Excess capacity is a characteristic of monopolistically competitive firms. What does excess capacity mean?
A) It means that firms do not produce the output level that corresponds to the minimum point on their average total cost curves.
B) It means that firms hire more than the minimum number of workers needed to produce the profit-maximizing level of output.
C) It means that firms produce with inefficient combinations of resources.
D) It means that firms build plants that are not large enough to achieve minimum efficient scale.
The correct answer and explanation is :
The correct answer is:
A) It means that firms do not produce the output level that corresponds to the minimum point on their average total cost curves.
Explanation:
Excess capacity refers to the situation in which a firm operates below its most efficient output level, meaning that it does not produce at the minimum point on its average total cost (ATC) curve. This concept is particularly relevant in monopolistic competition, where firms differentiate their products and have some degree of market power.
In monopolistic competition, firms face a downward-sloping demand curve due to product differentiation. Because of this, firms maximize profit where marginal revenue (MR) equals marginal cost (MC). However, this profit-maximizing output level is lower than the output level required to minimize ATC. As a result, firms operate with excess capacity.
If firms were producing at minimum ATC, they would be fully utilizing their available resources, achieving the lowest possible per-unit cost. However, in monopolistic competition, firms restrict output to maintain higher prices and avoid excessive competition. This is different from perfect competition, where firms produce at minimum ATC in the long run.
Implications of Excess Capacity:
- Higher Prices – Since firms do not produce at minimum cost, prices tend to be higher compared to perfectly competitive markets.
- Product Variety – The presence of excess capacity is often a trade-off for having more diverse products, as firms differentiate their offerings.
- Inefficiency – Resources are underutilized, meaning firms could lower costs by increasing production, but market conditions prevent them from doing so.
Thus, excess capacity is a characteristic inefficiency in monopolistic competition, but it is also what allows firms to offer differentiated products.
Here is the graph illustrating excess capacity in monopolistic competition. It shows the Average Total Cost (ATC) curve, Demand curve, Marginal Cost (MC) curve, and Marginal Revenue (MR) curve. The excess capacity is highlighted as the gap between the firm’s actual output (where MR = MC) and the output level that minimizes ATC.