3 Why do firms in monopolistic competition operate with excess capacity? Resources are used efficiently when marginal social benefit equals marginal social cost. Price measures marginal social benefit, and the firm’s marginal cost equals marginal social cost (assuming there are no external benefits or costs). So if the price of a French Connection jacket exceeds the marginal cost of producing it, the quantity of French Connection jackets produced is less than the efficient quantity. And you’ve just seen that in long-run equilibrium in monopolistic competition, price does exceed marginal cost. So is the quantity produced in monopolistic competition less than the efficient quantity?

Making the Relevant Comparison Two economists meet in the street, and one asks the other how her husband is. ‘Compared with what?’ is the quick reply. This bit of economic wit illustrates a key point:

before we can conclude that something needs fixing, we must check out the available alternatives.

The markup that drives a gap between price and marginal cost in monopolistic competition arises from product differentiation. It is because French Connection jackets are not quite the same as jackets from Banana Republic, Diesel, DKNY, Earl Jackets, Gap or any of the other dozens of producers of jackets that the demand for French Connection jackets is not perfectly elastic. The only way in which the demand for jackets from French Connection might be perfectly elastic is if there is only one kind of jacket and all firms make it. In this situation, French Connection jackets are indistinguishable from all other jackets. They don’t even have labels.