Question

What is meant by the term "excess capacity" as it relates to monopolistically competitive firms
and explain with good examples?
[7 marks]

Answer 1

Excess Capacity implies when the actual output is less than the potential output.

In any market structure, the potential output, also known as, minimum efficient scale occurs when the long run average cost is minimized and the firm produces an output which is at the minimum point of LRAC curve.

However, in Monopolistic competition, in the long run, each firm operates to the left of minimum point of average cost curve. Each firm, therefore produces an output which is less than the Minimum Efficient Scale.

A lower output signifies that some of the resources are not fully utilized and are kept idol. Due to this under utilization of resources, each firm in the market suffers from the Excess Capacity problem.

For Example, a normal barber shop suffers from the excess capacity. In days like COVID-19 where there are no customers in the shop and the resources are not having work to do, the shop suffers from excess capacity which is not minimizing its average cost.

Likewise, too many mobile producing firms or too many retailer stores in the market creates the problem of Excess Capacity.