Monopolistic Competition and Long-Run Excess Capacity

What the market looks like

Monopolistic competition has many firms, a differentiated product, and free entry and exit. Product differentiation gives each firm a downward-sloping demand curve, so in the short run the firm behaves exactly like a small monopolist: it produces where $MR = MC$ and reads price off demand, and it can earn positive economic profit.

How the long run closes the profit

Free entry is the engine. Positive profit attracts new firms selling close substitutes. Each incumbent then loses customers, so its demand curve shifts left and becomes more elastic (flatter), because buyers now have more alternatives. Entry stops only when the demand curve is tangent to the $ATC$ curve, so that

Symmetrically, losses cause exit, demand shifts right, and profit rises back to zero.

Two inefficiencies that survive

• Allocative inefficiency: the tangency happens on the downward-sloping part of demand, so $P > MC$ still holds and some deadweight loss remains.
• Productive inefficiency and excess capacity: a downward-sloping demand curve can only be tangent to $ATC$ where $ATC$ is still falling, which is left of minimum ATC. The gap between the firm's output and the output that minimises $ATC$ is called excess capacity.

Perfect competition, by contrast, ends at $P = MC = \text{minimum } ATC$. The extra cost is the price society pays for variety.