Model Answer
0 min readIntroduction
Monopolistic competition is a market structure characterized by numerous firms selling differentiated products. Unlike perfect competition, firms have some control over price, but unlike monopolies, this control is limited due to the presence of many competitors. A key feature often observed in these markets is ‘excess capacity’ – a situation where firms are not producing at the minimum point of their average total cost (ATC) curve. This arises particularly under conditions of vigorous price competition, where firms attempt to gain market share by lowering prices. The question asks whether this price competition inherently leads to excess capacity in such markets.
Understanding Monopolistic Competition and Excess Capacity
Monopolistic Competition: This market structure lies between perfect competition and monopoly. Firms differentiate their products through branding, quality, or location, creating a downward-sloping demand curve. However, the ease of entry and exit ensures that firms earn only normal profits in the long run.
Excess Capacity: Excess capacity exists when a firm produces below its optimal scale, meaning it could lower its average costs by increasing output. This is visually represented by a firm operating on the downward-sloping portion of its ATC curve.
The Link Between Price Competition and Excess Capacity
Price competition in monopolistically competitive markets forces firms to lower prices to attract customers. This happens because the differentiated products are close substitutes. When a firm lowers its price, it increases its quantity demanded, but it does so along its downward-sloping demand curve.
Here's how this leads to excess capacity:
- Downward-Sloping Demand Curve: Because of product differentiation, each firm faces a downward-sloping demand curve.
- Profit Maximization: Firms maximize profits where Marginal Revenue (MR) equals Marginal Cost (MC).
- Output Level: The MR=MC point is typically to the left of the minimum point of the ATC curve. This means the firm is producing at a level where it could reduce its average costs by increasing output.
- Price Competition & Shift in Demand: When firms engage in price competition, the demand curve for each firm shifts inward (becomes more elastic). To maintain profitability, firms must lower prices.
- Further Reduction in Output: Lowering prices leads to a further reduction in output to the point where MR=MC, resulting in a greater degree of underutilization of capacity.
Graphical Illustration
Imagine a firm’s ATC curve. The profit-maximizing output level (where MR=MC) is on the downward-sloping portion of the ATC curve. If the firm were to increase output, it could move towards the minimum point of the ATC curve, reducing average costs. However, increasing output would require lowering prices due to the downward-sloping demand curve, which might not be profitable in a competitive environment.
Long-Run Equilibrium and Excess Capacity
In the long run, entry and exit of firms drive economic profits to zero. However, even with zero economic profits, firms in monopolistic competition continue to operate with excess capacity. This is because the tangency between the demand curve and the ATC curve at the profit-maximizing output level still occurs on the downward-sloping portion of the ATC curve.
Examples
Consider the restaurant industry. Numerous restaurants offer differentiated dining experiences. Intense competition often leads to price promotions and discounts. Many restaurants operate below their potential capacity, especially during off-peak hours, representing excess capacity. Similarly, the retail clothing industry exhibits this pattern, with frequent sales and promotions indicating competitive pricing and underutilized capacity.
Conclusion
In conclusion, a monopolistically competitive market does indeed lead to excess capacity under price competition. The downward-sloping demand curve, combined with the profit-maximizing condition of MR=MC, forces firms to operate below their optimal scale. While entry and exit eliminate economic profits in the long run, the inherent characteristics of this market structure ensure that firms continue to maintain excess capacity, representing a degree of inefficiency. This is a trade-off for the benefits of product variety and consumer choice.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.