Question

Suppose steel manufacturers in the United States earned a rate of return on capital of 4%. Pretend that there are many producers of steels, steel is a homogenous product and there is free entry an exit into the steel industry. Further suppose that the average rate of return on capital for ALL manufacturing was 10%. a) What would you expect to happen to the number of firms in the steel industry? Explain why. Now, suppose that the US bans all imports of steel into the United States. b) What would you expect to happen to the price of steel in the US? Explain why. What would you expect to happen to the profitability of steel manufacturers in the US? Explain why. What would you expect to happen to the number of steel manufacturers in the US? Explain why. Now, suppose after a few years, the ban on the imports of steel into the United States is lifted. c) What would you expect to happen to the price of steel in the US? Explain why. What would you expect to happen to the profitability of steel manufacturers in the US? Explain why. What would you expect to happen to the number of steel manufacturers in the US? Explain why.

Answer 1

a) The number of firms in the steel industry would increase because of the positive rate of return on capital in the steel industry. Given that there is free entry and the product in steel industry is homogeneous, we have a perfect competition scenario and the capital owners will enter the steel market to earn the positive profit.

b)

On ban of imports: Now the price of steel will increase after ban of import. This is because the supply of steel in US becomes upward after ban on imports sloping implying that increase in price of steel will increase the quantity supplied of steel in contrast to the previous scenario where with free imports any amount of the steel can be purchased at the world price which is below the domestic equilibrium price. So after the ban on imports of steel is imposed, the economy returns to the domestic market equilibrium which imply a higher price.

The profitability of the steel manufacturers will increase because of the increase in the price of steel after ban on imports is introduced. The profitability refers to the rate of return on capital which is determined directly by the price of output (r = P*MPK, where P is the price of output here steel). So when P increases the rate of return or the profitability increases.

The number of steel manufacturers in US will increase further (than in part (a)). Because oif the increased rate of return on capital owing to the increase in price of steel after the ban on import of steel

c) When Ban is lifted:

The price of steel will fall. This is because if the increased supply from the rest of the world. This increase in the supply will reduce the price to the world level at which there is perfectly elastic supply of steel.

The profitability of the steel manufacturers will reduce because of the fall in price of the steel in the domestic market. The profitability depends on the value of the marginal product of the capital in the steel industry. So when price falls due to opening of trade, the return on capital r = Pw*MPK, Pw(world price of supply)<Ps, the price of steel that existed before the ban on imports was lifted.

Due to fall in profitability the number of steel firms will reduce because the steel manufacturing firms will exit market. This exiting market will continue until the profits/losses are reduced to zero.