The Inefficiency of Marginal-Cost Pricing and The Apparent Rigidity of Prices
NBER Working Paper No. 1347
Under conditions of natural monopoly, private contracts or government regulation may attempt to avoid inefficiency by setting up a pricing formula. Once the capital stock is chosen,the right price to charge the buyer is marginal cost. But the point of this paper is that marginal-cost pricing provides the wrong incentives for the choice of the capital stock by the seller. If the seller can achieve a high price by deliberately under-investing and driving up marginal cost, there will be asystematic tendency toward too small a capital stock. One type of contract or regulatory policy that avoids this problem charges marginal cost to each buyer, but provides a revenue to the seller that is equal to long-run unit cost, not short-run marginal cost. Such a contract or policy will make the price, in the sense of the revenue of the seller per unit of output, appear to be unresponsive to market conditions.