In a perfectly competitive market with free entry and exit, firms are earning supernormal profit at the prevailing price. Which of the following will happen?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → New firms enter, the market supply curve shifts rightward and the price falls
Supernormal profit draws new firms into the market. Their entry shifts the market supply curve to the right, while demand stays the same. So the price falls until the extra profit is gone.
Entry adds sellers, not buyers, so it is the supply curve that moves.
NCERT (2026-27): “5.1.2 Market Equilibrium: Free Entry and Exit … To see why it is so, suppose, at the prevailing market price, each firm is earning supernormal profit. The possibility of earning supernormal profit will attract some new firms. As new firms enter the market supply curve shifts rightward. However, demand remains unchanged. This causes market price to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all firms in the market earning normal profit, no more firms will have incentive to enter. Similarly, if the firms are earning less than normal profit at the prevailing price, some firms will exit which will lead to an increase in price, and with sufficient number of firms, the profits of each firm will increase to the level of normal profit. At this point, no more firm will want to leave since they will be earning normal profit here. Thus, with free entry and exit, each firm will always earn normal profit at the prevailing market price.” |