Market Equilibrium - Free Entry and Exit

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Market Equilibrium

Market Equilibrium is the state where the market supply and demand balance each other well, which results in stabilizing the prices. Practically, an over-supply of the goods or services causes the prices to go down, this results in higher demand. While an under-supply or shortage causes the prices to go up resulting in lessening the demand. The balancing effect of supply and demand gives rest in a state of equilibrium.

In this context, we will know about the market equilibrium that resides in a Free Entry and Exit situation.

Market Equilibrium Free Entry and Exit

The students are quite clear on the presumption of market equilibrium where the market has a fixed number of firms. While, let us face the reality here, where no markets are actually confined to a specific number of firms. So, in this section, we will study the market equilibrium where the enterprises can enter and exit the marketplace according to their will. 

The presumption of free entry and exit implies that in equilibrium, there is no enterprise that earns a supernormal profit or sustains an acute loss by remaining in the production. The equilibrium cost price will be equal to the minimum average cost of the enterprises.

Suppose, the market has a possibility of earning a supernormal profit, this will attract some enterprises to freely enter the market and compete. Thereby, they distribute the profit incurred in between them resulting in all the firms earning normal profit. 

Now with new firms joining the profit-oriented market this will result in:

  • The market supply curve will shift rightward. The demand remains constant.

  • This will cause the market cost price to decrease

  • When the prices decrease, the supernormal profits are chalked out

  • After all the enterprises in the market start to earn a normal profit, no more enterprises will be attracted to enter the market.

  • Likewise, if the enterprises are earning less than normal profit, then some enterprises will exist which will lead to an increase in the cost price, and with a lesser number of enterprises, the profits of all the enterprises will rise to the degree of normal profit.

Definition of Market Equilibrium 

This is a situation where for a particular good, supply = demand. When this market is in equilibrium, then there is no tendency for the prices to change. 

Market equilibrium can be represented by using the supply and demand diagrams

In the diagram following, the equilibrium price is P1. The equilibrium quantity is Q1.

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In Case the Price is Below the Equilibrium 

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In the above diagram, the price which is P2 is below the equilibrium. Here the price, demand is greater than the supply. Hence, there is a shortage of (Q2 – Q1)

If there is a shortage, the firms will put up prices and then supply more. As the price rises, there will be a movement along the demand curve and there will be less demand.

The price will rise to P1 until there is no shortage. While supply = demand.

If the Price is Above the Equilibrium

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If the price was at P2, this would be above the equilibrium of P1. At the price of P2, then supply (Q2) would be greater than the demand (Q1) and therefore there is too much supply. There is a surplus. (Q2-Q1)

Therefore, the firms would reduce this price and then the supply less. This would encourage more demand and the surplus will be eliminated. Then the new market equilibrium will be at Q3 and P1.

Movements to a New Equilibrium

1. Increase in Demand

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If there was an increase in income the demand curve would shift to the right (D1 to D2). Initially, then there would be a shortage of the good. Therefore, the price and the quantity supplied will increase leading to a new equilibrium at Q2, P2.

2. Increase in Supply

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An increase in supply will lead to a lower price and more quantity sold.

FAQ (Frequently Asked Questions)

1. Which Market Has Free Entry and Exit?

Ans. The Perfectly competitive markets are identified by very low costs of entry and exit. Furthermore, the firms in a perfectly competitive market have lesser market power and so they are price-takers, they take the prevailing market price as given rather than setting their own price, hence they are known as the price takers. 

Free entry is a term that is used by economists to describe a condition where the sellers freely enter the market for an economic good by establishing their production and beginning to sell the product. Along these same lines, the free exit occurs when a firm can exit the market without limit then economic losses are being incurred.

2. What Do You Mean By Average Cost?

Ans. In economics, we mean average cost as the unit of the cost that is equal to the total cost (TC) which is divided by the number of units of a good that is produced (the output Q). The average cost has strong implications on how firms will choose to price their commodities in their strategy.

The Average Cost is the per-unit cost of production which is obtained by dividing the total cost (TC) by the total output (Q). Per unit cost of production, means that all the fixed and variable cost is to be taken into the consideration for calculating the average cost. Hence, it is also called Per Unit Total Cost.

3. Explain Supply and Demand.

Ans. Supply and demand, in economics, means the relationship between the quantity of a commodity that the producers wish to sell at various prices and the quantity which the consumers wish to buy. The resulting price is referred to as the equilibrium price and this represents an agreement between the producers and the consumers of the good.