Question

Explain the significance of free entry and free exit under perfect competition. How does it ensure normal profit in the long-run?

Answer 1

1. Efficient Allocation of Resources:
   • New firms enter when profit is possible, increasing supply and reducing prices.
   • Loss-making firms exit, reducing supply and increasing prices.
   • This keeps the market balanced.
2. Encourages Competition:
   • Free entry ensures that no firm can earn excessive profit for long.
   • This leads to better prices, quality, and efficiency.
3. Market Self-Correction:
   • The market automatically adjusts based on profits/losses without external control.

Normal profit means zero economic profit; the firm covers all costs, including opportunity costs, but it earns no extra profit.

1. If firms earn supernormal profit, new firms enter the market.
   • This increases supply, which causes the price to fall.
   • Profit reduces until only normal profit remains.
2. If firms face losses, some will exit.
   • This reduces supply, raising price.
   • Losses reduce, and remaining firms earn normal profit.

Thus, free entry and exit ensure that in the long run, firms in perfect competition earn only normal profit.