Excess capacity arises under monopolistic competition because profit-maximizing firms

Question

BlackTom AI · Accepted Answer

In monopolistic competition firms set output where marginal revenue (MR) equals marginal cost (MC), and because demand is downward-sloping MR < price, the chosen output is typically below the efficient scale; this creates excess capacity. 1) Relevant knowledge points and concepts - Downward-sloping demand curve: each firm faces some market power, so price (P) > MR. - Profit maximization: firms produce where MR = MC. - Average total cost (ATC) and efficient scale: the minimum point of the ATC curve is the output that minimizes per-unit cost (efficient scale). - Excess capacity: the gap between a firm’s profit-maximizing output and the output that would minimize ATC. 2) Step-by-step reasoning - Because each firm’s demand curve is downward-sloping, MR lies below demand (MR < P). - Profit-maximizing condition: choose output q* such that MR(q*) = MC(q*). - The ATC curve is U-shaped; its minimum occurs at the efficient scale q_min. - For a monopolistically competitive firm, q* < q_min (output chosen is to the left of the ATC minimum). - Therefore ATC(q*) > ATC(q_min): the firm is not producing at the lowest possible per-unit cost. 3) Intermediate logical steps - Downward demand → MR < P. - MR = MC → q* determined by intersection with MC (at a lower output than the ATC minimum). - Compare q* and q_min → ATC higher at q*. 4) Why the correct answer is correct Because the firm’s profit-maximizing rule (MR = MC) under a downward-sloping demand yields an output smaller than the efficient scale, the firm does not minimize per-unit cost. This directly explains excess capacity. 5) Why other options are incorrect - “Produce on the rising portion of ATC”: incorrect; they typically produce on the downward-sloping (left) side of the ATC minimum, not the rising right side. - “Face perfectly elastic demand”: this describes perfect competition, not monopolistic competition. - “Exit the industry when it is no longer profitable”: exit behavior explains long-run adjustment to zero economic profit but does not cause excess capacity. Conclusion: Excess capacity arises because firms do not minimize their per-unit cost of production. This matches the provided correct answer.

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