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Marginal cost pricing

A method of setting price, by which the price at which an output can be sold on the market is equated with the marginal cost of producing that output. In diagrammatic terms, the required price and output are found at the point at which the demand curve cuts the marginal cost curve. Marginal cost pric:ing is often recommended as an appropriate policy for public enterprise and regulated industries, on the grounds that it is the pricing policy which maximizes social welfare. The argument goes as follows. The theory of demand tells us that each consumer values the marginal unit of a good he buys at exactly the price he pays for it. For example, if you buy fifty units of electricity per day at a price of 15p per unit, then the fiftieth unit is worth just 15p to you: no more, no less. The marginal cost of the good shows the value of the resources absorbed in producing the marginal unit of output, and hence the valne of the other goods and services which the economy could have produced with those resources. Now, if a price and output were chosen such that price exceeded marginal cost, that would mean consumers place a higher value on the marginal portion of their consumption than it costs to divert resources from other uses to produce that portion. It would therefore be possible to increase net consumer benefits in the economy by supplying more of the output. Thus no price greater than marginal cost can be consistent with maximizing net consumer benefit or social welfare. Likewise, if price and output were such that marginal cost exceeded price, the value of the resources absorbed in producing the marginal portion of output exceeds consumers’ valuation of that output, and net benefit can be increased by reducing output. If it is not to be possible to make such welfare-increasing output adjustments, it is necessary that price be set equal to marginal cost. Clearly, the whole argument rests on two underlying propositions: (a) that output price is a correct measure of the benefit consumers derive from their marginal consumption, and (b) that marginal cost is a correct measure of the value of the resources absorbed in producing the marginal bit of output. If one or both of these propositions is not true, the ‘marginal cost pricing rule’ may have to be modified.

Reference: The Penguin Dictionary of Economics, 3rd edt.