Q.What is meant by "excess capacity" under monopolistic competition, and why does it arise even though every firm earns only normal profit in the long-run group equilibrium?

Excess capacity is the gap between a firm's group-equilibrium output and the larger output at which its AC curve is actually minimised; it arises because the demand curve is tangent to AC on its still-falling portion, not at its lowest point.

Under monopolistic competition's long-run group equilibrium, free entry has driven each firm's own demand curve down (through new competing variants entering the market) until it is just TANGENT to that firm's average cost (AC) curve — at this single point of tangency, price exactly equals AC, so the firm earns only normal profit, no super-normal profit, and there is no longer any incentive for further entry.

The crucial difference from perfect competition lies in the SLOPE of the demand curve at the point of tangency. A perfectly competitive firm's demand curve is perfectly HORIZONTAL, so it can only be tangent to a U-shaped AC curve at AC's single lowest (minimum) point — any other point on a U-shaped AC curve has some slope, and a horizontal line can only touch it without crossing at the flat bottom.

A monopolistically competitive firm's demand curve, however, slopes DOWNWARD (because its product is differentiated, giving it some independent pull on buyers). A downward-sloping line can be tangent to a U-shaped AC curve at a point that is still on AC's FALLING (leftward) segment — i.e., at an output SMALLER than the output where AC would actually reach its true minimum. …

A common error is to think excess capacity means the firm is making a LOSS or earning less than normal profit — in fact the firm earns exactly normal profit at this output; excess capacity …