Question

There exists under perfect competition a free entry and exit of firms.

Short answer

Question: Explain how the concept of perfect competition leads to free entry and exit of firms in the market. Answer: The concept of perfect competition leads to free entry and exit of firms in the market due to its unique characteristics. These include having many buyers and sellers trading homogenous products, and no barriers to entry or exit. Firms can easily enter the market when there are profits to be made, which increases competition and drives down prices. On the other hand, if a firm operates at a loss, it can exit the market without incurring any exit costs, allowing remaining firms to regain profitability. In the long run, perfect competition reaches a state of equilibrium in which economic profits are zero, ensuring no incentives for new firms to enter or for existing firms to exit the market.

Step-by-step solution

Introduction to Perfect Competition

Perfect competition is a market structure where there are many buyers and sellers, the products offered by the firms are identical, and there is no barrier to entry or exit. There is also perfect information available to all participants. Under perfect competition, individual firms have no market power and are price takers. This means that the price of goods and services are determined by market forces, i.e., supply and demand.

Characteristics of Perfect Competition

In perfect competition, the following characteristics are present: 1. Many buyers and sellers: There are numerous buyers and sellers in the market, making it difficult for any single buyer or seller to influence the market price. 2. Homogeneous products: The products offered by the firms in the market are identical or homogenous. Buyers have no preference for the products offered by a particular seller over the ones offered by another seller. 3. Free entry and exit of firms: There are no barriers to entry or exit in the market. Firms can freely enter or exit the market without incurring any costs. 4. Perfect information: All market participants have access to the same information about the prices and quality of products offered by different sellers.

Implications for Entry and Exit of Firms

Due to the characteristics of perfect competition, it has particular implications on the entry and exit of firms in the market: 1. Firms can freely enter the market: When there are profits to be made in the industry, new firms can easily enter the market without facing any barriers. This results in an increase in competition and downward pressure on price and profits. 2. Firms can easily exit the market: If a firm operates at a loss, it can exit the market without incurring any exit costs. This leads to a decrease in industry supply and upward pressure on price, allowing remaining firms to improve profitability. 3. Long-run equilibrium: In the long run, under perfect competition, the process of entry and exit continues until economic profits are zero. When economic profits are zero, there are no incentives for new firms to enter the market, and there are no incentives for existing firms to exit. This leads to a long-run equilibrium where the market price equals the minimum average total cost of production. By understanding the characteristics of perfect competition and the implications on entry and exit of firms, it becomes clear how perfect competition facilitates free entry and exit of firms in the market.