Q.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 in a market is above the minimum average cost ($P > min AC$) of the firms, it implies that existing firms are earning positive economic profits (also known as supernormal profits).

With the allowance for free entry and exit of firms, these positive economic profits act as an incentive for new firms to enter the market. As new firms enter, the overall market supply of the good increases. Assuming the market demand curve remains unchanged, this increase in market supply will cause the equilibrium price to fall.

This process of entry and price reduction will continue until the market price falls to the level of the minimum average cost. At this point, economic profits become zero, removing the incentive for further entry, and the market reaches its long-run equilibrium. …

Let's understand the core concept of market equilibrium and the role of free entry and exit in a perfectly competitive market. In such a market, firms are price takers, and the market price is determined by the intersection of overall market demand and market supply. The concept of "free entry and exit" is crucial because it dictates how the market adjusts to profit opportunities or losses in the long run.

When the equilibrium price is above the minimum average cost of the firms, it means that firms are earning supernormal profits (also known as economic profits). Average cost represents the cost per unit of output, and the minimum average cost is the lowest point on a firm's average cost curve, indicating the most efficient scale of production. If the price received for each unit is higher than this minimum average cost, firms are making more than just normal profits (which cover all explicit and implicit costs, including the opportunity cost of capital and entrepreneurship).

Here's how the market price will adjust with free entry and exit:

1. Incentive for Entry: The existence of supernormal profits acts as a strong signal and incentive for new firms to enter the market. Since there are no barriers to entry (a characteristic of free entry), new firms will be attracted by the prospect of earning these higher-than-normal returns.

2. Increase in Market Supply: As new firms enter the market, the total number of producers increases. Each new firm contributes to the overall quantity of goods supplied to the market. Consequently, the aggregate market supply curve shifts to the right. This means that at every possible price, a larger quantity of the good is now offered for sale.

3. Downward Pressure on Price: With an increase in market supply, and assuming the market demand curve remains unchanged, there will be an excess supply at the initial equilibrium price. To clear this excess supply and restore equilibrium, the market price must fall. The increased competition from new entrants forces prices down. …