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5.1.2 - Market Equilibrium: Free Entry and Exit

Interactive Audio Lesson

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Introduction to Market Equilibrium with Free Entry and Exit

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Teacher
Teacher

Today, we are discussing market equilibrium in scenarios where firms can freely enter and exit.

Student 1
Student 1

What does it mean when we say firms can enter and exit freely?

Teacher
Teacher

It means that businesses can join or leave the market without facing barriers. This condition ensures that firms will adjust their presence based on the profits they are earning.

Student 2
Student 2

So, if firms make more than normal profits, more firms enter?

Teacher
Teacher

Exactly! This will shift the supply curve to the right, eventually lowering the market price until only normal profits are made.

Student 3
Student 3

And what happens if they are making losses?

Teacher
Teacher

Good question! If firms are earning less than normal profit, some will exit the market, shifting the supply curve leftward, which will increase the price.

Student 4
Student 4

Can you explain what normal profit is?

Teacher
Teacher

Normal profit is the minimum level of profit needed for a firm to stay in business; it's the cost of opportunity for their resources.

Teacher
Teacher

To summarize, with free entry and exit, equilibrium price equals minimum average cost, and firms adjust until only normal profits are earned.

Effect of Demand Shifts

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Teacher
Teacher

Now let’s consider what happens when the market demand curve shifts.

Student 1
Student 1

Does that mean prices change immediately?

Teacher
Teacher

Initially, yes. If demand increases, it creates excess demand at the current price, leading to a temporary rise in prices.

Student 2
Student 2

Does that encourage new firms to enter the market?

Teacher
Teacher

Yes! This is what leads to new firms entering the market, which increases supply and eventually drives prices back down to the minimum average cost.

Student 3
Student 3

What if demand decreases?

Teacher
Teacher

In that case, you'd see excess supply, leading some firms to reduce prices, causing some to exit the market until equilibrium is restored.

Student 4
Student 4

So demand shifts have a significant impact?

Teacher
Teacher

Absolutely! They affect equilibrium quantity but not equilibrium price in the long run under free entry and exit.

Teacher
Teacher

To conclude, shifts in demand shake things up short-term, but equilibrium price stabilizes at minimum average costs over time.

Illustrative Example of Wheat Market

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Teacher
Teacher

Let’s explore an example involving the wheat market to concretize our understanding.

Student 1
Student 1

What are the demand and supply curves for wheat?

Teacher
Teacher

For our example, we can define the demand curve as qD = 200 - p and the supply of a single firm as qS = 10 + p.

Student 2
Student 2

How do we find the equilibrium price?

Teacher
Teacher

We set demand equal to supply. From our equations, we find p = 20. At this price, the total market supply meets the demand.

Student 3
Student 3

And what about firms?

Teacher
Teacher

At p = 20, if each firm supplies 30 kg, we need 6 firms to meet the total market demand of 180 kg.

Student 4
Student 4

So the equilibrium number of firms is 6?

Teacher
Teacher

Exactly! When conditions change, the number can also shift, but equilibrium price remains stable at the min AC.

Teacher
Teacher

In conclusion, understanding the wheat market example helps solidify how equilibrium price and number of firms interact in free entry and exit scenarios.

Introduction & Overview

Read a summary of the section's main ideas. Choose from Basic, Medium, or Detailed.

Quick Overview

This section examines market equilibrium under the assumption of free entry and exit of firms, leading to a situation where firms earn normal profit.

Standard

Market equilibrium occurs when the number of firms can freely enter or exit the market. In such cases, the equilibrium price equals the minimum average cost of firms, preventing supernormal profits. This section discusses how shifts in demand affect equilibrium price and quantity under these conditions.

Detailed

Market Equilibrium: Free Entry and Exit

This section focuses on the implications of having a fluid number of firms within a market, particularly emphasizing free entry and exit. In a competitive market, the lack of barriers for firms means that in equilibrium, no firm earns supernormal profits or incurs losses. The equilibrium price corrects to the point where it equals the minimum average cost (AC) of production, thereby ensuring all firms earn a normal profit.

When supernormal profits exist, new firms are attracted to the market, causing the supply curve to shift rightwards, which lowers prices until only normal profits remain. Conversely, if firms earn less than normal profit, some firms will exit, shifting the supply curve leftwards and increasing prices, thereby restoring normal profits for the remaining firms.

The equilibrium price can thus be expressed as:
p = min AC
In equilibrium, the quantity supplied will meet the demand at this price point. An example involving a market for wheat illustrates this principle clearly.

Moreover, shifts in demand affect equilibrium. If the demand curve shifts right, excess demand can cause prices to rise temporarily until new firms enter, restoring the equilibrium once again at the minimum average cost. Thus, while the quantity supplied and number of firms may vary with changes in demand, the equilibrium price remains stable at the minimum average cost under conditions of free entry and exit.

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Audio Book

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Equilibrium Implications of Free Entry and Exit

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In the last section, the market equilibrium was studied under the assumption that there is a fixed number of firms. In this section, we will study market equilibrium when firms can enter and exit the market freely. Here, for simplicity, we assume that all the firms in the market are identical.

What is the implication of the entry and exit assumption? This assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by remaining in production; in other words, the equilibrium price will be equal to the minimum average cost of the firms.

Detailed Explanation

This chunk explains the basic principles of market equilibrium when firms can freely enter and exit. It highlights that with free entry and exit, the market tends to stabilize at a point where firms make only normal profits. This means no additional firms will be willing to join if profits are normal, and existing firms will not leave if they are not incurring losses. In essence, the equilibrium price in such a market is determined at the minimum average cost of production, ensuring that firms cover their costs without making excess profit.

Examples & Analogies

Consider a farmer’s market where anyone can sell fruits. If one seller starts making a lot of money selling apples, other sellers will want to join in and start selling apples too. This influx of sellers will increase the supply of apples, leading to a decrease in their price until the profits become normal. Eventually, the price will stabilize at a level where no one makes an extraordinary profit, just like how in our example, each seller would earn just enough to cover their costs.

Supernormal Profits and Market Dynamics

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To see why it is so, suppose, at the prevailing market price, each firm is earning supernormal profit. The possibility of earning supernormal profit will attract some new firms. As new firms enter the market supply curve shifts rightward. However, demand remains unchanged. This causes market price to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all firms in the market earning normal profit, no more firms will have incentive to enter.

Detailed Explanation

This chunk discusses the dynamics of market entry when supernormal profits exist. When existing firms earn more than normal profit, it serves as an incentive for new firms to enter the market. This increase in competition causes the supply to rise, which in turn leads to a decrease in the price of the good. As prices drop due to increased supply, the extra profits that attracted new firms diminish, bringing the market back to a state where firms only earn normal profits, eliminating further incentives for entry.

Examples & Analogies

Imagine a popular new burger joint that starts making a lot of money quickly. Other entrepreneurs might notice this and want to open their own burger restaurants nearby. As more burger places open, the competition increases, and prices for burgers start to drop. Eventually, the profit margins tighten, and it becomes less attractive for new restaurants to open, stabilizing the market where all restaurants make just enough money to stay afloat.

Loss Mitigation and Exit from Market

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Similarly, if the firms are earning less than normal profit at the prevailing price, some firms will exit which will lead to an increase in price, and with sufficient number of firms, the profits of each firm will increase to the level of normal profit. At this point, no more firm will want to leave since they will be earning normal profit here.

Detailed Explanation

In this section, the focus is on the opposite scenario: when firms earn less than normal profit. If the price in the market is too low and firms cannot cover their costs, they will begin to exit the market. As firms leave, the overall supply of the good decreases, which can cause prices to rise. This increase in price may allow remaining firms to reach normal profit levels again, ensuring stability in the market.

Examples & Analogies

Think about a small coffee shop that finds it hard to make enough sales to pay the rent. If several coffee shops in the area fold due to low sales, the overall amount of coffee for sale decreases. This can lead to an increase in the price of coffee because of limited supply. Remaining coffee shops can then earn enough to cover their costs and keep operating. This flow illustrates how firms react to losses and contribute to market stabilization.

Equilibrium Price and Average Cost

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Therefore, free entry and exit of the firms imply that the market price will always be equal to the minimum average cost, that is p = min AC. From the above, it follows that the equilibrium price will be equal to the minimum average cost of the firms. In equilibrium, the quantity supplied will be determined by the market demand at that price so that they are equal.

Detailed Explanation

This section summarizes that in a market with free entry and exit, the equilibrium price will always equal the minimum average cost of production for firms. This relationship is foundational to understanding how competitive markets operate. The quantity of goods supplied at this price will match the demand in the market, ensuring efficiency and equilibrium.

Examples & Analogies

Consider a marketplace with artisans selling handmade jewelry. If they are all producing at a level where their costs (average costs) are covered but not exceeded, they will price their jewelry competitively at an amount reflecting this cost. When buyers come to the market, they will find enough artisans able to sell jewelry at that price, demonstrating how supply equals demand at the equilibrium price.

Definitions & Key Concepts

Learn essential terms and foundational ideas that form the basis of the topic.

Key Concepts

  • Free Entry and Exit: The ability of firms to enter or leave a market freely, impacting equilibrium.

  • Normal Profit: The concept that firms earn just enough to cover their opportunity costs.

  • Market Dynamics: How supply and demand shifts lead to changes in market equilibrium.

  • Equilibrium Price: The price at which quantity demanded equals quantity supplied.

  • Minimum Average Cost: The lowest cost firms incur per unit of output in the long run.

Examples & Real-Life Applications

See how the concepts apply in real-world scenarios to understand their practical implications.

Examples

  • In the wheat market example, the demand curve is qD = 200 - p, while the supply curve for a firm is qS = 10 + p. At equilibrium price p = 20, total market supply meets demand at q = 180.

  • When demand rises or falls for a commodity like wheat, firms adjust, demonstrating the dynamic nature of market equilibrium under free entry and exit.

Memory Aids

Use mnemonics, acronyms, or visual cues to help remember key information more easily.

🎵 Rhymes Time

  • Firms come in and out, no doubt; when profits rise or drop all about.

📖 Fascinating Stories

  • Imagine a lively market where farmers sell wheat. When they earn more than normal, newcomers rush in to join. Their competition drives prices down until just enough remain to stay afloat, defining the market's equilibrium.

🧠 Other Memory Gems

  • DINE - Demand Increases, New entries; Excess Supply, exits.

🎯 Super Acronyms

PES - Price Equals Supply - reflecting that in equilibrium price equals minimum average cost.

Flash Cards

Review key concepts with flashcards.

Glossary of Terms

Review the Definitions for terms.

  • Term: Normal Profit

    Definition:

    The minimum level of profit needed for a firm to remain operational, covering all opportunity costs.

  • Term: Minimum Average Cost (AC)

    Definition:

    The lowest cost per unit of output that firms face in the long run.

  • Term: Excess Demand

    Definition:

    Occurs when demand for a commodity exceeds the supply available at a given price.

  • Term: Excess Supply

    Definition:

    Occurs when the supply of a commodity exceeds the demand at a given price.

  • Term: Market Equilibrium

    Definition:

    The state where market supply equals market demand at a certain price level.