Long run equilibrium of a firm also implies ‘group’ equilibrium. However, equilibrium output is less than the least cost output OQ, since downward sloping demand curve can be tangential to the U-shaped LAC curve at some point to the left of minimum point.
It means that economies of scale are not fully exploited by the firm and there is excess capacity (unutilised capacity) equal to Q, Q. in Fig. 15.3. Lipsey and Chrystal call it excess capacity theorem.
The concept of excess capacity is relevant only in the long-run. In the short-run, excess capacity can exist in any type of market structure including perfect competition, wherein firms may not produce at the lowest point on the average cost curve.
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Under monopolistic competition, there are too many small firms in the group, each producing an output less than optimal, since the point of tangency of average cost curve and downward sloping demand curve always occurs at the falling portion of the former.
Therefore, at equilibrium, each firm produces at a cost higher than the minimum. When a firm continues to produce a smaller output at higher cost, it has excess capacity. Excess capacity refers to the difference between the optimum or ideal output level corresponding to the minimum point of average cost curve and the output actually attained in equilibrium. In brief, it is the difference between least cost output and profit maximising output. All firms under monopolistic competition have excess capacity in the long-run.
Fig. 15.3 depicts the long-run equilibrium of a monopolistic competitor, where AR = LAC. As AR curve is downward sloping, the equality between AR and LAC will occur at the falling portion of the LAC curve, i.e., to the left of the minimum of LAC curve.
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In Fig 15.3, OQ1 is excess capacity, which is the difference between least cost output (OQ1) and profit maximising output (OQ). It represents the output, which the resources employed by the firm could produce efficiently (i.e., at the least possible average cost), but, which is not being produced.
This unutilised or un-exhausted capacity is an economic wastage of resources caused by the peculiar structure of the market. It leads to overcrowding of the group since each firm produces smaller than optimum output. The limit cost can be lowered by reducing the number of firms where each firm produces more output at the lowest (less) cost.
Greater is the elasticity of demand curve confronting a monopolistically competitive firm, lesser is the excess capacity and vice-versa. However, economists like Kelvin Lancaster and Chamberlin consider that higher cost and price resulting from producing to the left of minimum LAC is socially acceptable so far as the choices and hence satisfaction given by different products for which people are prepared to pay high price. Hence, excess capacity is not wasteful.