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Abstract

This paper develops a partial equilibrium model of a small open-economy producing and trading an unsafe product that is supplied by perfectly competitive producers. The presence of product safety considerations, in this case risks to health, introduces a wedge between the market prices producers receive and the higher risk-adjusted prices consumers respond to. The size of the wedge depends positively on the per-unit cost of illness and the proportion of unsafe units embodied in the parent risky product. The model is used to analyze the welfare effects of trade with and without a country-of-origin labeling (COOL) program. Assuming imports are less safe than domestic production, the welfare gains from trade in the absence of COOL are ambiguous and may justify the imposition of a trade ban. Even if a full ban does not improve welfare, some restriction of trade is always welfare-enhancing. These outcomes derive from an informational distortion that prevents consumers from distinguishing the different country-specific risks embodied in the foreign and domestic products resulting in a pooling equilibrium. The presence of a COOL program removes the informational distortion and generates a welfare maximizing separating equilibrium in which the safer (domestic) product commands a higher market price. In the presence of a COOL program, more trade - caused by a reduction in protection - is better than less trade.

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