In contrast with perfect competition, excess capacity characterizes monopolistic competition. Excess capacity is due to which of the following?
A) Monopolistically competitive firms produce at the minimum point on their average total cost curves.
B) Monopolistically competitive firms face downward-sloping demand curves. In the long run, firms produce where their demand curves are tangent to their long-run average total cost curves.
C) Monopolistically competitive firms produce where marginal revenue is equal to marginal cost.
D) Monopolistically competitive markets have low barriers to entry.
The correct answer and explanation is :
Correct Answer:
B) Monopolistically competitive firms face downward-sloping demand curves. In the long run, firms produce where their demand curves are tangent to their long-run average total cost curves.
Explanation:
Excess capacity in monopolistic competition arises because firms do not produce at the minimum point of their average total cost (ATC) curve, unlike firms in perfect competition. Instead, they produce at a point where their demand curves are tangent to their ATC curves in the long run.
Why Does Excess Capacity Exist?
- Downward-Sloping Demand Curve:
- In monopolistic competition, firms sell differentiated products, which gives them some degree of market power.
- Because of this differentiation, each firm faces a downward-sloping demand curve rather than a perfectly elastic one, as in perfect competition.
- Tangent Point in Long Run Equilibrium:
- When new firms enter a monopolistically competitive market, the demand for existing firms’ products shifts leftward due to increased competition.
- In the long run, firms reach an equilibrium where their demand curve is tangent to the long-run ATC curve.
- At this point, firms do not produce at the minimum of their ATC curve, meaning they operate with excess capacity—they could produce more at a lower cost but choose not to because of market constraints.
- Comparison to Perfect Competition:
- In perfect competition, firms operate at the minimum ATC, meaning no excess capacity exists.
- In monopolistic competition, firms have some control over price, leading to a price markup and underutilization of capacity compared to perfect competition.
Thus, excess capacity exists because firms do not operate at full efficiency due to downward-sloping demand curves and product differentiation.
Illustration: Excess Capacity in Monopolistic Competition
I have generated an image illustrating excess capacity in monopolistic competition compared to perfect competition.