Excess Capacity in Monopolistic Competition

Abstract

Will a monopolistic competitor operate at the minimum point of his average cost curve? Demsetz argues that this is possible (1959, 1964). In this paper Demsetz's argument is critically examined and then rejected in favor of a necessarily negative slope at equilibrium and, hence, excess capacity in that average cost is higher than marginal cost. According to Chamberlin (1957, chaps. 5 and 6) the firm under monopolistic competition faces a downward-sloping demand curve. Since the firm is forced to operate at zero profit, the average cost curve is tangent to such a demand curve at the equilibrium point. With falling average cost excess capacity is said to exist. Furthermore, since marginal cost is lower than price, a Pareto-optimum condition is thereby violated.1 Demsetz (1959, 1964) claims that Chamberlin's analysis is based on a partial relation between quantity and price that fails to recognize that at different levels of output the profit-maximizing firm will attempt to shift the demand curve facing it by changing its expenditures on quality, location, and promotion simultaneously with changes in its expenditures on quantity. Consequently, the demand curve associated with one quantity is obtained for a given level of selling expenditures and in general will differ from that associated with another quantity, since the selling expenditures change with quantity. The market-equilibrium locus of consumers' quantities and prices then is not on a single demand curve, and the negative-slope property of a demand curve does not apply to the marketequilibrium locus. So far so good. Demsetz, however, claims that the market-equilibrium locus is the relevant curve and says that since a zero slope is a likely result, the excess-capacity argument no longer holds. The purpose of this paper is to refute Demsetz's claim.2