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Questions
Explain the implication of ‘freedom of entry and exit to the firms’ under perfect competition.
Briefly discuss the 'implication of 'freedom of entry and exit' under perfect competition.
Solution
The basic implication of the feature of freedom of entry and exit for firms under perfect competition is that all firms in the market earn zero economic profit in the long run. Each individual firm is able to operate at the point where the minimum of the long-run average cost curve (LAC) is tangent to the price line. This implies that the firm neither earns supernormal profits nor suffers abnormal losses.
If the firms are earning supernormal profits (that is, the price is greater than the minimum of LAC, then it attracts new firms to the market. Consequently, the total output in the industry increases and the price falls. The price continues to fall until it reaches the minimum of the LAC curve and the super-normal profits are wiped out.
As against this, if the firms are suffering abnormal losses (that is, the price is less than the minimum of LAC, then it leads some of the firms to exit the market. Consequently, the total output in the industry falls and the price rises. The price continues to rise until it reaches the minimum of the LAC curve and the abnormal losses are wiped out.
Thus, the freedom of entry and exit of firms under perfect competition implies that all firms earn only normal profits in the long run.
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