| Abstract: | Using a product differentiation model, this paper discusses the issue of transnational firms evading tariffs and investing directly in a host country (through foreign direct investment (FDI)). Where product quality is differentiated between foreign and host country firms and assuming a firm's quality requirement is a long‐term strategy and is not affected by a foreign firm's trade decision, we obtain the following findings. First, whether or not a host country firm produces high or low quality products, raising the quality requirement for foreign products will increase the possibility of a foreign firm choosing FDI instead of exporting a product to the host country. Second, raising the quality requirement for domestic products will lower the possibility of foreign firms choosing FDI without regard to the product's quality. Finally, given a competitor in the host country, in FDI, a foreign high‐quality product‐producing firm has an advantage over a low‐quality product‐producing firm. We also find that even when firms' quality decisions are affected by a foreign firm's trade decision, most of the above results will still hold. |
