A trade embargo is a common way to punish a country. The question I ask is what effect does an embargo have on an imperfectly competitive market? I extend the standard quality duopoly model to show that if the embargo is on the high quality good the quality diminishes and causes an ambiguous effect on prices. An embargo on the low quality good raises the quality of the better good and increases both firm's price.punishment

Bryan McCannon

English

Research Papers in Economics

The impact of a trade embargo on quality 
Bryan McCannon
Elmira College
Abstract
A trade embargo is a common way to punish a country. The question I ask is what effect does
an embargo have on an imperfectly competitive market? I extend the standard quality
duopoly model to show that if the embargo is on the high quality good the quality diminishes
and causes an ambiguous effect on prices. An embargo on the low quality good raises the
quality of the better good and increases both firm's price.
This is a preliminary note. I would like to thank Paul Woodburne, Eric Bond and the participants of the Pennsylvania Economic
Association meetings. Please feel free to contact me with any critiques, comments, or suggestions.
Citation: McCannon, Bryan, (2004) "The impact of a trade embargo on quality." Economics Bulletin, Vol. 6, No. 14 pp. 1−7
Submitted: June 25, 2004.  Accepted: September 12, 2004.
URL: http://www.economicsbulletin.com/2004/volume6/EB−04F10006A.pdf1I n t r o d u c t i o n
A trade embargo is an increasingly popular way for a country to punish
another. Prior to 1990 the United Nations levied only two trade sanctions.
Between 1990 and 1998 the United Nations has imposed eleven and since 1970
the United States has added another seventy-seven (Elliott and Hufbauer, 1999).
Products produced in these countries still compete in international markets
with products produced in countries without any sanctions. A straightforward
question one may ask is what eﬀect does levying a trade embargo have on a
market? Many have studied the eﬀectiveness of sanctions as well as the impact
of quantity restrictions on competitive markets. I focus here on trade embargoes
eﬀect on the quality of goods produced in imperfectly competitive markets.
To address this question I extend the standard vertical product diﬀerentia-
tion duopoly model used in Gabszewicz and Thisse (1979, 1980), Shaked and
Sutton (1982, 1983) and Tirole (2002). The outcome depends on whether the
embargo is levied on the country that produces a high quality product or a low
quality product. If the embargo is on the former then the quality of the good
decreases and the gap in quality between the two products shrinks. The eﬀect
on prices is ambiguous. The embargo has the direct eﬀect of increasing both
ﬁrm’s prices but the shrinking quality gap reduces product diﬀerentiation and
increases price competition. If the embargo is placed on the country that pro-
duces the lower quality good then the gap in quality increases with the higher
quality ﬁrm producing an even better product. This causes the price of both
goods to increase.
2 The Model
There are two ﬁrms labelled H and L and a continuum of consumers with
a mass normalized to unity. Each consumers is assigned a type θi ∈
£
θ,θ
¤
.T h e
types are assigned uniformly and are not observed by either ﬁrm. First, the two
ﬁrms simultaneously select a quality, sj, from the interval [s,s].T h e c o s t t o
assigning a quality sj is denoted X(sj) where X is continuously diﬀerentiable,
strictly increasing and strictly convex. Since the ﬁrms are ex ante identical they
are labelled so that sH ≥ sL.N e x t ,b o t hﬁrms observe sH and sL and select a
price pj. Finally, each consumer has the option to purchase one product. Thus,
he can buy H’s product, L’s product, or neither. A consumer of type θi receives
a utility of
θisj − pj (1)
1from purchasing the product produced by j.Aﬁrm earns a proﬁto f
(pj − c)µj − X (sj) (2)
where µj is the number of consumers that purchase j’s product and c is the
marginal cost of production. I focus on the subgame perfect Nash equilibrium.
As in Tirole (2002), two assumptions will be used to simplify the analysis.
The ﬁrst is θ ≥ 2θ.1 This assumption requires that there is a suﬃcient amount
of heterogeneity in the consumers’ preferences for quality. As will be shown,
it guarantees the existence of a pure strategy equilibrium. Secondly, every
consumer prefers to make a purchase. This is done to simplify the analysis.
Since sH ≥ sL, consumers with the highest propensities for quality prefer
to buy H. There will exist a threshold consumer type, e θ, where the utility
from purchasing H and L are equal. It follows that e θ =
pH−pL
sH−sL. Now consider
modeling an embargo on one of the products. A trade embargo results in a
speciﬁc population being restricted from buying the good. It is this property of
trade embargoes that I introduce to the model. I ﬁrst consider the case where
a trade embargo is placed on the higher quality product.
2.1 An Embargo on the High Quality Good
First suppose that Country A bans H’s product.2 I assume that the dis-
tribution of tastes is the same in every country. Thus, let A denote the fraction
of the population that is in the country that has enacted the trade embargo on
H.A v a l u e o f A =0represents the model without the trade embargo and a
larger A represents a larger proportion of the world that levies the trade em-
bargo. The demand for H is now µH =( 1− A)
³
θ −e θ
´
. L not only sells to
those consumers whose taste for quality is relatively small but also sells to all
consumers in Country A. L’s demand is µL =
³
e θ − θ
´
+A
³
θ −e θ
´
.3 Hence, in
the pricing game, the best responses for the ﬁrms are
BRE
H =
pL + c +( sH − sL)θ
2
(3)
BRE
L =
pH + c +( sH − sL)
³
Aθ−θ
1−A
´
2
.
1Since there is a mass of one distributed uniformly over
k
θ,θ
l
Ia s s u m eθ ≥ 0 and that the
interval is of length one, θ −θ =1 , so that the size of an interval corresponds to a proportion
of the population.
2Assume that neither ﬁrm is located in Country A. Also, in practice, this could represent
a coalition of countries enacting a trade embargo (e.g. the United Nations).
3The second assumption, which requires that every consumer prefers to make a purchase,
implies that c +
(s−s)(θ−2θ+Aθ)
3(1−A) ≤ θ s.
2Notice that H’s best response function is the same with and without the
trade embargo. L’s with the trade embargo is simply a parallel shift out in its
best response function without a trade embargo. Solving, the equilibrium prices
are
pE
H = c +
(sH − sL)
3
µ
2θ − θ − Aθ
1 − A
¶
(4)
pE
L = c +
(sH − sL)
3
µ
θ − 2θ + Aθ
1 − A
¶
.
Now consider the choice of quality. The prices give rise to a demand of µH =
2θ−θ−Aθ
3 for H.P r o ﬁts are
πE
H =
(sH − sL)
¡
2θ − θ − Aθ
¢2
9(1− A)
− X (sH) (5)
πE
L =
(sH − sL)
¡
θ − 2θ + Aθ
¢2
9(1− A)
− X (sL).
L’s proﬁti sd e c r e a s i n gi nsL. This is because lowering its quality reduces costs
and increases the diﬀerentiation of the products. As a result, L chooses the
smallest value, sE
L = s. H selects sE
H as the value of sH that solves
¡
2θ − θ − Aθ
¢2
9(1− A)
= X0 (sH). (6)
For small values of A the left hand side of (6) is decreasing in A. Therefore,
as the size of the population restricted from buying H increases from zero (no
trade embargo) the left hand side decreases and, as a result, the quality of H
decreases. For large values of A the left hand side is increasing in A.T h e
turning point occurs at e A =1− 1
θ. Since, for values of A larger than e A,t h e
left hand side is increasing in A, there exists a large value for which the quality
is no longer less.4 Figure 1 illustrates the decrease in the quality of Firm H’s
product and the change as A increases from zero.
I can summarize the predictions of the eﬀect of a trade embargo placed
on a country that produces the higher quality good. First, the quality of the
restricted good decreases. The lost consumers lower marginal revenue leading
to a reduction of marginal cost by producing a cheaper product. Second, the
high quality good loses sales. Finally, there is an ambiguous eﬀect on prices.
The restriction on trade has the direct eﬀect of increasing both ﬁrms’ prices, (4),
but the reduced diﬀerentiation of the goods causes stronger price competition
and lower prices. Thus, the cumulative impact on prices is ambiguous.
4Denoted as a, the value can be found by setting the left hand side of (6) when A =0
equal to (6) with A = a.T h u s ,a =1− 1
θ
2.
3Figure 1: Quality with an Embargo on H
£
£
£
£ £
A
s
s∗
H
1 a e A
2.2 An Embargo on the Low Quality Good
Instead, suppose that Country A does not allow the sale of L’s product.
Thus, a proportion of the customers that would have preferred L now only have
H to buy. Much of the work follows analogously from the previous section. The
demand for L is now µL =( 1− A)
³
e θ − θ
´
. H not only sells to those consumers
whose taste for quality is relatively large but also sells to all consumers in
Country A. Again, A =0is the model without the embargo. In the pricing
game, the best responses for the ﬁrms are
BRe
H =
pL + c +( sH − sL)
³
θ−Aθ
1−A
´
2
(7)
BRe
L =
pH + c − (sH − sL)θ
2
.
In the previous section, when the embargo is levied on H, its best response
function is unaﬀected. Here, the trade embargo is on L and its best response
function is unchanged. As before, the prices selected by the ﬁrms in the pricing
stage increase with the trade embargo. The equilibrium prices are now
pe
H = c +
(sH − sL)
¡
2θ − θ − Aθ
¢
3(1− A)
(8)
pe
L = c +
(sH − sL)
¡
θ − 2θ + Aθ
¢
3(1− A)
.
4The resulting proﬁt functions are
πe
H =
(sH − sL)
¡
2θ − θ − Aθ
¢2
9(1− A)
− X (sH) (9)
πe
L =
(sH − sL)
¡
θ − 2θ + Aθ
¢2
9(1− A)
− X (sL).
Again, L’s proﬁt function is strictly decreasing in its quality so that se
L = s.
Firm H’s equilibrium choice solves
¡
2θ − θ − Aθ
¢2
9(1− A)
= X0 (sH). (10)
Again, I can summarize the predictions of the eﬀect of a trade embargo placed
on a country that produces the lower quality good. First, the relative qual-
ity of the restricted good decreases. The low quality producer maintains the
lowest quality possible. The gained consumers increase the high quality ﬁrm’s
marginal revenue, (10), leading to a increase in marginal cost by producing a
better product thus lowering the restricted ﬁrm’s relative quality. Second, the
high quality good loses sales. The high quality producer disproportionately in-
creases its price limiting its sales to only those consumers with exceptionally
high propensities for quality. Finally, the embargo increases both ﬁrms’ prices.
The restriction on trade again has the direct eﬀect of increasing both ﬁrms’
prices, (8), and the increased diﬀerentiation of the goods causes weaker price
competition and higher prices. Thus, the cumulative impact increases prices.
3C o n c l u s i o n
The goal of this paper is to illustrate the eﬀect of a trade embargo on the
quality of products produced in an imperfectly competitive market. To address
this question I extend the standard vertical product diﬀerentiation duopoly
model. Since the majority of trade embargoes are enacted by one country a ﬁrm
in the sanctioned country often competes internationally. Therefore, I focus on
integrated duopoly markets. I show that an embargo lowers the restricted goods
(relative) quality. The trade embargo has the direct eﬀect of raising both ﬁrms’
prices due to the restricted trade. The overall impact on prices depends on
whether the embargo causes more or less diﬀerentiation of the products. The
model also applies to other forms of domestic policy, such as "Buy American"
campaigns, where a group of consumers do not purchase a particular good.
Future work could deal with more complicated trade restrictions. Also, the
model lends itself to clear empirical predictions that could be tested.
54 References
Elliott, K. & G. Hufbauer, 1999, "Same Song, Same Refrain? Economic
Sanctions in the 1990s", American Economic Review, 89, 403-408.
Gabszewicz, J. & J.-F. Thisse, 1979, "Price Competition, Quality and Income
Disparities," Journal of Economic Theory, 20, 340-359.
Gabszewicz, J. & J.-F. Thisse, 1980, "Entry (and Exit) in a Diﬀerentiated
Industry," Journal of Economic Theory, 22, 327-338.
Shaked, A. & J. Sutton, 1982, "Relaxing Price Competition Through Product
Diﬀerentiation," Review of Economic Studies, 49, 3-13.
Shaked, A. & J. Sutton, 1983, "Natural Oligopolies," Econometrica, 51, 1469-
1484.
Tirole, J. 2002. The Theory of Industrial Organization, Cambridge: MIT
Press.
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