BE/U5 Topic 6 Excess Capacity under Monopolistic Competition
Theories of Chamberlin’s monopolistic competition and Joan Robinson’s imperfect competition have revealed that a firm under monopolistic competition or imperfect competition in long-run equilibrium produces an output which is less than socially optimum or ideal output.
This means that firms operate at the point on the falling portion of long-run average cost curve that is, they do not produce the level of output at which long-run average cost is minimum. Long-run equilibrium of a firm under monopolistic competition is achieved when the demand curve (or average revenue curve) facing a firm becomes tangential to the long-run average cost curve so that it earns only normal profits.
Under such circumstances a firm can reduce average cost (and hence price) by expanding output to the minimum level of long-run average cost, but it will not do so because its profits are maximized (equality of marginal revenue with marginal cost is attained) at the level of output smaller than that at which its long-run average cost is minimum.
Society’s productive resources are fully utilized when they are used to produce the level of output which renders long-run average cost minimum. Thus a monopolistically competitive firm produces less than the socially optimum or ideal output, that is, the output corresponding to the lowest point of long-run average cost curve. This is in sharp contrast to the position of the firm in long-run equilibrium under perfect competition, which operates at the minimum point of the long-run average cost curve.
The amount by which the actual long-run output of the firm under monopolistic competition falls short of the socially ideal output is a measure of excess capacity which means un-utilized capacity. The existence of excess-capacity under imperfect or monopolistic competition can be understood from Figures 1 and 2. Figure 2 depicts the long-run position of a perfectly competitive firm which is in long-run equilibrium at the level of output ON corresponding to which long-run average cost is minimum.
It is at output ON that the double condition of long-run equilibrium, namely Price = MC = AC is fulfilled. It is thus clear that firms under perfect competition produce socially ideal output. On the other hand, a firm under monopolistic competition depicted in Fig. 1 is in long-run equilibrium at output OM at which its marginal revenue is equal to marginal cost and price is equal to average cost (Average revenue curve AR is tangential to average cost curve LAC at point F corresponding to output OM).
It will be noticed that at output OM long-run average cost is still falling and goes on falling up to output ON. This means that the firm can expand its production up to ON and reduce his long-run average cost to the minimum. Ideal output is the output at which long-run average cost is minimum.
Therefore, the firm is producing MN less than the ideal output. Thus MN output represents the excess capacity which emerges under monopolistic competition. It is worth nothing that the concept of excess capacity refers only to the long run. This is because in the short run under any type of market structure (including perfect competition) there can be all sorts of departures from the ideal reflecting incomplete adjustment to the existing market conditions.
Causes of Excess Capacity
What factors are responsible for the existence of excess capacity under monopolistic competition? It is due to the existence of excess capacity that average cost of production and price of product are higher and output smaller monopolistic competition than under perfect competition.
There are three main causes of the emergence of excess capacity under monopolistic competition. First, the most important cause of the existence of excess capacity under monopolistic competition is downward-sloping demand curve (or average revenue curve) of the firm.
A downward-sloping curve can be tangent to a U-shaped average cost curve only at the latter’s falling portion. It is only the horizontal demand curve or average revenue curve (as is actually found under perfect competition) which can be tangent to a U-shaped average cost curve at the latter’s minimum point. From this, it also follows that the greater the elasticity of average revenue (or demand) curve confronting a monopolistically competitive firm, the less the excess capacity and vice versa. When the demand curve facing a firm is perfectly elastic, there is no excess capacity, as is the case under perfect competition.
Now, demand curve facing individual firms under monopolistic competition slopes downward due to product differentiation found in it. Various firms produce different varieties and brands of product and each has a certain degree of monopoly power over the variety or brand it produces for fixing price and output.
If products were homogeneous the demand curve would not have been downward sloping and equilibrium would have been established at the minimum point of LAC without there being any excess capacity.
The second reason for the emergence of excess capacity under monopolistic competition, as has been emphasised by Chamberlin, is the entry of a very large a number of firms in the industry in the long run. Lured by excess profits in the short run new firms enter the industry in the long run. This results in sharing of market demand among many firms so that each firm produces a smaller output than its full or optimum capacity.
There are too many grocery shops, too many cloth manufacturing firms, too many automobile parts producing firms, too many barber shops each operating with excess capacity. In fact, under monopolistic competition, given the same demand and cost conditions, number of firms will be larger than even under perfect competition. This is because by expanding output to the minimum point of LAC, fewer firms will be required to meet the given demand for industry’s product.
The conception and the measure of excess capacity as enunciated above is based upon a particular notion of ideal output. Marshall, Kahn, Harrod, Cassel’ and Joan Robinson have regarded ideal output or optimum size of the firm as that output at which its long-run average cost is minimum. To, quote Joan Robinson, “In a perfectly competitive industry each firm in full equilibrium will produce that output at which its average costs are minimum.
Each firm will then be of the optimum size. If competition is imperfect, the demand curve for the output of the individual firm will be falling and the double condition of equilibrium can only be fulfilled for some output at which average cost if falling. The firms will, therefore, be of less than optimum size when profits are normal. It is only if conditions of perfect competition prevail that firms will be of the optimum size and there is no reason to expect that they will be of optimum size in the real world since in the real world competition is not perfect.”
Benefits of Excess Capacity
However, many modern economists are of the view that excess capacity under monopolistic competition is desirable in some respects. According to them, excess capacity under monopolistic competition provides some benefits which increase consumer welfare.
As mentioned above, the excess capacity comes into existence mainly due to product differentiation under monopolistic competition. Now, this product differentiation leads to product variety which is highly beneficial to the consumers.
The ability to choose among a wide variety of clothes, furniture, restaurant meals and other types of styles of product designs add greatly to the satisfaction or welfare of the consumers. Therefore, according to this view, social benefits of excess capacity should be weighed against the cost to the society of excess capacity.