Question

Explain the following statements with economic reasoning and appropriate diagram(s) .The long-run equilibrium of a monopolistically competitive firm is neither productively efficient norallocatively efficient and there is an excess capacity.

Answer 1

A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. For allocative efficiency to hold price must equal the marginal cost of the last unit produced. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price . If a firm has excess capacity, it means that the firm is not producing its minimum efficient scale of output.

Monopolistically competitive firms face downward-sloping demand curves. In the long run, firms produce where their demand curves are tangent to their long-run average total cost curves. Thus monopolist firm has excess capacity and it does not take advantage of economies of scale.Monopolistically competitive firms operate with excess capacity because the zero-profit tangency equilibrium occurs along the downward-sloping part of a firm’s average cost curve, so the firm’s plant has the capacity to produce more output at lower average cost than it is actually producing. This is what is meant by excess capacity in monopolistically competitive industries.

Allocative Inefficiency. In the above diagram the price is set above MC, thus showing allocative inefficiency.

Productive Inefficiency In the above diagram the firm is not producing in lowest point on AC curve, thus showing productive inefficiency.

Excess Capacity. The efficient scale is to produce at Q2 level of output i.e the lowest point on AC curve but the firm is producing at Q1 level of output thus the difference between Q2 and Q1 showing the excess capacity.