What is the effect of free entry and exit in perfect competition?

Free entry and exit in perfect competition leads to zero economic profit in the long run.

In a perfectly competitive market, firms are price takers and have no control over the market price. They can only adjust their output levels to maximise profits. When firms in such a market start making supernormal profits, it acts as a signal for new firms to enter the market. This is because the barriers to entry are low or non-existent in perfect competition. The increase in the number of firms leads to an increase in the supply of the product, which in turn lowers the market price. As the price falls, the supernormal profits start to diminish.

On the other hand, if firms are making losses, they will exit the market as there are no exit barriers in perfect competition. The exit of firms reduces the supply of the product in the market, which pushes the price up. As the price increases, the losses start to decrease.

This process of entry and exit continues until all firms in the market are making only normal profits, i.e., their total revenue is just covering their total costs, including the opportunity cost of capital. This is known as the long-run equilibrium in perfect competition. At this point, there is no incentive for new firms to enter the market or for existing firms to exit the market.

Therefore, free entry and exit in perfect competition ensure that resources are allocated efficiently in the market. Firms are producing at the lowest point on their average cost curves, which means they are maximising their productive efficiency. Moreover, since the price in the market equals the marginal cost of production, allocative efficiency is also achieved. This means that the mix of goods and services produced in the market is just what consumers want.

In conclusion, free entry and exit in perfect competition play a crucial role in determining the market price and the level of profits. They ensure that firms do not make supernormal profits or losses in the long run, leading to an efficient allocation of resources.