Excess Capacity: Concept and Explanation

Excess Capacity Under Monopolistic Competition

Excess capacity is defined as the difference between the ideal output and the actual output attained in the long run, where ideal output is the output which is produced by the firms where the long-run average cost is at its minimum.

Under monopolistic competition, the firms though earn zero economic profits but there always exists the problem of excess capacity because the monopolistically competitive firms’ output does not coincide with the output at the minimum of the LAC curve.

As we can see in the figure, a monopolistic firm produces M output which is less than the ideal output N. This difference is termed as excess capacity because each firm is producing its output at an average cost that is higher than it could achieve by producing its capacity output. Excess capacity is a kind of inefficiency of the firms which reduces social welfare and makes the consumers worse off.

Excess Capacity Under Chamberlin Model

Prof. Chamberlin’s explanation of the theory of excess capacity is different from that of ideal output under perfect competition. Under perfect competition, each firm produces at the minimum on its LAC curve, and its horizontal demand curve is tangent to it at that point.

Its output is ideal, and there is no excess capacity in the long run. Since under monopolistic competition, the demand curve of the firm is downward sloping due to product differentiation, the long-run equilibrium of the firm is to the left of the minimum point on the LAC curve.

According to Chamberlin, so long as there is freedom of entry and price competition in the product group under monopolistic competition, the tangency point between the firm’s demand curve and the LAC curve would lead to the “ideal output” and no excess capacity.

When there is no price competition due to the prevalence of these factors, the curve dd is of no significance, and the firms are only concerned with the group DD curve. Suppose the initial short-run equilibrium is at S where the firms are earning supernormal profits because the price OP corresponding to point S is above the LAC curve.

With the entry of new firms in the group, super-normal profits will have competed away. The new firms will divide the market among themselves, and the DD curve will be pushed to the left as d1d1 in Figure, where it becomes tangent to the LAC curve at point A1. This point A1 is of stable equilibrium in the absence of price competition for all firms in the group, and they are earning only normal profits. Each firm is producing and selling OQ output at QA (= OP) price.

In Chamberlin’s analysis, O1 is the ‘ideal output’. But each firm in the group is producing OQ output in the absence of price competition. Thus OQ1 represents excess capacity under non-price monopolistic competition.

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