The first term on the right hand side is the so-called pure profit effect, arising from the fact
that imperfectly competitive firms set prices above average costs. The second term describes
the decreasing-average cost effect, which reflects the gains from the fall of average costs of
the production as firms expand output. The third source of gains from trade is the firm exit
effect that reflects the trade-off between the existence of more firms on the market and the
desirable entire industry product due to a downward sloping average cost curve. Free entry
drives profits to zero and with the opening of trade some firms will exit due to negative
profits. Fewer firms will then produce the same output with lower average costs. In addition,
the recent literature emphasizes the increase of varieties (Markusen 1981, Helpman and
Krugman 1985).
Accumulation effects
Cross-country studies show considerable inconsistencies between results from static
numerical studies and linkages between trade policies and incomes through investments. The
static effects fail to account for the relationship between trade, investment and growth, which
is fairly well established empirically. According to classical growth theory the changes in
saving and investment patterns provide a potential for accumulation. The accumulation effects
capture the changes in the amounts of resources through the interaction between trade policy
and capital accumulation (Francois, McDonald and Nordstrom 1996).
The effects of free trade on the environment occur mainly indirectly through the
changes in production and consumption patterns. There are four categories of environmental
effects on trade. The scale effects arise from higher growth, which stems from the trade
liberalization. The increase in production causes more emissions. Considering the
environment as a consumption good, the increased personal income may lead to an increased
demand for a wide range of goods e.g. for environmental amenities. This illustrates the
environmental benefits from trade. However environmental quality is a public good and thus
the rising demand for environmental quality needs to be transformed into more restrictive
environmental standards. Finally economic growth is followed by a decline of the population,
which is one of the major sources of pressure on natural resources. Product and technology
effects capture the change in products varieties that become available after the trade
liberalization, as well as the easier access to foreign technologies. The increase of pollution
often leads to an over-proportional increase in environmental damage. Thus decentralization
might alleviate the damage from pollution through the spatial distribution of production i.e.
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