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Question:

Suppose the price at which the equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it?

Answer:

In the equilibrium price (Rs 8) in the above figure (of Q-5) is above the minimum of average cost, then it implies that the firm is earing supernormal profits. This situation will attract new firms in the market. As the new firms entre, the industry supply of output will also increases. New firms will continue to enter the industry that will leads the price to fall until it becomes equal to the minimum of the average cost. Thus, the supernormal profits are wiped out and all the firms earn normal profits. When the free entry and exit of firms is allowed, the equilibrium is determined by the intersection of demand curve and the ‘P = min AC’ line.


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