Question

Explain the implication of the following.
(a) Freedom of entry and exit of firms under perfect competition
(b) Non-price competition under oligopoly.

Answer 1

(a) There is freedom of entry and exit under perfect competition. This means that in the long run, firms can only earn normal profits. In case a few firms earn super normal profits in the short run, new firms will enter the market. Market supply will increase and market price will fall, extra profits will be wiped out.

In case of abnormal losses, a few firms will leave the market. Market supply will decrease and price will increase. Hence abnormal losses will be wiped off.

(b) oligopoly market structure makes the market price of the commodity rigid, i.e. the market price does not move freely in response to changes in demand. It is because if one firm feels that a price increase would generate higher profits by increasing the price, other firms do not follow. The price increase would therefore lead to a huge fall in the quantity sold by the firm leading to a fall in its revenue and profit. On the other hand, a firm may estimate that it could earn a larger revenue and profit by selling a larger quantity of output and therefore lowers the price at which it sells the commodity. Other firms would perceive this action as a threat and therefore follow the first firm and lower their price as well. The firm that had initially lowered the price is able to achieve only a small increase in the quantity it sells. A relatively large lowering of price by the first firm leads to a relatively small increase in the quantity sold. Thus, this firm experiences an inelastic demand curve and its decision to lower price leads to a lowering of its revenue and profit. Any firm therefore finds it irrational to change the prevailing price.