Question

What is the significance of ‘freedom of entry and exit of firms’ under monopolistic competition?

Answer 1

1. The freedom of entry and exit of firms under monopolistic competition holds great significance in maintaining the balance of the market in the long run. This feature allows new firms to enter the market freely when existing firms are earning supernormal profits.
2. As new firms enter with similar but differentiated products, competition increases, which reduces the demand and market share of existing firms. This process continues until all firms earn only normal profits.
3. On the other hand, if some firms are incurring losses, they are free to exit the market. The reduction in the number of sellers decreases overall supply, causing prices to rise and losses to be eliminated. This process ensures that only those firms that can cover their costs and earn normal profits remain in the market.
4. Thus, freedom of entry and exit under monopolistic competition leads to a self-adjusting mechanism where firms earn neither excess profit nor suffer long-term losses, maintaining equilibrium in the market.