Executive Summary

Differences in product quality among firms and varying levels of quality appreciation across countries play a crucial role in shaping trade relationships. Quality production has costs, but it also shifts the demand curve and can influence observed trade relationships in either a positive or negative way. Traditional simulation models do not consider these aspects, and therefore the simulation results from these models may be biased. Accurate simulation models are essential for policymakers to design effective policies and for firms to develop strategies aligned with their profitability. Therefore, enhancing the accessibility of such models to simulation practitioners is of significant value. This deliverable entails the documentation of a summary of the developed modeling framework, its parametrization, and calibration, extending the international trade simulation framework to include firms that produce distinct product qualities. Additionally, this deliverable provides a numerical illustration of the model by applying an arbitrary 10% bilateral tariff shock between two trading partners. The simulated results from this quality differentiation framework are compared with those obtained using only horizontal differentiation, as specified in the Melitz model. Our results reveal significant differences in the impact of a given shock when comparing the two modeling frameworks: the traditional Melitz model that does not incorporate product quality differentiation, and the extended model that does. Specifically, our analysis shows that the impacts are relatively lower when product quality differentiation is considered. These findings have important implications. Traditional trade models that overlook product quality differentiation may overestimate the effects of policy interventions, such as tariffs. In contrast, models that account for variations in product quality offer a more nuanced and accurate representation of trade impacts. This underscores the critical need to make these advanced simulation models accessible to practitioners, enabling more informed and effective policy and strategy development.