International Trade - Theory and Policy, 2010a

Now suppose the price of steel increases exogenously. The immediate effect will be to raise the value of
the marginal product of steel, shifting up VMPS 1 to VMPS 2 . The new equilibrium is given at point F. At F,
labor allocated to steel production will have risen to OSB, while labor used in textiles will have fallen
to OTB. The equilibrium wage increases to w2.
The intuition for these changes follows from the underlying dynamic effects. At first, when the price of
steel rises, the wage and rental rates remain fixed. This means steel revenue rises while costs remain the
same, stimulating an increase in steel profits. Positive profit, in a perfectly competitive market, induces
new entry of firms into steel production, expansion of current firms in the industry, or both. To expand,
steel must induce workers to move over from textile production. This requires an increase in the wage
since labor demand temporarily exceeds labor supply. To prevent all the labor from shifting to steel, the
textile industry must raise the wage to its workers as well. As labor shifts from textiles to steel and as the
wage rises, the costs of production in steel and textiles rise. In steel, this erodes the temporary profits it
was making. Textiles respond to the higher costs by cutting production and releasing workers. Remember,
there is no ability to expand capital inputs in steel since we assume steel’s capital stock is fixed
exogenously in size, and due to specificity, capital cannot be moved in from the textile industry. In the
end, industry profits are driven to zero in both industries once the wage rises sufficiently.
Saylor URL: http://www.saylor.org/books
Saylor.org
248