Market Equilibrium
Market Equilibrium is the state where the market supply and demand balance each other well, which results in stabilizing the prices. Practically, an over-supply of the goods or services causes the prices to go down, this results in higher demand. While an under-supply or shortage causes the prices to go up resulting in lessening the demand. The balancing effect of supply and demand gives rest in a state of equilibrium.
In this context, we will know about the market equilibrium that resides in a Free Entry and Exit situation.
Market Equilibrium Free Entry and Exit
The students are quite clear on the presumption of market equilibrium where the market has a fixed number of firms. While, let us face the reality here, where no markets are actually confined to a specific number of firms. So, in this section, we will study the market equilibrium where the enterprises can enter and exit the marketplace according to their will.
The presumption of free entry and exit implies that in equilibrium, there is no enterprise that earns a supernormal profit or sustains an acute loss by remaining in the production. The equilibrium cost price will be equal to the minimum average cost of the enterprises.
Suppose, the market has a possibility of earning a supernormal profit, this will attract some enterprises to freely enter the market and compete. Thereby, they distribute the profit incurred in between them resulting in all the firms earning normal profit.
Now with new firms joining the profit-oriented market this will result in:
The market supply curve will shift rightward. The demand remains constant.
This will cause the market cost price to decrease
When the prices decrease, the supernormal profits are chalked out
After all the enterprises in the market start to earn a normal profit, no more enterprises will be attracted to enter the market.
Likewise, if the enterprises are earning less than normal profit, then some enterprises will exist which will lead to an increase in the cost price, and with a lesser number of enterprises, the profits of all the enterprises will rise to the degree of normal profit.
Definition of Market Equilibrium
This is a situation where for a particular good, supply = demand. When this market is in equilibrium, then there is no tendency for the prices to change.
Market equilibrium can be represented by using the supply and demand diagrams
In the diagram following, the equilibrium price is P1. The equilibrium quantity is Q1.
[Image will be uploaded soon]
In Case the Price is Below the Equilibrium
[Image will be uploaded soon]
In the above diagram, the price which is P2 is below the equilibrium. Here the price, demand is greater than the supply. Hence, there is a shortage of (Q2 – Q1)
If there is a shortage, the firms will put up prices and then supply more. As the price rises, there will be a movement along the demand curve and there will be less demand.
The price will rise to P1 until there is no shortage. While supply = demand.
If the Price is Above the Equilibrium
[Image will be uploaded soon]
If the price was at P2, this would be above the equilibrium of P1. At the price of P2, then supply (Q2) would be greater than the demand (Q1) and therefore there is too much supply. There is a surplus. (Q2-Q1)
Therefore, the firms would reduce this price and then the supply less. This would encourage more demand and the surplus will be eliminated. Then the new market equilibrium will be at Q3 and P1.
Movements to a New Equilibrium
1. Increase in Demand
[Image will be uploaded soon]
If there was an increase in income the demand curve would shift to the right (D1 to D2). Initially, then there would be a shortage of the good. Therefore, the price and the quantity supplied will increase leading to a new equilibrium at Q2, P2.
2. Increase in Supply
[Image will be uploaded soon]
An increase in supply will lead to a lower price and more quantity sold.
FAQs on Market Equilibrium: Free Entry and Exit Conditions
1. What is the concept of free entry and exit in a market?
In economics, free entry describes a condition where new firms can easily enter a market to produce and sell a product without facing significant legal, technological, or financial barriers. Conversely, free exit means that a firm can leave the market without incurring major costs or restrictions if it is sustaining losses. This dual condition is a key feature of certain market structures.
2. What are the key conditions that determine market equilibrium with free entry and exit?
Under the condition of free entry and exit, the market equilibrium is achieved when two primary conditions are met:
- The market price (P) becomes equal to the minimum average cost (AC) of the firms.
- At this price, no firm earns supernormal profits or incurs losses; all firms in the market earn only normal profit.
3. In which type of market structure is free entry and exit a defining characteristic?
Free entry and exit is a defining characteristic of a perfectly competitive market. In this market, there are numerous buyers and sellers, a homogeneous product, and no barriers to entry or exit. This ensures that the long-run equilibrium price is driven down to the minimum average cost, a hallmark of perfect competition.
4. Can you provide some real-world examples of industries with conditions close to free entry and exit?
While a perfectly competitive market is a theoretical model, some real-world industries exhibit characteristics of free entry and exit. Examples include:
- Street food vendors: The initial investment is low, and it is relatively easy to start or stop a food stall business.
- Freelance services: Markets for services like graphic design, content writing, or tutoring online have very low barriers to entry.
- Small-scale farming: In many regions, farmers can switch between different crops based on profitability, simulating entry and exit from specific product markets.
5. What is the main implication of free entry and exit on a firm's long-run profit?
The primary implication is that firms in such a market can only earn normal profit in the long run. If firms start making supernormal profits (profits above the normal level), new firms will be attracted to the market. This increases supply, drives down the price, and erodes the supernormal profits until only normal profit remains. If firms are making losses, some will exit, reducing supply and raising the price until the remaining firms are back to earning normal profit.
6. How does the entry of new firms affect the market supply curve and the equilibrium price?
The entry of new firms, attracted by supernormal profits, leads to an increase in the total quantity of the good supplied at any given price. This causes the market supply curve to shift to the right. With the demand curve remaining unchanged, this rightward shift in supply creates a surplus at the existing price, forcing the equilibrium price to fall until it equals the minimum average cost of production.
7. What happens if the market price falls below the minimum average cost in a market with free exit?
If the market price falls below the minimum average cost (P < min AC), firms will start incurring economic losses. The condition of free exit allows these loss-making firms to leave the market to cut their losses. As firms exit, the overall market supply decreases, causing the market supply curve to shift to the left. This reduction in supply leads to a higher equilibrium price, which continues to rise until it is once again equal to the minimum average cost for the remaining firms.
8. How is market equilibrium with free entry and exit different from equilibrium with a fixed number of firms?
The key difference lies in long-run profitability. In a market with a fixed number of firms, firms can earn supernormal profits or sustain losses in the long run if there are barriers preventing entry or exit. However, in a market with free entry and exit, the long-run equilibrium is always at a point where firms earn only normal profit, as the price is always driven to the level of minimum average cost by the movement of firms into or out of the market.
