🛒principles of microeconomics review

key term - Excess Capacity

Definition

Excess capacity refers to the unused or underutilized production capability of a firm or industry. It occurs when a firm's actual output is less than its potential or maximum output, indicating the firm has the ability to produce more without incurring additional fixed costs.

5 Must Know Facts For Your Next Test

  1. In monopolistic competition, firms often have excess capacity because they produce at a point where price is greater than marginal cost, but less than the minimum point on the average cost curve.
  2. Excess capacity allows firms in monopolistic competition to quickly increase output if demand increases, without incurring significant additional fixed costs.
  3. The presence of excess capacity in monopolistic competition is a result of the firms' desire to differentiate their products and maintain some degree of market power.
  4. Excess capacity can lead to inefficient resource allocation, as firms are not producing at the minimum point on their average cost curves.
  5. In the long run, excess capacity in monopolistic competition will be eliminated as new firms enter the market, driving down prices and profits until firms are operating at the minimum point on their average cost curves.

Review Questions

  • Explain how excess capacity arises in a monopolistically competitive market.
    • In a monopolistically competitive market, firms intentionally maintain excess capacity in order to have the flexibility to quickly respond to changes in demand. This is because they produce at a point where price is greater than marginal cost, but less than the minimum point on the average cost curve. The desire to differentiate their products and maintain some degree of market power leads firms to operate with excess capacity, even though it results in a less efficient allocation of resources.
  • Describe the role of excess capacity in a firm's profit maximization decision-making process under monopolistic competition.
    • Firms in a monopolistically competitive market aim to maximize profits, which involves producing the quantity of output where marginal revenue equals marginal cost. However, due to the presence of excess capacity, these firms are able to produce at a point where price is greater than marginal cost, but less than the minimum point on the average cost curve. This allows them to maintain some degree of market power and differentiate their products, even if it means operating at a less than optimal level of efficiency.
  • Analyze how the presence of excess capacity in a monopolistically competitive market affects the long-run equilibrium of the industry.
    • In the long run, the presence of excess capacity in a monopolistically competitive market will lead to the entry of new firms. As new firms enter, they will drive down prices and profits until firms are operating at the minimum point on their average cost curves, eliminating the excess capacity. This long-run equilibrium is characterized by zero economic profits, as firms are producing at the point where price equals minimum average cost. The elimination of excess capacity in the long run ensures a more efficient allocation of resources within the industry.