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This assumption is really vital to the idea of perfect competition.
In perfect competition, firms can not make economic profit and there is allocative efficiency. The easy entry and exit of firms is the reason for this.
If a firm is charging too high of a price, other people or firms will find out about it. They will then be able to enter the market because entry is easy. When they do, supply will go up which means that the equilibrium price will go down and the equilibrium quantity will go up.
So, ease of entry into the market allows for supply to increase and for allocative efficiency to occur.
Under condition of perfect competition no firm can sell at a price higher than the market equilibrium price, and at the same time no firm has an economic incentive to sell at a price lower than the market equilibrium price. So in the long-run in a competitive market, every seller sell its products at the market equilibrium price, and the total quantities offered by all the suppliers at this price exactly equals the quantity demanded by buyers at the equilibrium price. However, such a market equilibrium can be disturbed in short run due to several reasons listed below.
- The production costs of suppliers goes up. As a result some suppliers may start making losses and would want to leave the market. This has the effect of reducing the total quantity supplied and shifting the supply curve to right.
- The production costs of suppliers goes down. As a result all suppliers may be willing to supply more quantities at the equilibrium price. Also suppliers will be making extra profit, which may induce some outside suppliers to enter the market. This has the effect of increasing the total quantity supplied and shifting the supply curve to left.
- General increase in demand leading to shifting of demand curve to right. This will tend to push the market price up, creating the same effect on supply as that of reduction in production cost.
- General decrease in demand leading to shifting of demand curve to left. This will tend to push the market price down, creating the same effect on supply as that of increase in production cost.
In all the above cases, unless the suppliers are able to leave or enter a market with ease, when costs go up or demand falls some suppliers will be forced to remain in the market even in long run in spite of making losses. Similarly when costs reduce or the demand goes up, the existing suppliers will be able to charge premium prices. Both these situation do not violate the essential conditions for existence of a perfectly competitive market, but it does mean that the perfect competition by itself will not be able to ensure allocation of productive resources of an economy in the best possible way.
Thus existence of entry and exit barriers will result in suppliers in some industries continuing to make excessive profit, while those in others making losses. As a matter of fact, barriers to entry do exist and are substantial. This is the reason for some industries being very profitable while others barely able to survive.
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