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2) When the signal is "dithered" to make the noise less "correlated", and hence less noticeable. The dithering noise that is added by the codec appears to be the larger effect, and to be more responsible for the increase in noise levels on repeated encodings. Is this correct, or have I misinterpreted what I've read?
No, no. It is a different matter. Most commonly dithering is used when mastering CDs (after resampling from 20-24bit to 16bit) - for the reasons you stated - to decorrelate qunatisation noise - in this case, the noise is basically 1-2 bit only, caused by rounding-off errors.
(This type of dithering can also be done by lossy decoder sometimes, but not encoder.)
The quantisation noise introduced by lossy encoder is of orders of magnitude larger than dither noise. It depends on the ATH, masking etc.
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A given high note overtone on the piano, for example, might be retained by the codec if it is played alone, but discarded if it overlaps with a great wallop on the bass drum. Is this right?
Yes.
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And finally, there is temporal/frequency smearing, caused by the impossibility of reproducing a perfectly sharp transient in time without an infinite number of frequencies, and vice-versa. I would suspect that this might be the least significant of the three effects.
What you say ("impossibility....") is true for continuous signal. Descrete transient signal can be perfectly reconstructed from finite number of descrete transform coefficients (= number of samples). Well, I'm sure you knew it.
So, the smearing problem is somewhere in the combination of the used filters and window functions.
The evilness of smearing is in that its width doesn't depend on the bit-rate. It's related to the encoder window width.
E.g. transcoding from 320kbps to 320 kbps will add little quantisation noise, but smearing is always present.
So it is a very signigicant effect too. People who are very sensitive to pre-echo will suffer more (as the smearing can quickly escape outside of the pre-echo threshold)