Question

(a) Does a firm under monopolistic competition make profits in the long run? (b) What is excess capacity? Does it lead to wastage of the economy's scarce resources?

Short answer

Explain the concept of excess capacity and its implications on the economy's scarce resources. Answer: In the long run, firms under monopolistic competition do not make economic profits, as they tend towards earning just enough to cover their costs due to the entry and exit of firms. Excess capacity refers to the difference between a firm's actual output level and its output at the minimum average cost. It occurs in monopolistic competition, as firms produce less than the efficient scale due to market power and product differentiation. Excess capacity can lead to wastage of scarce resources, as they may not be used as efficiently as in a perfectly competitive market. This is because some resources are allocated to branding, product differentiation, and advertising, rather than production and resource use.

Step-by-step solution

Understanding Monopolistic Competition

Monopolistic competition refers to a market structure where several firms sell products that are similar but not necessarily perfect substitutes. It is a combination of perfect competition and monopoly. In this market structure, each firm has some market power, but they do not act as price takers like in perfect competition nor do they have significant control over the market price like in a pure monopoly. The firms try to differentiate their products from their competitors to gain an advantage, usually through branding, advertising, or product quality. #a# Long-run Profits in Monopolistic Competition

Short-run Profits

In the short run, firms in a monopolistically competitive market can make profits, losses, or break even depending on their costs, demand, and the degree of product differentiation.

Long-run Profits

In the long run, however, profits are driven towards zero due to the entry and exit of firms and the adjustments in production decisions. If a firm is making profits in the short run, new firms will enter the market, attracted by the profits. As more firms enter, the demand for the product of existing firms decreases, reducing their market power. This, in turn, reduces their profits. Conversely, if firms are making losses, some firms will exit the market, leading to a higher demand for the remaining firms and a potential return to profitability. This process continues until economic profits equal zero, and the firms are earning just enough to cover their costs. In the long run, under monopolistic competition, there is a tendency towards normal profits.

Conclusion

So to answer part (a) of the exercise: Firms under monopolistic competition do not make economic profits in the long run, though they may make profits in the short run. #b# Excess Capacity and its Effects on the Economy

Defining Excess Capacity

Excess capacity refers to the difference between a firm's actual output level and the level of output where it would achieve minimum average cost (also known as the efficient scale of production). In monopolistic competition, firms have excess capacity because they produce at a level that is less than the efficient scale, due to their market power and product differentiation.

Excess Capacity and Resource Allocation

Excess capacity can lead to wastage of scarce resources in an economy, as firms are not producing at the lowest possible cost. In a perfectly competitive market, resources are allocated efficiently, and there is no excess capacity because each firm produces at the minimum average cost. However, in monopolistic competition, some resources are allocated to branding, product differentiation, and advertising, which are all aimed at increasing the firm's market power. This allocation of resources might not be the most efficient in terms of overall production and resource use.

Conclusion

To answer part (b) of the exercise: Excess capacity refers to the difference between a firm's actual output level and its output at the minimum average cost. Excess capacity in monopolistic competition can lead to a wastage of scarce resources, as they are not used as efficiently as they might be in a perfectly competitive market structure.