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Difficulty: MediumMonopolistic Competition: Features, Product Differentiation, and Equilibrium

In long-run equilibrium, a firm in a monopolistically competitive market earns zero economic profit while producing at an output level where average total cost is still declining. Which factor directly explains why the firm operates with excess capacity under these market conditions?

  1. Product differentiation gives the firm a downward-sloping demand curve, forcing tangency with average total cost to occur to the left of its minimum point.Answer
  2. B
    Firms engage in collusive price agreements that deliberately restrict output below the minimum efficient scale.
  3. C
    Marginal revenue exceeds average revenue in the long run, leading firms to select a sub-optimal output level.
  4. D
    Government price ceilings impose maximum production limits to prevent firms from exploiting consumers.

Answer

Product differentiation gives the firm a downward-sloping demand curve, forcing tangency with average total cost to occur to the left of its minimum point.
Product differentiation provides each firm with some degree of market power, giving it a downward-sloping demand curve. In long-run equilibrium, free entry forces economic profits to zero where the demand curve is tangent to the Average Total Cost (ATC) curve. A downward-sloping straight line can only be tangent to a U-shaped curve on its downward-sloping side (to the left of the minimum point of ATC). Thus, the firm produces less than the output level that minimizes average total cost, giving rise to excess capacity.

Step-by-Step Solution

1
Analyze the long-run equilibrium condition in monopolistic competition
Free entry and exit drive economic profit to zero, meaning Price (Average Revenue) equals Average Total Cost (P=ATCP = ATC).
Abnormal profits attract new entrants, shifting existing firms' demand curves to the left until P=ATCP = ATC.
2
Examine the slope of the demand curve under product differentiation
Because goods are differentiated, each firm possesses slight market power, making its demand curve downward-sloping rather than perfectly elastic.
A downward-sloping demand curve cannot be tangent to a U-shaped average cost curve at its lowest point (where the slope of ATC is zero).
3
Deduce the output level relative to minimum Average Total Cost
Tangency must occur on the downward-sloping portion of the Average Total Cost curve, resulting in an output lower than the socially efficient (capacity) output.
The gap between actual production output and the output at minimum ATC represents excess capacity.

Key Concept

Excess capacity in monopolistic competition long-run equilibrium
Estimated Time:1m 30s
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Topics

Monopolistic Competition: Features, Product Differentiation, and Equilibrium

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