Chapter 20: Problem 752

Explain the excess capacity theorem of monopolistic competition.

Short Answer

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The excess capacity theorem in monopolistic competition states that firms will produce at an output level where marginal cost (MC) equals marginal revenue (MR), leading to the setting of a price based on the demand curve at that output level. However, this output level is typically less than the minimum efficient scale (MES), resulting in unused production capacity known as excess capacity. This suggests that monopolistic competition leads to inefficiencies in resource utilization, but it also provides consumers with a greater variety of differentiated products.

Step by step solution

1. Introduction to Monopolistic Competition

Monopolistic competition is a market structure that lies between perfect competition and monopoly. It is characterized by a large number of small firms, each producing a differentiated product. The firms are able to set their own prices, but there is still competition due to product differentiation and easy entry and exit of firms in the market.

2. Demand and Marginal Revenue Curves for Monopolistically Competitive Firms

A monopolistically competitive firm faces a downward-sloping demand curve, which means that as it raises the price of its product, the quantity demanded will decrease. This is because consumers have the option to switch to similar products offered by competing firms. Additionally, the firm has a separate marginal revenue curve that lies below the demand curve, signaling that the additional revenue generated from selling one more unit will decrease as output increases.

3. Profit Maximization for Monopolistically Competitive Firms

To maximize profits, monopolistically competitive firms will produce at the output level where their marginal cost (MC) equals marginal revenue (MR). This is because at this point, the additional revenue gained from selling an extra unit is equal to the additional cost incurred in producing that unit. Any increase or decrease in output beyond this point would result in a decrease in total profit.

4. Excess Capacity in Monopolistic Competition

When the profit-maximizing output level is determined, the firm will set the price for its product based on the demand curve at that output level. However, this output level typically falls short of the minimum efficient scale (MES), which is the lowest possible average cost of production that can be achieved in the long run. This unused production capacity is known as excess capacity. Under perfect competition, firms would operate at the minimum efficient scale; however, due to the price-setting power in monopolistic competition, the firms operate with excess capacity.

5. Implications of the Excess Capacity Theorem

The excess capacity theorem suggests that monopolistic competition leads to inefficiencies in the form of unused production capacity. It implies that resources are not being fully utilized in the market and that if firms were to operate at the minimum efficient scale, they could produce at lower average costs. However, it's important to note that this market structure provides consumers with a greater variety of differentiated products, which has its own benefits and may offset some of the inefficiencies associated with excess capacity.