Explain the Concept of Excess Capacity in Monopolistic Competition.

The Concept of Excess Capacity in Monopolistic Competition.

Monopolistic competition refers to a market structure in which there are many firms selling differentiated products, which are close substitutes of each other. The important result is that each firm faces a downward sloping demand curve for its own product. In the short run, each firm makes profits at the profit maximizing equilibrium (E) following MC = MR condition. However, in the long run, assumption of freedom of entry and exit drives the profits to zero for each firm. This absence of positive and profits means that for each firm the negatively sloped demand curve is tangent to the long run average cost curve, so that each firm ends up making only normal profits.

Thus, average revenue must equal average cost at some output for all these firms. This situation is shown in the following diagram:

Long run equilibrium

The typical firm is at long run equilibrium at E, the price charged is Pand Quantity produced is Q. But each firm is producing an output (QL) less than the one for which its long run average cost reaches its minimum point given by (Qc). This is the excess capacity theorem of monopolistic competition. Each firm is producing its output at an AC that is higher than it could achieve by producing full capacity output. i.e. each firm has unused or excess capacity (Qc — QL).

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