Excess capacity in monopolistically competitive industries results because in equilibrium

Monopolistic competition is the economic market model with many sellers selling similar, but not identical, products. The demand curve of monopolistic competition is elastic because although the firms are selling differentiated products, many are still close substitutes, so if one firm raises its price too high, many of its customers will switch to products made by other firms. This elasticity of demand is like pure competition where elasticity is perfect. Demand is not perfectly elastic because a monopolistic competitor has fewer rivals than would be the case for perfect competition, and because the products are differentiated to some degree, so they are not perfect substitutes.

Monopolistic competition has a downward sloping demand curve. Thus, just as for a pure monopoly, its marginal revenue will always be less than the market price, because it can only increase demand by lowering prices, but by doing so, it must lower the prices of all units of its product. Hence, monopolistically competitive firms maximize profits or minimize losses by producing that quantity where marginal revenue = marginal cost, both over the short run and the long run.

Short-Run Profit or Loss

In the short run, a monopolistically competitive firm maximizes profit or minimizes losses by producing that quantity where marginal revenue = marginal cost. If average total cost is below the market price, then the firm will earn an economic profit.

• D = Market Demand
• ATC = Average Total Cost
• MR = Marginal Revenue
• MC = Marginal Cost

As can be seen in this graph, the market price charged by the monopolistic competitive firm = the point on the demand curve where MR = MC.

Short-Run Profit = [Price - ATC] × Quantity

However, if the average total cost exceeds the market price, then the firm will suffer losses, equal to the average total cost minus the market price multiplied by the quantity produced. Losses will still be minimized by producing that quantity where marginal revenue = marginal cost, but eventually the firm either must reverse the losses or be forced to exit the industry.

Short-Run Loss = [ATC - Price] × Quantity

Long-Run Equilibrium: Normal Profits

If the competitive firms in an industry earn an economic profit, then other firms will enter the same industry, which will reduce the profits of the other firms. More firms will continue to enter the industry until the firms are earning only a normal profit.

However, if there are too many firms, then firms will incur losses, especially the inefficient ones, which will cause them to leave the industry. Consequently, the remaining firms will return to normal profitability. Hence, the long-run equilibrium for monopolistic competition will equate the market price to the average total cost, where marginal revenue = marginal cost, as shown in the diagram below. Remember, in economics, average total cost includes a normal profit.

Note that where MC rises above MR, the costs exceed additional revenue, which is why the firm maximizes its profit by producing only that quantity where MR = MC, and charging the price at position 1 in the graph.

2 Market Price = Marginal Cost = Allocative Efficiency

3 Productive Efficiency = Minimum ATC

Excess Capacity = Quantity Produced at Minimum ATC – Quantity yielding the greatest profit [MR = MC].

Because monopolistically competitive firms do not operate at their minimum average total cost, they, therefore, operate with excess capacity. Note in the above diagram that firms would lose money if they produced more to achieve either allocative or productive efficiency. That most firms operate with excess capacity is evident when looking at most monopolistically competitive firms, such as restaurants and other retailers, where salespeople are often idle.

Some firms may have enough of an advantage to continue earning economic profits, even in the long run. For instance, a business can have an excellent location relative to other locations in the area, which will always give it an advantage over other firms in that local market. Or a firm may have a patent or trademark on its product that prevents competition. In such cases, firms have some degree of market power that would allow them to price their products above competitors' prices without losing too much business.

Productive and Allocative Efficiency of Monopolistic Competition

Productive efficiency requires that:

Price = Minimum Average Total Cost

Pure competition can achieve productive efficiency, but most monopolistic competitive firms do not, since they sell at a price higher than the minimum average total cost, and would actually lose money selling at their minimum ATC. To use their excess capacity, they must produce a quantity equal to their minimum ATC, but they would not be able to sell that amount without lowering their prices, thus either reducing their profits or incurring losses.

The monopolistic firm also does not achieve allocative efficiency. Allocative efficiency requires that:

Price = Marginal Cost

The monopolistic firm exhibits a downward sloping demand curve. That means that, to sell more units, it must lower its price, but if it lowers its price, then it must lower its price on all units. Thus, like a monopoly, marginal revenue continually declines as quantity is increased. The firm maximizes profits when marginal revenue = marginal cost, but this only occurs at a quantity less than what a purely competitive firm would produce, where marginal cost = market price. The marginal cost curve will always intersect the marginal revenue curve before it intersects the demand curve, because as previously stated, at any given quantity, marginal revenue is always less than the market price. Because of this allocative inefficiency, some consumers will forgo the product because of its higher price.

Monopolistic competitive firms achieve neither productive nor allocative efficiency: the greater the differentiation of the products, the greater the inefficiency. However, monopolistic competition creates a greater variety of products and services, and this greater diversity is more likely to satisfy consumer tastes, which leads to a more desirable market.