Question

Explain in detail the conditions that would cause firms to enter or exit a perfectly competitive market. What is the effect of this entrance and exit on the market and long-run profitability of competitive firms?

Answer 1

In a competitive market, firms enter only in the long run when there are economic profits earned by existing firms in the market. This is because firms required no initial investment which suggests that entry is free. Similarly, new firms do not enter and existing firms exit only in the long run when there are economic losses borne by these existing firms in the market. This is because firms can avoid bearing the fixed cost which suggests that exit is free in the long run.

When entry occurs, new firms start producing and supplying in the market at the existing price. This raises the supply and so supply curve shifts to the right. With a reduction in price each firm faces, the existing firms that were earning economic profits in the short run, will now find their profits declining since price is reducing but cost remain unchanged. This ultimately eliminates all the economic profits and this stops the entry of new firms.

When exit occurs, existing firms start leaving the market in the long run. This reduces production and so this decreases the supply and so supply curve shifts to the left. With an increase in price each firm faces, the existing firms that were bearing economic losses in the short run, will now find their losses declining since price is increasing but cost remain unchanged. This ultimately eliminates all the economic losses and this stops the exit of existing firms.

In both cases, long run has no economic profits for any working firm and all of them earn only normal profits.