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Market Efficiency

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Market Efficiency

Are you an efficient learner? Can you grasp concepts quickly and go to the next step of applying them straight away? In another case, someone may need to go into all the little details to understand how something works. Well, we are all different. Regardless of your answer, market efficiency in economics is distinct from how you are possibly used to thinking about the word. Don't worry; we are here to help you understand market efficiency with the utmost proficiency! No pun intended. You will have to stick around for a little longer, though! If you are ready, then let's get started!

Market equilibrium vs. efficient equilibrium

Let's start comprehending the idea of market efficiency by comparing and contrasting a simple market equilibrium vs. an efficient equilibrium. Standard market equilibrium occurs when supply is equal to demand at a specific price. An efficient market equilibrium is best described by looking at a perfectly competitive market. This will be our benchmark for defining an efficient market equilibrium.Consider a perfectly competitive unregulated market with perfect information and externalities nonexistent. Of course, all the conditions for a perfectly competitive market should hold. Then the market equilibrium will look like the one in Figure 1 below.

Need more certainty about the conditions that have to hold for a perfectly competitive market?We've got you covered!Check out this article:- Perfectly Competitive Market.

Market Efficiency Efficient market equilibrium graph StudySmarterFig. 1 - Efficient market equilibrium

Figure 1 above shows an efficient equilibrium in a perfectly competitive market. At price P and quantity Q, equilibrium occurs such that both the producer surplus, represented by the yellow area, and the consumer surplus, represented by the triangle shaded in purple, are maximized. This shows a market that has achieved economic efficiency.

Market or economic efficiency occurs when producer and consumer surpluses are maximized.

Imagine now that a government implements price controls through a price ceiling. The goal that the government has in mind is to help increase consumer welfare by lowering prices. What would the consequences of such a decision be for market efficiency? Let's take a look at Figure 2 below.

Market Efficiency Graph showing effect of price control on market efficiency  StudySmarterFig. 2 - Effect of price control on market efficiency

Figure 2 above shows the effect of price control on market efficiency. The initial equilibrium was at the intersection of the demand and supply curves at price P and quantity Q. However, after the suppliers had to lower their prices due to the imposed price ceiling at P1, a deadweight loss occurred. Wait, wasn't the price ceiling supposed to improve the well-being of the consumers in this market?

Deadweight loss is a net loss of producer and consumer surplus in a market due to inefficiency.

Although some consumers benefitted from lower prices, others did little. At a lower price of P1, more consumers are willing to buy the product, resulting in a market shortage. The deadweight loss (DWL) illustrated by the triangle shaded in red occurs due to this reduction in quantity. Government intervention resulted in reduced market efficiency in this case. In the aggregate, producers plus consumers are worse off than they were without government intervention.

Did we get you interested in these topics?We have more waiting for you, so check out the following:- Price Ceilings;- Price Floors.

Market efficiency examples

Let's go over some examples of market efficiency to sharpen our understanding.

We will consider the effects of the following government interventions on market efficiency:

  1. Tax;

  2. Subsidy.

Imagine the government introducing a tax in the market. The effects of the tax are illustrated in Figure 3 below.

Market Efficiency Graph showing tax effect on market efficiency StudySmarterFig. 3 - Tax effect on market efficiency

Figure 3 above shows the market's initial equilibrium, where the supply and demand curves intersect. A government tax results in consumers paying a higher price (P2 compared to Pe) and producers receiving a lower price (P1 compared to Pe). A lower quantity is now exchanged in the market (Q2 compared to Qe). Consumer and producer surplus both reduce at the expense of the tax revenue, shaded in green, that goes to the government. But that is not the end of the story. Due to a reduction in quantity from Qe to Q2, a deadweight loss (DWL) occurs. A tax introduced by the government led to a reduction in overall market efficiency.

Let's consider the effect a government subsidy would have on market efficiency. The results of the subsidy are illustrated in Figure 4 below.

Market Efficiency Graph showing subsidy effect on market efficiency  StudySmarterFig. 4 - Subsidy effect on market efficiency

Figure 4 above depicts a subsidy provided by the government which increases the corresponding consumer surplus, shown by the area highlighted in purple, and producer surplus, shown by the area highlighted in yellow. The increase in producer surplus results from an increase in the price they receive for their product (P3 compared to Pe). An expansion of consumer surplus comes from the lower price they pay for the product (P2 compared to Pe). It seems like the subsidy intervention had increased market efficiency in this case. Yes and no. Although both consumer and producer surplus increased, a more significant improvement in market efficiency could have been attained at the higher quantity (Q2 compared to Qe) now exchanged in the market. The deadweight loss triangle highlighted in red shows that not all of the efficiency was attained.

Discover more in our article - Taxes and Subsidies!

Market efficiency vs. market failure

What is the difference between market efficiency vs. market failure? Market efficiency is the opposite of market failure. If the market is fully efficient, then there is no market failure. In contrast, if a market loses some of its efficiency, the degree of market failure increases.

Market failure occurs when the price mechanism fails to provide correct signals to producers and consumers, resulting in inefficient resource allocation.

There are two major contributors to market failure:

  1. Externalities;

  2. Incorrect types or a lack of information.

Let's take a look at each of these in turn!

Externalities and market efficiency

What effect do externalities have on market efficiency? Externalities occur when unintended consequences have spillover effects on other parties outside of a transaction mechanism.Externalities result in market failure due to a deadweight loss that they bring. Consider Figure 5 below.

Market Efficiency Graph showing externality and market efficiency StudySmarterFig. 5 - Externality and market efficiency

Figure 5 above shows how a negative externality causes a welfare loss and a decrease in market efficiency due to pollution. The market is initially at a point where the marginal private cost curve (S0=MPC) intersects the demand curve (D). For simplicity, we assume that the marginal private benefit is equal to the marginal social benefit and equal to demand (MPB=MSB=D).The pollution is too high at price P0 and quantity Q0 because the higher cost to society, or the spillover effect, is ignored. This results in a deadweight loss, shown by the red triangle DWL.The government can intervene to reduce this welfare loss and improve market efficiency by introducing a tax on the producer. A surcharge will shift the supply curve from S0 to Stax, bringing the marginal private cost (MPC) to the marginal social cost (MSC). The quantity of pollution, therefore, drops from Q0 to Qtax eliminating deadweight loss and improving market efficiency.

Learn more in our article - Externalities!

Externalities occur when unintended consequences have spillover effects on other parties outside of a transaction mechanism.

Types of information market efficiency

What effect do the different types of information have on market efficiency?

A lack of information or incorrect types of information can result in decreased market efficiency.

Perfect information occurs when consumers and producers have access to all the available information relevant to the market transaction.

When information is not perfect, something economists call 'imperfect information,' market efficiency is reduced, and market failure can occur.In a situation of adverse selection, where the buyer does not have sufficient information about the product, they may be misled into buying a substandard quality product at a price higher than their willingness to pay. This would result in a decreased consumer surplus for the buyer and a reduction in overall market efficiency.

Dive deeper into these topics by clicking here:- Adverse Selection;- Asymmetric Information.

Market efficiency finance

Market efficiency in finance is different from market efficiency in economics. Market efficiency in finance refers to the asset market prices correctly conveying the information about the returns that these assets can generate. Because prices reflect all the available information, no investor can generate an excess return by predicting where the asset price will move. This is at the core of the Efficient Market Hypothesis first stipulated by Eugene Fama in the 1960s.

We've got you covered in the area of finance too!Make sure to check out the following articles:- Financial Economics;- Security Market Line;- Efficient Market Hypothesis.

Market Efficiency - Key takeaways

  • Market or economic efficiency occurs when producer and consumer surpluses are maximized.
  • Deadweight loss is a net loss of producer and consumer surplus in a market due to inefficiency.
  • Market failure occurs when the price mechanism fails to provide correct signals to producers and consumers, resulting in inefficient resource allocation.
  • There are two major contributors to market failure:
    1. Externalities;
    2. Incorrect types or a lack of information.
  • Externalities occur when unintended consequences have spillover effects on other parties outside of a transaction mechanism.Perfect information occurs when consumers and producers have access to all the available information relevant to the market transaction.

Frequently Asked Questions about Market Efficiency

Market or economic efficiency occurs when producer and consumer surpluses are maximized.

Market failure occurs when the price mechanism fails to provide correct signals to producers and consumers, resulting in inefficient resource allocation.

There are two major types of market failure:
1. Market failure resulting from externalities;
2. Market failure due to a lack of information.

The importance of market efficiency results from the fact that both consumer and producer surpluses are maximized. In other words, given the unregulated free market, the price and quantity of the product sold are such that consumer and producer welfare are both maximized.

The characteristics of an efficient market are the same as those of a hypothetical perfectly competitive market.

Final Market Efficiency Quiz

Question

What is the Laffer curve?

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Answer

Laffer Curve depicts the relationship between the tax rate and tax revenue.

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What does the Laffer curve show?

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It shows that as tax rates increase from 0%, tax revenue increases; however, after a specific tax rate, tax revenue begins to fall, reaching zero at a 100% tax rate.

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Is the Laffer curve valid?

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The Laffer curve is valid as an economic theory. Nevertheless, its practical implications are not agreed upon by economists.

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How to graph a Laffer curve?

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The tax rate is plotted on the horizontal axis, while the tax revenue is plotted on the vertical axis. At the tax rate of 0%, tax revenue is zero. An increase in the tax rate up to the maximum tax rate leads to increased tax revenue. As the tax rate climbs past the maximum tax rate point, tax revenue begins to fall until reaching zero at a 100% tax rate.

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Why is the Laffer curve important?

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Laffer Curve is critical because it was widely used in the US federal government policy and affected many people.

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Who gave the concept of the Laffer Curve?

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Arthur Laffer is an economist who, in 1974, came up with the idea of the curve, later named after him, that shows the relationship between the tax rate and tax revenue.

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What does the Laffer Curve plot?

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Laffer Curve plots the relationship between the tax rate and tax revenue.

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What is the income effect?

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The income effect occurs when individuals decrease their working hours after the wage increases. This is because people demand more leisure when their income is higher.

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What is the substitution effect?

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The substitution effect occurs when individuals increase their working hours in response to a wage increase. Working has become more attractive compared to leisure when the wage is higher.

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Critiques of the Laffer Curve suggest that the labor supply curve is ____

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backward bending.

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There is no consensus on how the behavior of individuals would change in response to tax cuts.

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True.

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It is practically impossible to calculate the effects of a tax cut because elasticities of demand and supply in the labor market are difficult to calculate.

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True.

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What is a quota?

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A quota is a regulation set in place by the government that restricts the quantity of a good over a certain period.

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What is deadweight loss?

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Deadweight loss is the combined loss of consumer and producer surplus due to the misallocation of resources.  

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What is the purpose of a quota?

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Quotas are a type of protectionism meant to keep prices from falling too low or rising too high.

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___________ is the additional revenue foreign producers earn as a result of the domestic price increase associated with a reduced supply. 

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Quota rent

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True/False: Like a tariff, a quota only applies to imported goods.

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False, they can apply to production and exports as well.

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True/False: The benefits of a quota to producers outweigh the costs to consumers.

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False. The gains that producers make typically do not exceed the cost to consumers of these quotas.

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If a government wants to earn a share of import profits, should they employ a quota or a tariff?

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A tariff, quotas do not earn the government any money.

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What is a combination of a tariff and a quota called?

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A tariff-rate quota.

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If a country is experiencing a shortage of textiles because foreign prices are higher than domestic prices and producers are exporting all their goods, what can the government do?

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They can set an export quota to limit the number of textiles that can be exported. 

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A firm is producing hundreds of thousands of cheap cars and flooding the market causing prices to fall. What can the government do to limit the number of cars this firm is producing?

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They can set a production quota that limits the number of cars this firm can produce in a year. 

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When is a quota more effective than a tariff?

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A quota is more effective when the government wants to actively limit the amount of a good in the economy.

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How do import quotas increase domestic prices, and who benefits from this?

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They increase domestic prices by reducing the total number of goods available in the domestic market. Producers benefit because they are able to sell their goods at a higher price since they do not have to compete with foreign producers anymore.

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How do quotas cause deadweight loss?

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The quota prevents the market from reaching its natural equilibrium by keeping domestic prices above the global market price, making it inefficient.

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Why might a government choose to set a quota?

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To limit the amount of a good being imported, exported, produced, or harvested.

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How might quotas be used to protect natural resources?

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Quotas like Individual Transferable Quotas (ITQ) can be used to limit the number of natural resources that can be harvested, like fish and catch quotas that limit the number of fish that can be caught. 

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What is a tariff?

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A tariff is a tax on imported goods. 

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True/False: All taxes are tariffs but not all tariffs are taxes.

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False, because a tariff is a tax on imported goods but there are other taxes that apply to domestic goods and those are not tariffs.

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What is a quota? 

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quota is a limit on the quantity of a good that can be imported.

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What is quota rent?

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Quota rent is the profit that foreign producers are able to earn when a quota is put in place. The amount of quota rent is the size of the quota multiplied by the change in price.

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What are the four types of tariffs?

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The four types of tariffs are ad valorem tariffs, specific tariffs, compound tariffs, and mixed tariffs.

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An importer has to pay a 10.6% tax on a $56,000 car that they are importing. What type of tariff is this?

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An ad valorem tariff.

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You want to import 50,000 sticks of butter. At the border, they tell you that you have to pay $0.12 per stick. What type of tax are you paying?

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You are paying a specific tariff.

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Joe wants to start importing cheese. When he asks the government how much tariff he will have to pay, they tell him that he will have to either pay $4 on each pound of cheese or 20% of the value of the shipment. What type of tariff is this?

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This is a compound tariff.

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When Marge imports chocolate, she has to pay $10 for each pound of chocolate and 11% of its value. What type of tariff is this?

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This is a mixed tariff.

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Who profits from a tariff?

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The government and domestic producers.

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Who or what is negatively impacted by tariffs?

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Domestic consumers, importers, free trade, nations subjected to the tariff, and political relations.

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Why might a government set a tariff?

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The federal government imposes tariffs as a way to protect domestic industries, keep prices high, and as a source of revenue.

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What effect do tariffs have on free trade?

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Tariffs interrupt the flow of resources from one country to the next, risking reduced economic growth. This limits free trade because it prevents the economy from adjusting itself and finding equilibrium.

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What is a good or service called that is produced abroad and sold domestically?

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An import.

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What is a good or service called that is produced domestically and sold abroad?

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An export.

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True/False: For a good to be considered an import it has to be brought in by a domestic importer.

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False, a foreign company can also bring their goods over to sell them directly.

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What happens to the domestic price of a good when a country starts importing the good?

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The domestic price decreases because it has to compete with the world price. 

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Why do imports not have an effect on GDP?

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Because GDP calculates the total value of goods produced domestically and even if we include the consumption of imports in the "consumer spending" section, it is canceled out when it is subtracted under the "imports" section.

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Does having a high volume of imports cause inflation?

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No, it reduces inflation and in some cases even causes deflation because if a nation consumes many cheaper foreign goods, domestic prices will have to come down to compete with the world price.

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Explain how having a high volume of imports affects the exchange rate.

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If a nation buys a lot of goods from another, they require the foreign nation's currency. This increases demand for the foreign currency which increases its value. The exchange rate will increase as the foreign currency becomes more valuable than the domestic one.

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What are some benefits to importing goods?

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They provide product diversity, more types of goods and services, reduce costs, and allow for industry specialization.

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What are imports that are considered consumer goods?

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Cell Phones, Toys, Games, Jewelry, Footwear, Televisions, Toiletries, Rugs, Glassware, Books, etc.

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How do imports increase product diversity?

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They introduce products into the market that may have not been available domestically. 

Example: importing a special cheese that can only be produced in its native climate.

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