Economics (NCERT) Notes

5.6 Market Equilibrium: Free Entry and Exit

Free entry and exit of firms
•Earlier, the market equilibrium was studied under the assumption that there is a fixed number of firms.
•In this lesson, we will study market equilibrium when firms can enter and exit the market freely.

Assumptions
•We assume that all the firms in the market are identical.
•It implies that in equilibrium no firm earns supernormal profit or incurs loss by remaining in production;
•It means that the equilibrium price will be equal to the minimum average cost of the firms.

If firms are earning supernormal profit
•Suppose that at the prevailing market price, each firm is earning supernormal profit.
•It will then attract some new firms.
•As new firms enter the market, supply curve shifts rightward (increases), but the demand remains unchanged.
•This causes market price to fall.
•As prices fall, supernormal profits are eventually wiped out.
•At this point, with all firms in the market earning normal profit, no more firms will have incentive to enter.

Market Price at free entry and exit
•Firms will earn supernormal profit so long as the price is greater than the minimum average cost.
•At prices less than minimum average cost, they will earn less than normal profit.
•Therefore, at prices greater than the minimum average cost, new firms will enter, and at prices below minimum average cost, existing firms will start exiting.
•At the price level equal to the minimum average cost of the firms, each firm will earn normal profit so that no new firm will be attracted to enter the market. Also the existing firms will not leave the market since they are not incurring any loss by producing at this point. So, this price will prevail in the market.
•Therefore, free entry and exit of the firms imply that the market price will always be equal to the minimum average cost, i.e. p = min AC

Price Determination with Free Entry and Exit
•With free entry and exit in a perfectly competitive market,
•the equilibrium price is always equal to min AC and
•the equilibrium quantity is determined at the intersection of the market demand curve DD with the price line p = min AC.

Equilibrium number of firms
•At p0 = min AC each firm supplies same amount of output (q0f)
•Therefore, the equilibrium number of firms in the market is equal to the number of firms required to supply q0 output at p0, each in turn supplying q0f  amount at that price.
•If we denote the equilibrium number of firms by n0, then
n0 = q0/ q0f

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