Question

a) What is the Excess Capacity Theorem? Why do you think it is faced by a monopolistic competitive market?

b) Describe the relationship between average cost (AC) and marginal cost (MC).

Answer 1

Ans) Excess capacity is the difference between optimal output and quantity produced. This occurs when marginal cost is less than ATC and there is possibility to decrease ATC by increasing the output but the firm doesn't do so because the profit is maximised.

In monopolistic competition, in long run, price is equal to ATC and firms earn zero economic profit. But the price is not equal to minimum of ATC. Therefore, in long run, a monopolistic firm produces less quantity than socially optimal and therefore does not attain productive efficiency (P = min ATC).

2) When MC is below ATC, ATC is decreasing. When MC is above ATC, ATC is increasing. MC curve intersect ATC curve at its minimum.