A “marginal cost” is the cost of an extra amount of something. In production, the marginal cost is the cost of the additional inputs used to make another unit of output.

Ideally, the best price to charge a user of a good or service is the marginal cost.

Ideally, the best price to charge a user of a good or service is the marginal cost. Consider the price of corn. Where there are no taxes or government subsidies for producing corn, then if the marginal cost of producing another bushel of corn is $4, but the price is $3, the farmer loses $1 for each bushel produced. The farmer would produce less corn. Firms cut back production when the marginal cost is greater than the market price.

On the other hand, if the price of corn is $5, the farmer makes a $1 profit from producing another bushel of corn. The profit-maximizing farmer would produce more corn. Typically, the extra output from adding more of a variable input, such as labor, declines when one of the other inputs is fixed, such as land. Therefore the marginal cost of production rises with greater output. As the farmer expands production and his marginal cost rises, it eventually equals the price of corn, and at that quantity, the farmer maximizes profit.

Therefore, when the producer and seller are price takers, having to sell at the global market price, the firms will produce the quantity at which price equals marginal cost, and that maximizes both their profits and the well-being of society, as the marginal willingness to pay equals the marginal cost of production. That’s as good as it gets.

When it is not crowded, the best price of mass transit is to make it free to users. Hotels practice marginal-cost pricing for their transit. There is no fee to use the elevator and escalators. These transit services provide mobility, and it is in the interest of the owner to avoid impeding mobility, even if he foregoes the dollars he could collect by charging for transit. The cost of the elevators and escalators is paid from the hotel room charge.

Marginal-cost pricing also applies to collective goods and services, things that people use together, where one more user does not reduce the use by others. An example is mass transit. If a metropolitan area offers trains and large busses, what is the socially best price to charge? You now know the answer: the marginal cost. The energy cost to carry one more passenger on a train or large bus is close to zero, less than the cost of collecting fares, so the socially optimal charge is also zero. When it is not crowded, the best price of mass transit is to make it free to users.

Hotels practice marginal-cost pricing for their transit. There is no fee to use the elevator and escalators. These transit services provide mobility, and it is in the interest of the owner to avoid impeding mobility, even if he foregoes the dollars he could collect by charging for transit. The cost of the elevators and escalators is paid from the hotel room charge. A hotel can charge a much higher price for rooms than if the guests had to walk up flights of stairs. Thus the transit generates a higher rental.

Free transit puts more people into trains and busses, and reduces traffic. The ideal transit makes the city more attractive and productive, increasing the land rent. The higher rent provides the means to efficiently pay for the transit. Landowners pay back to the city the higher rent they get from the public transit.

The same concept applies to city transit. Free transit puts more people into trains and busses, and reduces traffic. The ideal transit makes the city more attractive and productive, increasing the land rent. The higher rent provides the means to efficiently pay for the transit. Landowners pay back to the city the higher rent they get from the public transit.

Zero-priced transit applies when there is no congestion. When a bus is totally full, one more user does impose a marginal cost, making the bus even more crowded and unpleasant for everyone else. In that case, the marginal cost and ideal price is a fare just high enough to eliminate the congestion. The same concept applies to fees for parking and road use.

In the corn example, the firms are price takers, because there are a million farms producing the identical corn. Now let’s consider product variety. Suppose there are a thousand publishers of mystery novels, which are close substitutes but not identical. Now a publisher can set a price for its book. To sell more books, the firm must reduce the price, and get a lower marginal revenue. The profit-maximizing publisher will set a price at which the marginal cost of producing an extra copy equals the revenue from that extra copy.

At that profit-maximizing quantity, the price is higher than the physical marginal cost. Is that socially inefficient? No, the gain to the public is the product variety. If there were only one mystery novel, the price would be lower, but some readers want particular authors, themes, and styles. The price that is higher than marginal cost pays for the benefit of having many brands and styles, so the result is effectively marginal-cost pricing: the marginal willingness to pay equals the physical cost of producing another book plus the cost of providing product variety.

Marginal cost pricing is efficient especially when combined with the payment of the fixed costs from the rentals generated by the service.

We cannot have marginal-cost pricing for all goods, but it does provide a benchmark for the pricing of many public services such as mass transit. Marginal cost pricing is efficient especially when combined with the payment of the fixed costs from the rentals generated by the service, such as by the hotel elevator. Let’s have more MPC—marginal cost pricing!

© Text Copyright Fred Foldvary, Ph.D. rights reserved.
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