The following diagram shows market equilibrium in which of the following situations?

When free entry and exit of firms allowed

The correct answer is Option 2: When free entry and exit of firms allowed

When free entry and exit of firms is there, firms can’t earn supernormal profits. This means they will earn only normal profits. Normal profits are earned when Price = Average Cost. 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. Graphically, this is shown where the market will be in equilibrium at point E at which the demand curve DD intersects the p₀ = min AC line such that the market price is p₀ and the total quantity demanded and supplied is equal to q₀.