchanged and the contribution to  its utility function from
consumption of the experience
good, formerly $\left( \frac{1}{ 2 }  \right)^\alpha$ per capita, is
now
the greater amount  $\left(\frac{\theta}{2 p^*}  \right)^\alpha$.  The
South's utility rises  to  the  level as the North's would take
if the North needed to use reputational investment that eats up the
entire profit of the Northern firms.


The North is   more complicated  because its national income contains
profit, and possibly  reputational investment which eats into
profit.
The value of goods consumed is $(x_0 (North) +    p_h x_h(North))$.
Income  includes
not just wages, equal to $w$ times the one unit of labor, but profit,
$x_h (p_h -\phi w)$. Once trade opens up, the sales $x_h $ include
sales both in the North and the South.  Thus,  the North's aggregate
budget equation is:
 \begin{equation} \label{e31}
 p_0 x_0 (North) +   p^*  x_h (North)  = w(1) +
(p^* - \phi w  ) [x_h(North) + x_h(South)]
 \end{equation}

\noindent
Once we set $w=1$,   $x_h (South)   =
 \frac{S}{2 p^*}, $  and
$p_0=1$, the budget equation becomes:
 \begin{equation} \label{e32}
(1) x_0 (North) +
 p^*  x_h (North)  =  1+(p^* - \phi    ) \bigg[ x_h(North) +
\left(\frac
{1}{2 p^
*}\right) S  \bigg]
\end{equation}
 This can be combined with equation (\ref{consumption2}),
$x_0 (North)=p^*
x_h (North)$, to  yield:
\begin{equation}
\begin{array}{ll}
x_h(North) &= \frac{1}{2p^* - (\phi -1)r} + \frac{S}{2p^*(2p^* - (\phi
-
1)r )}\\
  & \\
 &= \frac{1}{ p^* + \phi + (\phi-1)r  - (\phi -1)r } + \frac{S}{2p^*
(2p^* - (\phi -1)r )}\\
 & \\
 &=  \frac{1}{ p^* + \phi  } + \frac{S}{2p^*(2p^* - (\phi -1)r)}\\
\end{array}
\end{equation}
in which case:
\begin{equation}  \label{x0trade}
\begin{array}{ll}
x_0(North)& =
   \frac{p^*}{ p^*  + \phi  } + \frac{S  }{2 (2p^* - (\phi -1)r)}\\
\end{array}
\end{equation}

We must check, however, that the North is large enough that its labor
can produce enough to satisfy world demand for the high-quality good.
Each unit costs $\phi$ in labor to produce and the North has 1 unit of
labor, so  for production to be feasible requires that
\begin{equation}  \label{q1}
 \phi[x_h(South)+  x_h(North)]  =\phi \left[\frac{S}{2 p^*   }  +
\frac
{1}{ p^* + \phi  } + \frac{S}{2p^*(2p^* - (\phi -1)r)} \right]  \leq
1.
\end{equation}
 In equality (\ref{q1}) turns out to be equivalent to the ``Large-
North
assumption'' of inequality  (\ref{q2a}), here repeated:
\begin{equation}  \label{q2}
 S  \leq  \frac{2(\phi + (\phi-1)r)(\phi-1)}{2 \phi + + (\phi-1)r +
1}.
\end{equation}





   The North's consumption per capita of the simple good is higher
than
the South's   (which is 1/2). Under autarky,  we have seen from
equation
(\ref{e6})   that  $x_0
(North)  =  \frac{p^*}{p^* + \phi}$, so the North's consumption of the
simple good rises with free trade.  It rises in proportion to the size
$S$ of the South, since the North is now earning profits from
Southern
sales. Similarly, the North's consumption of the high-quality good is
higher than under autarky (when it equals just the first term of
equation (\ref{x0trade}))  and higher than the South's consumption
under
free trade (since  $\frac{1}{ p^* + \phi  } >\frac{1}{ 2p^*   }$, even
if $S=0$.)




 Just as under autarky,  Northern welfare is not so high if it must
use
reputational investment. If the opening up of trade is unforeseen,
however, and it is incumbent firms that export to the South, the
reputational investment under autarky will not eat up the entire
Northern profit. It will at most eat up the expected autarky profit,
leaving the export profits undissipated.

   In short, free trade increases the welfare of both countries. The
South benefits because its prices change and it starts to consume the
high-quality experience good. The North benefits because though its
prices do not change, its income increases as a result of pure
profits
from exports to the South.







\bigskip

  \noindent
{\bf  6.  The Small-North Case}

  The analysis above assumed that the North was large enough to supply
both its own demand for the high-quality good and the South's demand
at
the quality-ensuring price of $p^*$.  What if that is not true? I will
not analyze this case in detail, but I will outline what will happen
if
assumption (\ref{q2a}) is false because the South is too large
relative
to the North.

There would then  be excess demand for the high-quality good at
the price of $p^*$.  Thus, $p_h$ would have to rise above $p^*$   once
trade opened up. If it rose above $p_h$ without any further changes,
however,   Northern firms would be earning more than the profit
necessary to give them an incentive to produce high-quality. They
would
therefore bid up the price of their input, labor, until their profits
were again at the minimum level necessary to make them indifferent
between high and low quality. This might occur at a some price for the
high-quality good in the interval $(p^*, \theta)$, or the price might
rise all the way to $p_h=\theta$, in which case consumers would be
indifferent between high and low quality.

  If $p_h$ is in the interval $(p^*, \theta)$ then the North will
specialize in the high-quality good, exporting some of it to the
South,
and the South will specialize in the low-quality good, exporting some
to
the North. Compared to autarky,  the North will be better off, since
it
will be exporting   to the South at a profit to the firms and a higher
wage to the workers. The South will also be better off than under
autarky, since it will pay a price of less than $\theta$ for high
quality.

 If $p_h$ rises aqll the way to $\theta$, then the North will
specialize
in the high-quality good,  exporting some of it to the South, and the
South will  produce both the simple good and the  low-quality good,
exporting some  of the simple good to the North.   Trade will help the
North since it will be exporting to the South at a profit to the firms
and a higher wage to the workers. Trade will have no effect on the
South's welfare, since Southern consumers will be paying a price high
enough to be indifferent between the low quality they used to solely
consume and the high quality that is their new alternative.



\bigskip

  \noindent
{\bf  7.  Other Models of Quality and  Trust}


\bigskip
\noindent
{\bf A Technology Model of Quality Differences across Countries}


How does the trust model compare with   a purely technological model
of
quality differences across countries? Recall that a technology model
has
the problem of explaining why technology cannot be transferred from
country to country.

 The  present  model could easily be converted  to a model of
technology differences between countries: simply assume that consumers
observe quality before purchase, and that    one
   unit of the high-quality reputation   good    costs
$     \phi_n< \theta < \phi_s$
units  of labor  to produce in the North and the South.
  If we worked out this model (as I did in the working paper version
of
this article, Rasmusen [2006]),  we would find that under autarky the
South would produce only the  low-quality experience good, the North
would produce only high-quality, and welfare would be higher in the
North. Opening up trade would cause the South   to specialize in the
simple good, exporting some of it to the North and consuming the rest.
The North would produce  the simple good and the high-quality good,
and
would export some of the high-quality good to the South. The price of
the experience good would rise in the South, but the quality would
rise
even more. All that is just as found in the paragraphs above. The
difference comes in welfare: in the technology model,  the North's
welfare is unaffected by trade  and the South's    per capita utility
in
the South   rises  all the way to  the North's level; in the trust
model,  both countries gain from trade, but the South's utility is
still
lower than the North's.

\bigskip
\noindent
{\bf A Legal Model of Quality Differences across Countries}

  Another reason for quality differences across countries is
differences
in laws.  One country might have higher quality products because it
has
laws requiring high quality or because it has laws forbidding false
claims of high quality.

   The trust model is easily adapted to include such laws. Either kind
of law would result in companies producing only high quality, either
because low quality would be illegal or because low quality would be
outsold by high quality.  The  differences in the outcome is that
welfare would be even higher than in the trust equilibrium because the
price of the high-quality good would be lower: $p_h=\phi$ instead of
$p_h=p^*$. Its price would equal its cost, instead of being higher,
and
sellers would earn zero profit. A consequence of profits being zero is
that after trade opened up, the North's welfare would be unchanged
compared to autarky, and the South's welfare would rise to equal the
North's.

    Good laws are certainly helpful in promoting efficiency.
Prohibiting fraud certainly encourages quality to be higher. Requiring
minimum quality levels also can raise quality, though government
failure
often results in mandated quality being too high so as to raise the
wages and profits of politically influential producers.  Between the
risk of government failure and the difficulty of legal enforcement of
quality standards for subjective characteristics such as the quality
of
software's documentation or the reasonableness of an insurance claims
adjuster, however, laws are not a panacea for product quality.


\bigskip
\noindent
{\bf The   Literature on Trust Differences Across Countries}


 Having shown how trust works in this context, it is now possible to
contrast it with other models of trust in international trade and
development.

   First, note that trust is not mediated by institutions in the
present
model.  Particular institutions may create optimistic expectations by
a
general atmosphere of trust, omething akin to    trust  in   the
literature on  social capital  by   Robert  Putnam (2000) and others.
Trust here, however, is trust  between buyers and sellers, not  trust
established by government or private institutions or trust that
generates good institutions. Much recent work, e.g. Acemoglu,
Johnson
\&   Robinson (2002), has suggested that differences in institutions
can
explain trade and backwardness.  It might be, for example, that the
quality of a country's institutions explain  its tendency to trade
complex products, as in   Berkowitz, Moenius  \&   Pistor (2003)  and
Moenius   \&  Berkowitz (2004). Here, however, good institutions---
e.g.
laws against fraud--- are not the reason for high quality.


 Similarly, Levchenko (2006), though using a model adapted from
industrial organization,   asks the   question of
how institutions affect trade. Levchenko's
starting point is that institutions, modelled as a technological
feature,
matter more in some sectors than others. He parameterizes
institutional
quality
following the style of Caballero  \& Hammour (1998),  which in turn is
in the
spirit of the contractual incompleteness approach of
  Hart \&   Moore (1990). Institutions affect not just overall
productivity,
but the relationship between different factors,  whose ability to
contract with
each other depends on institutions such as the  laws and the courts.
Levchenko
starts, as the present paper will, with a model in which North and
South
differ
in technology, leading to a standard difference in comparative
advantage. In
Levchenko's version of this model, the South gains more than the North
from
trade. He then develops a Grossman-Hart-Moore model in which factors
are
rewarded differently across industries. Some industries depend more on
institutions, and  labor in those industries earns  higher wages.
After
trade
opens up, though, the North's advantage in those industries captures
those
``good jobs'' from the South. Levchenko provides empirical support for
the
pattern of trade he predicts: the United States imports more from
countries that
have good institutions, but only in industries that involve more
complicated
production. Levchenko's model is based on trust, like the reputation
model's, but  it is trust between  producers rather than between
producer and consumer.

    Several articles in international trade, on the other hand, do
look
at the  relationship between  trust, price, and reputation. The
closest
in assumptions to the present one is
Falvey (
1989), which   also uses a
version of the Klein-Leffler reputation model  and asks how reputation
will
affect trade patterns. The key assumption in that paper  is that
consumers know the reputations of domestic firms but not foreign
firms,
and this ignorance
leads to a bias against imported goods. In the present paper,  we have
assumed
that  firms could take their reputations abroad with them, and that
consumers had no
 bias in favor of  or against foreign goods per se. That, in
combination
with consideration of the possibility of multiple equilibria, will
lead
us to the conclusion  that a country that exports in equilibrium  has
an
advantage in quality, not a disadvantage.

Basu \& Chau (1998) does not use a Klein-Leffler model, but their
model
has some of the same flavor.  In it, there are both  differences in
both
reputation and technology in  North and South.  Consumers all prefer
high quality to low, but the extent to which they do depends on
income.
Each country has many firms  differing in their production costs for
high quality.  Each consumer chooses a particular   firm's product to
sample, after which he receives a noisy signal of that product's
quality. He may   consume that product, or sample another instead.
Thus,
there is one period of consumption, preceded by sampling. Firms have
some incentive to produce high quality, since that  reduces the
probability that consumers will get a bad signal and refuse to buy.
Thus, the percentage of firms that chooses high quality depends on the
prices they expect from high and low quality.   Since consumers only
observe country of origin and price before shopping, if they expect
the
South to have low quality, more Southern firms will choose low
quality,
hoping to get a good signal by accident.  If  Southern general
reputation and price  were to rise, that would increase the profit
margin that a Southern  firm would lose if consumers rejected its
product and increase the number of Southern firms that would find high
quality profitable.  The driving force is  the consumer's ability to
roughly test the quality of the product, not the  present model's
multiple periods and incentive for a firm to maintain its reputation;
in
the Basu-Chau model, firms are anonymous except for their country of
origin.    Both models, however,  show mechanisms by which
  higher prices can make firms prefer to produce high instead of low
quality, and in both models  the reputations-- of countries in Basu-
Chau
and of firms in the present paper-- arise from  exogenous expectations
but are  self-fulfilling.

 Chisik (2003)   notes that a country will  tend to specialize in the
goods for
which it has good reputations, and that good reputations increase a
country's
welfare. His model has  three  features absent  in  the present paper:
(
1) Some firms can produce high quality at lower cost than
others; (2) Firms can signal their quality, though noisily, by a
signalling
expenditure; and (3) Reputation for high quality is the same for all
firms in an
industry from a given country, pooling together the bottom firms and
the
top
firms in the eyes of foreign consumers. Feature (1) means that a
country
will tend
to specialize in the high-quality good if its firms have a
technological
advantage in quality production. This is an advance on simple models
of
technological advantage  because  when quality is unobservable  it is
hard for
a company  to convince customers that it can produce high quality at
low
cost.
Technological advantage plus reputation is needed.  Feature (2)  would
be irrelevant in the present model, since  signalling  can be
effective
only under the single-crossing property that firms differ in inherent
type (their technologies), which the present paper does not allow.
Feature (3) means
that a
country  should subsidize high quality because the low-quality firms
are
dragging down the country's general reputation.




  Haucap,   Wey \&  Barmbold (2000)  combine a  reputation model  of a
monopolist  whose quality  type is  unobservable to  buyers with
signalling by
location choice  (a model similar in style to  the purely domestic
production
model of Rasmusen \& Perri (2001) in which firms signal by capital
expenditure).
The central idea  is that  only a monopolist with a low marginal cost
for high
quality would survive in a high-wage, high-tax country,  whereas in  a
low-wage,
low-tax country such a firm would be unable to differentiate itself
from
a firm
with a higher marginal cost for quality  whose optimal strategy is to
produce
low quality and cheat the consumer.  Hence, consumers will pay high
prices for
high quality from the richer country, but will expect (and get) low
quality from
the poor  country.   Unlike the present paper's model, that of Haucap
et
al. is
partial rather than general equilibrium and monopolistic rather than
competitive, but the main differences are  that  in the present paper
firms are ex ante identical, and it is
the firm's identity----pure reputation----rather than some signal such
as
location
that gives consumers confidence in its quality.

  The present paper shows that quality differences can be driven by
reputation alone-- that  multiple equilibria with rational
expectations
exist. A country is fortunate if it  has firms for which consumers
have
optimistic expectations. Such firms will dominate sales in their own
country, and will export to a country  for whose firms consumer only
have pessimistic expectations.  This is not as good for the importing
country as if it had optimistic expectations for its own firms, but it
is better than autarky.

   How might the present model be tested?  Its explanation is based on
the idea that certain companies have reputations for producing high
quality that cannot be guaranteed by pre-purchase observation or by
contract. This implies that the quality differences should  exist only
for certain types of products and companies.  There should be no
quality
differences between countries in standardized commodities or
manufactured goods where the grade and the   terms of delivery  can be
easily measured and enforced in court. The quality differences should
be
largest for services, since service quality is hard to observe before
purchase and hard to enforce, and for branded goods with features
whose
quality is hard to measure, e.g. automobiles, pharmaceuticals,
computers.  Where quality differences between countries are large, we
should also see production in the high-quality country dominated by
older firms, which have had time to build up reputations. A country's
reputation for high quality would really consist, in this model, of an
aggregate of its companies' reputations for high quality.  An
implication is that consumers or retailers, while believing that
Northern  firms in general are trustworthy, would be more doubtful if
they know the Northern firm in question is a recent start-up.





\bigskip


\noindent
 {\bf 7.  Concluding Remarks}

 In the trust model,  even when two countries have identical
technologies and endowments, differences in expectations can lead to
different autarky welfares and to gains from trade by both a small
country (which obtains better prices) and a large country (which gains
extra profits). In one country,  firms produce high quality at  a
profit
and  consumers earn  surplus from buying high quality even  at premium
prices. Firm compete, but they do not reduce their prices because
consumers know that any firm doing so  lacks enough of a profit margin
to value its future reputation.    In the other country,     firms
produce low quality because that is what consumers expect and no
consumer will pay more for a purportedly better product.  Trade allows
the firms with valuable reputations, too valuable to risk by producing
low quality, to sell in both countries instead of in just the rich
country.

 As so often happens, this model is about economic development as well
as about international trade. Much  has been written  about rapacious,
self-defeating governments whose incentives   ruin their attempts to
profit from their citizens.   The story here is   a private-sector
analog:   rapacious,
 self-defeating firms       whose incentives  ruin their   attempts to
profit from their customers. Instead of the  key to development being
to
change the structure of government and reduce rentseeking, it is to
change consumer  expectations   in the product markets. If  consumers
expect high quality, they will get it. If they do not, quality will be
low.


 In broad terms, the reputation model  shows how important reputation
can be---
behaving, even, like  another factor of production.   A nation with a
greater factor
endowment  will have higher utility, and one could view good seller
reputations as something like a factor of production. Like technology
but unlike  most factors,
however, reputation is nonrivalrous. A firm with a good reputation can
expand its output without extra cost, including expanding  to a
different
country. That may be too strong a claim---reputation can be conveyed
at
zero
cost in this model, but in the real world, consumers do need to learn
of
a
firm's reputation, even if the reputation is already established for
most
consumers. But it does ring true that a firm with the valuable
attribute
of a
reputation for good quality will have lower costs of extending that
reputation
to new markets than a firm that must start from scratch. If so, one of
the benefits of international trade is to expand high-quality firms
with
good reputations across the world.

\newpage

 \noindent
 {\bf References}

\begin{description}
\item[]
Acemoglu, Daron, Simon Johnson \& James Robinson (2002) ``Reversal of
Fortune:
Geography and Institutions in the Making of the Modern World Income
Distribution,'' {\it  Quarterly Journal of Economics}, 117(4):
1231-1294
(November 2002).

\item[]
Akerlof, George (1970) ``The Market for Lemons: Quality Uncertainty
and
the
Market Mechanism,'' {\it Quarterly Journal of Economics,}   84(3):
488-
500
(August
1970).

\item[] Allen, Franklin  (1984) ``Reputation and Product Quality,''
{\it
RAND Journal of Economics},  15 (3): 311-327 (Autumn  1984).

\item[] Bagwell, Kyle \&  Michael H. Riordan (1991) ``High and
Declining
Prices Signal Product Quality,'' {\it American Economic Review},
81(1): 224-239  (March 1991).

\item[] Bagwell, Kyle \&  Robert Staiger (1989) ``The Role of Export
Subsidies when Product Quality Is Unknown,''  {\it   Journal of
International Economics,} 27(1-2): 69-89 (August 1989).

\item[] Basu, Arnab  K. \& Nancy  Chau  (1998) ``Asymmetric Country-
of-
Origin Effects on Intraindustry Trade and the International Quality
Race,'' {\it Review of Development Economics},  2 (2): 140-166 (June
1998).

\item[] Berkowitz, Daniel,  Johannes  Moenius  \& Katharina Pistor
(2003) ``Law, Trade and Product Complexity,''       working paper,
Northwestern University.

\item[] Caballero, Ricardo \& Mohamad Hammour (1998) ``The
Macroeconomics of Specificity,''{\it   Journal of Political Economy},
106(4): 724-767 ( August 1998).

\item[] Chisik, Richard (2003) ``Export Industry Policy and
Reputational
Advantage,'' {\it  Journal of International Economics},    59(2): 423-
451 (March 2003).

\item[] Choi,Yo Chul,  David Hummels \&Chong Xiang (2006) ``Explaining
Import Variety and Quality: The Role of the Income Distribution,''
NBER
Working Paper No. 12531, September 2006, \url{
http://www.nber.org/papers/w12531}.

\item[] Falvey, Rodney  (1989) ``Trade, Quality Reputations and
Commercial Policy,'' {\it International Economic Review}, 30(3):
607-622
(August 1989).

\item[] Farrell, Joseph   (1986) ``Moral Hazard as an Entry
Barrier,''{
\it RAND Journal of Economics,} 17:(3):440-449 (Autumn  1986).

\item[] Flam, Harry \& Elhanan Helpman (1987) ``Vertical Product
Differentiation and North-South Trade,'' {\it   American Economic
Review},  77(5): 810-822 (December 1987).

\item[] Grossman, Gene \&  Elhanan Helpman (1991) {\it Innovation and
Growth in the Global Economy},    Cambridge MA: MIT Press,    1991.

\item[] Hallak, Juan Carlos  (2006) ``Product Quality and the
Direction
of Trade,'' Forthcoming,  {\it Journal of International Economics}
68(1):  238-265  (January 2006).

\item[] Hallak, Juan Carlos  \& Peter K. Schott (2005) ``Estimating
Cross-Country Differences in Product Quality,'' \url{
http://www-personal.umich.edu/~hallak/hs82.pdf}, October 17, 2005.

\item[] Hart, Oliver \& John Moore (1990) ``Property Rights and the
Nature of the Firm,'' {\it  Journal of Political Economy}, 98(6):
1119-
1158 (December 1990) .

\item[] Haucap, Justus,  Christian Wey \& Jens Barmbold (2000)
``Location Costs, Product Quality and Implicit Franchise Contracts,''
{
\it   Journal of International Economics},  52(1): 69-87 (October
2000).

\item[] Hummels, David   \& Peter J. Klenow  (2005) ``The Variety and
Quality of a Nation's Trade,''    {\it   American Economic Review},
95(
3):  704-723 (June 2005).

\item[] Johansson   Johny K. \& Israel D. Nebenzahl   (1986)
``Multinational Production: Effect on Brand Value,'' {\it  Journal of
International Business Studies},   17(3): 101-126 (Autumn  1986).

\item[] Keller, Wolfgang (2004) ``International Technology
Diffusion,''
{\it Journal of Economic Literature}, 42(3): 752-782 (September 2004).

\item[] Klein, Benjamin \& Keith Leffler   (1981) ``The Role of Market
Forces in Assuring Contractual Performance,''  {\it  Journal of
Political Economy,} 89(4): 615-641  (August   1981).

\item[] Levchenkco, Andrei (2006) ``Institutional Quality and
International Trade,'' forthcoming, {\it Review of Economic Studies},
September 2006. \url{
http://alevchenko.com/Levchenko_Institutions_Trade_Final.pdf}.

\item[] Macaulay, Stewart (1963) ``Non-Contractual Relations in
Business,'' { \it American Sociological Review,}    28: 55-70
(February
1963).

 \item[] Linder, Staffan (1961)  {\it An Essay on Trade and
Transformation}, . Almqvist \& Wiksell, Stockholm.

\item[] Moenius,  Johannes   \&   Daniel Berkowitz  (2004)
``Institutional Change and Product Composition: Does the Initial
Quality
of Institutions Matter?'' William Davidson Institute Working Paper
Number 662 (February 2004), \url{
http://www.pitt.edu/~dmberk/dev&tr0204.pdf}





\item[]
 Milgrom,  Paul  \&  John
Roberts (1986)
``Price and Advertising Signals of Product Quality,''{\it    Journal
of
Political Economy,}   94(4): 796-821 (August
1986).

\item[]
 Murphy,  Kevin M. \&  Andrei Shleifer (1997) ``Quality and Trade,'' {
\it
Journal of Developmental Economics},   53(1): 1-15.

\item[]
 Navaretti, Giorgio Barba  \& Isidro Soloaga  (2001)  ``Weightless
Machines and
Costless Knowledge An Empirical Analysis of Trade and Technology
Diffusion,''
World Bank working paper, \url{
http://econ.worldbank.org/files/1720_wps2598.pdf}.

\item[]
 Papadopoulos N. \& Heslop L.  (2002) ``Country Equity and Country
Branding:
Problems and Prospects,'' {\it  Journal of Brand Management},  9(4-5):
294-314    (April 2002).

\item[]
Pappu, Ravi,   Pascale G. Quester,  \& Ray W. Cooksey (2007)
``Country Image and Consumer-based Brand Equity: Relationships and
Implications for International Marketing,''  {\it
Journal of International Business Studies,} 38: 726-745.



\item[]
Putnam, Robert (2000) {\it Bowling Alone: The Collapse and Revival of
American
Community}, (New York: Simon and Schuster, 2000).


\item[]
Rasmusen, Eric (1989)  ``A Simple Model of Product Quality with
Elastic
Demand,''  {\it  Economics Letters}, 29(4): 281-283 (1989).



\item[]
Rasmusen, Eric \& Timothy Perri  (2001) ``Can High Prices Ensure
Product
Quality
When Buyers Do Not Know the Sellers' Cost?''   {\it Economic Inquiry},
39(4):
561-567 (October 2001).




\item[]
 Rogerson, William P. (1987) ``The Dissipation of Profits by Brand
Name
Investment
and Entry when
Price Guarantees Quality,''{\it Journal of Political
Economy,}   95(4): 797-809 (August 1987).

\item[]
   Roth,  Martin S. \& Jean B. Romeo (1992) ``Matching Product
Catgeory
and Country Image Perceptions: A Framework for
Managing Country-Of-Origin Effects,'' {\it
    Journal of International Business Studies},  23(3): 477-497 (3rd
Qtr.  1992).


\item[]
Schott,  Peter K. (2004)  ``Across-Product versus Within-Product
Specialization in International
Trade,'' {\it  Quarterly Journal of Economics},  119, 647-678.


\item[]
Shapiro, Carl (1983)
``Premiums for High Quality Products as Returns to Reputations,''{\it
Quarterly Journal of Economics}, 98(4):659-680 (November
1983).

 \end{description}




% \end{raggedright}

\end {document}





























