Suppose the price at which 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?
When the equilibrium price is above the minimum average cost of the firms, they will earn supernormal profit. This situation attracts new firms to enter the market, attracted by the prospect of earning higher profits.
As new firms enter the market, the market supply increases. This increase in supply leads to a fall in the market price. The process of entry of new firms continues as long as the price remains above the minimum average cost and firms are able to earn supernormal profit.
The price will continue to fall until it becomes equal to the minimum average cost. At this price level, each firm earns normal profit so that no new firm is 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.
Thus, with free entry and exit of firms, the market price will adjust and ultimately become equal to the minimum average cost of the firms, that is:
p = min AC
At this equilibrium price, the quantity supplied will be determined by the market demand at that price.
Explanation
The textbook context clearly explains the adjustment mechanism under free entry and exit. When price is above minimum AC, supernormal profits attract new firms. Entry increases supply, pushing price down until it equals minimum AC where firms earn only normal profit. This is a fundamental result in perfect competition with free entry and exit.
Solution Steps
Step 1: Identify that price above minimum AC creates supernormal profit
Step 2: New firms enter the market attracted by supernormal profit
Step 3: Market supply increases, causing price to fall
Step 4: Price falls until p = min AC where firms earn normal profit
Step 5: Entry stops at equilibrium where no incentive for entry or exit exists