Exporting as a Signal for Product Quality

Transcription

1 Economica (2000) 67, Exporting as a Signal for Product Quality By OZ SHY University of Haifa, and Stockholm School of Economics Final version received 18 November I develop a dynamic asymmetric information model where a domestic producer is unable to commit to producing a high-quality product. The domestic producer then can signal to consumers that it is producing a high-quality product by developing the infrastructure needed to start exporting the product. This signalling may take place even if selling internationally is less profitable than selling high quality only at home in the absence of credibility problems. Thus, this paper provides another explanation for the decision to start exporting. I then analyse how and which kind of export subsidies alter a firm s incentive to sell a high-quality product in different markets. INTRODUCTION It is commonly observed, in both developed and developing countries, that firms advertise the fact that their products are purchased abroad. Perhaps, the most notable advertising campaign in recent years is IBM s advertising that its notebook computers are used all over the world, from nuns in the Vatican to Thai fishermen. Israeli beer producers, to give another example, always advertise which markets in Europe sell their beer. Thus, consumers tend to believe that selling a product overseas means that the product is of a high quality. This paper attempts to rationalize firms decisions to export on the basis of these observations in a model where consumers can correctly anticipate the actions of the domestic firm. The paper demonstrates that a lack of credibility regarding the product s quality may induce a firm selling only locally to start exporting despite the fact that exporting is not the profit-maximizing strategy in the absence of credibility problems. When the quality of the product is initially unknown, a local producer who is capable of producing a high-quality product will not be able to make a profit in the home market, since rational consumers will refuse to believe that the firm is producing the more costly high-quality product, and will therefore refuse to pay for the quality premium. Thus, in a closed economy only a low-quality product is produced. I show, however, that a domestic producer may export solely for the purpose of signalling to domestic consumers that it is producing the more costly high-quality product. I also show that a market failure may occur when the domestic social welfare level associated with a firm s decision to export is lower than the social welfare associated with having a nonexporting firm. I develop a two-period model where, before the first period, the domestic producer decides whether to produce a high- or low-quality product and whether to export. A high-quality product has a higher unit production cost. Therefore, if the firm sells only locally and if consumers are paying a high price (a premium for a higher quality), it may have an incentive to cut costs and sell a low-quality product to consumers. Note that the decision to deceive domestic consumers by lowering the quality yields a higher profit compared with

2 80 ECONOMICA [FEBRUARY honest marketing, where the firm declares that it is selling a low-quality product only. The reason is that one-period deception does not cost anything to the domestic producer since in the second period consumers will continue buying a low-quality product anyway. Since consumers know that the local firm has an incentive to charge a high price for its low-quality product, rational consumers will refuse to pay the price for a high-quality product. Now, if the decision to export involves a high sunk cost (developing marketing channels overseas, obtaining export licences, foreign promotion and advertising), a firm will refrain from exporting. However, in the presence of an export subsidy, consumers in the domestic country will correctly associate the local firm s decision to export with its decision to produce the more costly high-quality product. In general, there are several reasons why manufacturing firms, especially in developing countries, decide to become exporters while maintaining profitable sales at home. These include: 1. Economies of scale: If the home market is small, a firm may be operating on a declining part of its average-cost curve. Therefore, increasing production via exports would reduce the average cost, which would consequently enhance profits. 2. Government s incentives: Firms start exporting in response to governments incentives following adoption of an export promotion policy. 3. Efficiency: Facing lower prices abroad may induce the local firm to cut its inefficient production costs (reducing X-inefficency). 4. Incomplete risk markets: Exchange rate fluctuations followed by variable domestic inflation rates may induce a domestic firm to export in order to obtain some foreign-currency revenue. 5. Merger and buy out: Private owners of domestic firms may wish to cash in on their investment by going public in foreign markets. In this case, the decision to export will be taken for the purpose of obtaining an international recognition prior to going public. The purpose of the present paper is to add an additional explanation for the decision to export, which is the signalling of quality to domestic (as well as overseas) consumers. The idea of incorporating signalling into trade theory was introduced earlier by several authors whose papers are discussed below. These papers focused on three major instruments used by firms to enhance the quality of exported or imported goods: price signalling, export subsidies and quality standards. The present paper adopts their approach in developing a new argument, showing that the decision to start exporting may itself be motivated by the desire to signal high quality. Bagwell and Staiger (1989) explore a situation in which asymmetric information about firm types blocks the entry of high-quality firms which are unable to charge for a quality premium unless supported by an export subsidy. Their analysis focuses on a game between domestic consumers and foreign suppliers. Bagwell (1991) focuses on the export market and shows that an export subsidy promotes the perception that a high-quality export can be provided at a relatively low price. Mayer (1984) and Grossman and Horn (1988) focus on the domestic market and analyse whether information barriers preclude efficient

3 2000] EXPORTING AS A SIGNAL FOR PRODUCT QUALITY 81 entry when consumers find it difficult to assess products quality before purchase. Donnenfeld and Mayer (1987) demonstrate how voluntary export restraints may be socially desirable as a policy for upgrading the quality of export products. The present paper is closely related to Bagwell and Staiger (1989) and Bagwell (1991), who have already demonstrated the role that export subsidies can play in facilitating the entry of high-quality firms under asymmetric information. So in this respect the present paper is not novel. However, the purpose of this paper is to analyse the firm itself, namely, the firm s decision whether to produce high quality and whether exporting can signal quality. Thus, the main point demonstrated in this paper is that, under asymmetric information about quality, the decision to export is chosen despite the fact that exporting is dominated by non-exporting under symmetric information. This is the main novelty of the present argument. Moreover, in order to establish this argument, the model must allow the firm to make the quality choice for its product. In this respect, the present model differs from Bagwell and Staiger (1989) but resembles very much that of Bagwell (1991), who incorporates this choice into his model. However, there are still two fundamental differences between the papers which affect the consequences of different kinds of export subsidies. In Bagwell (1991) quality signalling is accomplished by using a high price, whereas in the present model quality signalling is achieved via a decision to export. Second, Bagwell (1991) considers only the export market, whereas the present paper analyses both the domestic and export markets. Therefore, the role of the export subsidy in the present model is to create different-quality cheating incentives between the domestic and the export markets, whereas in Bagwell s paper the role of the subsidy is to encourage low-quality producers to charge a low price (sell large quantities), thereby reducing their incentive to fake high-quality products by charging a high price. This means that, whereas a specific subsidy may have an impact when an exporting firm engages in price signalling, it will be shown in Section IV that a specific subsidy is ineffective if the firm is engaged in export signalling, since a specific subsidy does not create different cheating incentives between the two markets. In contrast, an ad valorem subsidy is useful for creating different cheating incentives across markets since it ties the subsidy to export revenues which are affected by the choice of quality. Section I develops the asymmetric information model. Section II presents all the choices available to the domestic firm in terms of choosing its product s quality and whether or not to export. Section III defines the equilibrium concept for the present framework and demonstrates how an export decision can serve as a quality signalling mechanism, that is, a situation where the cheating incentive vanishes only when the firm expands to foreign markets. Section IV analyses the role various subsidies can play in solving a quality-credibility problem and the corresponding welfare consequences. Section V concludes. I. THE MODEL Consider a two-period-lived open economy with n D domestic consumers. The economy trades with the world (or foreign) economy with n F consumers. To

4 82 ECONOMICA [FEBRUARY simplify the algebra, I assume that ng def n D Gn F. A local firm is capable of producing a nondurable product at a high (HQ) or a low (LQ) quality levels only, but not both. I denote each period by t, tg1, 2. (a) Consumers All consumers prefer an HQ to an LQ product. Each consumer buys one unit of the product each period as long as the price does not exceed a given qualitydependent level. The utility gained from an HQ product is θ H and the utility gained from an LQ product is θ L, where θ H Hθ L X0. Formally, let p t denote the period t price facing a consumer. The period t (tg1, 2) utility of a consumer is (1) u t G θ H Ap t if the product is high quality θ L Ap t if the product is low quality 0 if the consumer does not buy the product. For simplicity, let θ L G0. I assume that in period tg1 consumers do not know the quality of the product. In period tg2 consumers are fully informed of the product s quality, but only after it has been consumed by some consumers; that is, if some consumers buy it, others are exposed to reviews in consumers publications. Therefore, after some consumers buy the product, the true quality becomes public knowledge. Thus, the product in question is what Nelson (1970) calls an experience good, meaning that it has to be purchased before its quality can be examined. A decision to produce the high-quality type of product requires a commitment to produce at a higher unit cost in both periods. Formally, let c H denote the unit cost of producing the high-quality product, and c L the unit cost of producing the low-quality product, where c H Hc L X0. Without substantial loss of generality, let c L G0. (b) The international export market and export subsidy In the international market, the domestic firm can sell the product provided that it sinks $F in establishing a foreign marketing base (e.g. the cost of foreign advertising, establishing dealerships, and paying for export licences). I assume that the local government provides the local firm with an ad valorem export subsidy denoted by s, sx0. Thus, if the firm exports each unit for a price p, its revenue on each unit of export is (1Cs)p. Anad valorem subsidy should be contrasted with a specific subsidy, where each unit of export receives a subsidy of σ regardless of export s price (in which case, the firm collects a per-unit revenue of pcσ). Section IV below demonstrates that a specific subsidy is ineffective for the purpose of quality signalling precisely because it is independent of the export price and hence the quality of exports.

5 2000] EXPORTING AS A SIGNAL FOR PRODUCT QUALITY 83 (c) Timing of decisions The interaction of the firm and consumers is as follows. Stage I: The monopoly firm decides and commits simultaneously on three variables: (i) quality, q {H, L}; (ii) period tg1 price, p 1 ; and (iii) whether to export, e {Yes, No}. Stage II: All consumers (domestic and abroad) observe only (p 1, e); that is, they observe the price set for period 1 and whether the firm invests in opening its export market (however, true quality is unobservable), and they then form their expectation (or belief) of the product s quality, B(p 1, e). Stage III (tg1): Based on the first-period price p 1, and their belief B(p 1, e), both consumer types decide whether to purchase the product so as to maximize their utility given in (1). Stage IV: True quality q is revealed (only if purchase was made at the earlier stage). In case that B(p 1, e) q, belief is updated to the true q. Stage V: The firm announces its second-period price p 2. Stage VI (tg2): Consumers make purchases. II. DOMESTIC FIRM S CHOICE OF QUALITY AND MARKETS I now calculate the firm s profit levels under different choices of the product s quality levels and the firm s decision whether to export or to sell domestically only. The outcomes are affected also by the realization of consumers beliefs. Taking only pure actions q {H, L}, e {Yes, No}, binary price decisions p 1 {0, θ H } and pure beliefs B {H, L} into account, there are 2 4 G16 cases to consider. Table 1 provides the profit levels for these sixteen cases. The actual computations of these profit levels are carried out in the following two subsections. TABLE 1 PROFIT LEVELS FOR ALL 2 4 POSSIBLE OUTCOMES Case q p 1 e B π 1 p 2 π 2 (i) H θ H Yes H n[(2cs)θ H A2c H ]AF θ H n[(2cs)θ H A2c H ] (ii) H θ H Yes L F 0 0 (iii) H θ H No H n(θ H Ac H ) θ H n(θ H Ac H ) (iv) H θ H No L (v) H 0 Yes H n(0a2c H )AF θ H n[(2cs)θ H A2c H ] (vi) H 0 Yes L n(0a2c H )AF θ H n[(2cs)θ H A2c H ] (vii) H 0 No H n(0ac H ) θ H n(θ H Ac H ) (viii) H 0 No L n(0ac H ) θ H n(θ H Ac H ) (ix) L θ H Yes H n(2cs)θ H AF 0 0 (x) L θ H Yes L F 0 0 (xi) L θ H No H nθ H 0 0 (xii) L θ H No L (xiii) L 0 Yes H F 0 0 (xiv) L 0 Yes L F 0 0 (xv) L 0 No H (xvi) L 0 No L Note: q {H, L} is true quality; p 1 {0, θ H } is price at tg1; e {Yes, No} is export investment; B(p 1, e) {H, L} is consumers quality belief at tg1. The table assumes that the producer must sell at the declared price.

6 84 ECONOMICA [FEBRUARY The table reveals two additional simplifications of the model. The first is that we consider only pure (binary) beliefs rather than the more general continuous beliefs in the form of assigning probability h for realizing quality H. Assuming a probabilistic belief function would make our analysis more complicated as profit levels would not be discrete and therefore could not be tabulated as in Table 1. The second simplification is that we consider the only two possible profit-maximizing first-period prices, p 1 {0, θ H }, instead of all non-negative prices. Again, assuming continuous prices would invalidate the analytical method used here, in the sense that profit levels could not be tabulated and later compared using a figure in the parameters space. (a) Domestic firm produces high quality (HQ) Suppose now that the firm produces an HQ product. I now compute cases (i) (viii) in Table 1. First, note that a decision to open export markets increases the firm s cost by F. Under case (i), consumers correctly believe that the product is HQ; hence they make purchases domestically and abroad in the two periods, yielding total sales of 2n each period. The revenue from domestic sales each period is nθ H and from foreign sales, n(1cs)θ H. Since the firm is exporting, it pays F at tg1. Under case (ii) consumers do not make any purchases in tg1 as they falsely believe that the product is LQ and therefore are not willing to pay a high price in tg1. Since there are no sales in tg1, quality belief is not updated and consumers continue to believe that it is an LQ product. Therefore, the firm lowers its price in tg2 top 2 Gθ L G0, so n domestic consumers and n foreign consumers pay each p 2 G0. Case (iii) is similar to case (i) but sales take place in the domestic market only; and case (iv) is similar to case (ii) but again with no foreign sales. Cases (v) (viii) correspond to an HQ producer who charges a lower price in tg1. Since some consumers definitely purchase in tg1 and realize the true HQ (i.e. their belief is revised), the firm raises its price to p 2 Gθ H in the second period. Thus, in case (v), since consumers believe that the product is HQ, n domestic consumers and n foreign consumers each pay p 1 Gθ L G0intG1, and pay p 2 Gθ H in tg2, where (1Cs)θ H is collected on each unit sold abroad. Case (vi) is similar, where in fact the initial belief of LQ does not make a difference since the initial price is low. Case (vii) and (viii) correspond to cases (v) and (vi) but with no exports. (b) Domestic firm produces low quality (LQ) Under case (ix), consumers are led to believe in tg1 that they are buying HQ whereas after purchasing they discover they have bought an LQ product. Hence price is reduced to p 2 Gθ L G0intG2. Since consumers belief is HQ in tg1, each of the domestic and foreign HQ-oriented consumers pay each p 1 Gθ H in tg1, where the revenue collected on each unit of export is (1Cs)θ H. In tg2, consumers pay p 2 Gθ L G0. Note that in tg1 the producer sells an LQ product for an HQ price, and therefore does not bear the HQ production cost.

7 2000] EXPORTING AS A SIGNAL FOR PRODUCT QUALITY 85 Under case (x), consumers do not buy in tg1 as they are not willing to pay p 1 Gθ H for LQ. In the second period, price is reduced to p 2 Gθ L G0; hence the product is sold as LQ domestically and abroad. Case (xi) is similar to case (ix) but sales are domestic only. Case (xii) is similar to case (x) but again sales are domestic only. Under case (xiii), despite the low price, consumers believe the product is HQ; hence all consumers in both countries buy at tg1 and pay p 1 Gθ L G0. At tg2, after finding the true quality, the firm cannot raise the price and therefore continues charging p 2 G0. Case (xiv) is similar to case (xiii) except that in tg1 the quality belief is different, but this does not affect the (zero) revenue collected by the firm. Case (xv) is similar to case (xiii), but with no export market. Case (xvi) is similar to case (xiv) but again with no export market. Finally, note that the firm can guarantee its individually rational profit level, zero, by setting qgl and eg No, as in cases (xii) and (xvi). III. EQUILIBRIUM In this section, I look for an equilibrium for the dynamic game defined in subsection I(c). Definition 1. An equilibrium is the list (qˆ, pˆ1, ê), B(p 1, e), where qˆ {H, L} is the true quality, pˆ1x0 is the price at tg1, and ê {Yes, No} is the producer s export decision. B(p 1, e) {H, L} is a consumer s belief function of the quality of the product prior to purchase based on observing (p 1, e); all satisfying the following conditions: (i) Given the consumers belief function B(p 1, e), the choice (qˆ, pˆ1, ê) maximizes the producer s sum of two-period profit levels. (ii) Consumers correctly anticipate the true quality of the product; that is, B(pˆ1, ê)gqˆ. Note that, as assumed throughout this paper, consumers are unable to observe q prior to purchase. Also note that I require only that consumers anticipate the true quality chosen in equilibrium; that is, consumers belief function does not necessarily predict the true quality of the product outside the equilibrium. Definition 1 rules out all cases where consumers belief does not match the true quality as equilibrium outcomes; that is, cases (ii), (iv), (vi), (viii), (ix), (xi), (xiii) and (xv) in Table 1 are not equilibria. In addition, cases (x) and (xiv) are ruled out as equilibrium outcomes as they yield profit levels that are lower than the individually rational profit levels given in cases (xii) and (xvi) in the table. Thus, Table 1 is now reduced to Table 2, which displays six possible equilibrium outcomes. Next, for exporting to be profitable, the profit from selling HQ at home and abroad (case (i)) must exceed or equal the profit from selling HQ domestically only (case (iii)); that is, 2n[(2Cs)θ H A2c H ]AFX2n(θ H Ac H ). Therefore, I assume the reverse.

8 86 ECONOMICA [FEBRUARY TABLE 2 PROFIT LEVELS FOR THE REMAINING CANDIDATE EQUILIBRIUM OUTCOMES Case q p 1 e B π 1 p 2 π 2 (i) H θ H Yes H n[(2cs)θ H A2c H ]AF θ H n[(2cs)θ H A2c H ] (iii) H θ H No H n(θ H Ac H ) θ H n(θ H Ac H ) (v) H 0 Yes H n(0a2c H )AF θ H n[(2cs)θ H A2c H ] (vii) H 0 No H n(0ac H ) θ H n(θ H Ac H ) (xii) L θ H No L (xvi) L 0 No L Assumption 1. Exporting is not profitable. Formally, (2) FH2n[(1Cs)θ H Ac H ], or, equivalently, c H H(1Cs)θ H A F 2n ; that is, the sunk cost of getting into the export market exceeds the revenue that can be collected from selling HQ to consumers abroad. Next, a necessary condition for exporting HQ (case (i)) to be an equilibrium is that the firm cannot increase its profit by selling LQ at an HQ price (case (ix)). That is, (3) 2n[(2Cs)θ H A2c H ]AFHn(2Cs)θ H AF, or equivalently, c H F (2Cs)θ H. 4 Similarly, with no exporting, a necessary condition for producing HQ (case (iii)) to be an equilibrium is that selling LQ at an HQ price domestically (case (xi)) is not profit-enhancing. That is, (4) 2n(θ H Ac H )Hnθ H, or, equivalently, c H F θ H 2. Finally, I sometimes refer to the following condition, which guarantees that the profit from exporting and producing HQ exceeds the individually rational profit level where the firm produces LQ and sells domestically only (i.e. where case (i) is non-negative): (5) 2n[(2Cs)θ H A2c H ]AFX0, or, equivalently, c H F (2Cs)θ H A F 2 4n. Constraints (2), (3), (4) and (5) are all drawn in Figure 1. In the figure, the parameter range above the steep downward-sloping line corresponds to (2) where exporting is not profitable. The parameter range below the flat downward-sloping line corresponds to (5), where exporting and producing HQ yields at least the individually rational profit level. The parameter range below the lower horizontal line corresponds to (4), where selling HQ domestically is more profitable than selling LQ domestically at an HQ price. The parameter range below the upper horizontal line corresponds to (3), where an exporting firm does not find it profitable to sell LQ at an HQ price instead of selling HQ.

9 2000] EXPORTING AS A SIGNAL FOR PRODUCT QUALITY 87 FIGURE 1. Parameter ranges for various properties of the model. The condition stated in the following proposition corresponds to the area between two horizontal lines in Figure 1. Proposition 1. Under Assumption 1, outcome (iii), selling HQ domestically only, yields the highest profit; and outcome (i), selling HQ internationally, yields the second highest profit among the candidate equilibrium outcomes listed in Table 2. However, if θ H 2 FcH F (2Cs)θ H, 4 then outcome (iii) is not an equilibrium outcome, since the firm will have a strict incentive to reduce the quality without reducing the price. Proof. A simple comparison of the profit levels in Table 2 reveals that (iii)h(i) by Assumption 1. The rest follows directly from the table. Next, the condition of the proposition implies that (4) is reversed. Hence, with no exports, selling LQ at an HQ price is profitable. Then, if B(θ H, No)GH, since (ix)h(iii), the firm can increase its profit by producing LQ and selling it at an HQ price. Proposition 1 provides the key to the argument of this paper, as it lists the conditions under which the firm cannot choose its profit-maximizing action since it cannot credibly commit to producing HQ (rather than producing LQ at an HQ price). Our next proposition predicts the equilibrium outcome in the presence of this credibility problem faced by the domestic firm, and demonstrates how, under a certain condition, it can use the export investment for the purpose of signalling its HQ. We restrict our attention to equilibria in pure actions only. Proposition 2. Given the condition listed in Proposition 1,

10 88 ECONOMICA [FEBRUARY (a) under condition (5) (region I in Figure 1), the firm signals that it is HQ by investing in nonprofitable export. Formally, the following is an equilibrium: (H, θ H, Yes), B(p 1, e)g H if (p 1, e)g(θ H, Yes) L otherwise ; (b) if condition (5) is reversed (region II in Figure 1), then there does not exist an equilibrium in which the firm sells an HQ product. Proof. (a) Proposition 1 shows that the profit level (i) exceeds the profit from all other outcomes in Table 2, except the profit in case (iii), which itself is not an equilibrium. So suppose that the firm sets (p 1, e)g(θ H, Yes) and consumers set B(θ H, Yes)GH. It remains to check that the firm will not deviate and reduce the quality to qgl instead of qgh. However, condition (3) ensures that this is not profitable. (b) A reversed condition (5) implies that the profit in case (xvi) exceeds the profit levels in case (i). The condition in Proposition 1 implies that (4) is reversed, hence outcome (iii) in Table 2 is not an equilibrium. Finally, Assumption 1 implies that outcome (v) in Table 2 is not an equilibrium. Proposition 2 demonstrates the problem faced by a firm attempting to upgrade to a more profitable quality level of its product. For some parameters, there is no way in which the firm can lead consumers correctly to believe that it is an HQ producer. Under a different parameter range, it can establish a correct reputation as an HQ producer provided it sells abroad. As shall be seen in Section IV, the export subsidy plays an indispensable role in sustaining credibility. IV. POLICY AND WELFARE I now discuss the role an export subsidy can play in signalling quality and the welfare implications of this subsidy. In order to be able to convince domestic consumers that the firm is HQ, it must be the case that, whereas selling LQ at an HQ price is profitable when selling domestically only, it becomes unprofitable if the firm exports part of its production. Thus, the key is asymmetry in the profitability of selling LQ at an HQ price in the home and foreign markets. This asymmetry exists because of the export subsidy provided by the government. Formally, Proposition 3. Without the subsidy, the firm will not be able to signal HQ. Proof. In view of Figure 1, as s 0, the two horizontal lines approach and both region I and region II vanish. An important question to ask at this point is whether any export subsidy can facilitate the quality credibility problem faced by the firm. That is, so far I have employed an ad valorem export subsidy, and the question is whether a specific subsidy can play the same role. Proposition 4. If the government provides a specific export subsidy, the firm cannot signal its HQ.

11 2000] EXPORTING AS A SIGNAL FOR PRODUCT QUALITY 89 Proof. Suppose that the government offers a subsidy of σ per each unit of export (instead of the ad valorem subsidy of a fraction of s of the revenue from exports). Then, condition (3) becomes 4n(θ H Ac H )C2nσH2nθ H C0C2nσ, which is identical to (4). Since we assume that (4) is reversed, then selling LQ at an HQ price is also profitable under exporting, so exporting cannot enhance credibility. Proposition 4 is rather intuitive. A specific subsidy is a subsidy per unit of export of any quality. Thus, a specific subsidy does not eliminate the gains from selling LQ at an HQ price abroad. In contrast, the ad valorem subsidy reduces the profitability from selling LQ as HQ while exporting since this subsidy is proportional to the stream of revenues generated from foreign sales which are proportional to the product s quality. Finally, there is a question whether the ad valorem subsidy is welfareimproving, taking into consideration that the government has to tax domestic consumers (or the firms owners, for simplicity) in order to be able to finance this export subsidy. Since the subsidy cancels out the tax, the welfare gains are examined by establishing whether exporting and selling HQ yields a higher profit than selling LQ at home only (therefore maintaining zero profit level). Substituting sg0 into (i) of Table 2 yields Proposition 5. If FF4n(θ H Ac H ), then the ad valorem subsidy is welfareincreasing. Otherwise, the subsidy reduces domestic social welfare. V. CONCLUSION I now discuss the role the various assumptions play in getting these results. There are only two assumptions without which the present argument cannot be established. The first is some kind of revenue asymmetry between the countries. The second is the sunk cost for opening the export markets. The revenue asymmetry is essential for generating different cheating incentives with or without exporting. The sunk cost is not essential for signalling quality, but is essential for making export unprofitable (thereby strengthening our argument). In this paper, the only way in which the domestic firm can convince local customers that it is producing HQ is to sell abroad. This requires an assumption that generates some asymmetry between the domestic and foreign markets. There are two ways in which asymmetry can be accomplished. The first, as assumed in this paper, is via a revenue-depending export subsidy. An alternative way is to assume that two groups of heterogeneous consumers exist in both locations but the distribution of consumers among the two groups may differ between the regions; in this case, if foreign consumers are more HQoriented than domestic consumers, the benefit from selling LQ as HQ while exporting is also reduced. Without assuming either an ad valorem subsidy or different distribution of preferences across countries, the signalling result cannot be obtained in a wide variety of models that I have tried out, including models with homogeneous consumers and different population sizes. Again, in all of these models, if selling LQ as HQ at home is profitable, then it is also profitable in international

12 90 ECONOMICA [FEBRUARY markets, so signalling is not possible. Signalling is not possible either with homogeneous preferences without a subsidy, even if I change the market structure to allow for foreign firms, transportation costs and tariffs. I would like to argue that assuming constant returns to scale production technologies is not a restriction on the robustness of the result, for the following reason. Assuming increasing returns to scale, for example, would imply that there are gains from output expansion, thereby making the export decision more profitable. Thus, assuming increasing returns would further enlarge (parameter-wise) the region in which signalling HQ via export is possible. Finally, there is a question to what degree the theory developed in this paper is testable. First, note that in the literature signalling models are generally not tested. This perhaps has to do with the fact that it is hard to isolate the specific actions that intend to enhance credibility with other profit-maximizing actions. Second, for this particular model, as suggested by one referee, the way to test this theory is to attempt to estimate the fraction of loss-making exports of new experience goods and compare it with that of other new goods. This will require data of each particular firm, which may be hard to obtain from the firms themselves. ACKNOWLEDGMENTS I have benefited from long conversations with Ari Kokko on firms exporting decisionmaking process, and with Tore Ellingsen. I am most grateful to three anonymous dedicated referees for providing me with lengthy reports consisting of comments, guidance, and suggestions on several drafts. REFERENCES BAGWELL, K. (1991). Optimal export policy for a new-product monopoly. American Economic Review, 81, and STAIGER, R. (1989). The role of export subsidies when product quality is unknown. Journal of International Economics, 27, DONNENFELD, S. and MAYER, W. (1987). The quality of export products and optimal trade policy. International Economic Review, 28, GROSSMAN, G. and HORN, H. (1988). Infant-industry protection reconsidered: the case of informational barriers to entry. Quarterly Journal of Economics, 103, MAYER, W. (1984). The infant-export industry argument. Canadian Journal of Economics, 17, NELSON, P. (1970). Information and consumer behavior. Journal of Political Economy, 78,