Elimination of Excess Capacity in Monopolistic Competition: An Alternative Approach

Monopolistic competition is a real life market structure in which the elements of both perfect competition and monopoly exist. The paper examines the properties of perfect competition and monopoly under the purview of both conventional and Islamic economics. It finds that perfect competition is permissible in Islamic economic framework but monopoly is not. Monopolistic competition, however, cannot be fully abolished because of its real life relevance. The main problem lying with the monopolistic competition is that each firm preserves the capacity of producing more than what they produce in equilibrium- this is generally known as excess capacity. The current paper proposes a model that eliminates excess capacity and shows how the monopolistically competitive firms may remain at an output level that is socially optimum. The proposed model is a modification of Chamberlin (1933) model. According to the proposed model, the firms will produce socially desirable output if they are given some incentives. Amount of required incentive is the difference between the cost of producing additional units of output and the profit foregone due to the deviation from profit maximizing output level.