Marginal Cost and Public Goods

In neoclassical theory, firms are supposed to maximise profit by seeking a level of output where they equate marginal revenue with marginal cost. For most real world firms, however, this is an absurd policy that would result in insolvency and bankruptcy, because most firms need to recoup both variable costs and overhead/fixed costs before they can be profitable.

Neoclassical economics can cause havoc when applied to the pricing policies of certain types of public utilities or public goods, as Steve Keen argues:

“The flaws in economic reasoning … have a very direct impact on public policy in the area of the pricing of public services. Because economists believe that competitive industries set price equal to marginal cost, economists normally pressure public utilities to price their services at ‘marginal cost.’ Since the marginal costs of production are normally constant and well below the average costs, this policy will normally result in public utilities making a loss. This is likely to mean that public utilities are not able to finance the investment they need in order to maintain the quality of services over time. This dilemma in turn interacts with the pressure that economists also apply to privatize public assets, and to let individuals ‘opt out’ of the public provision of essential services. The end result, as Galbraith so eloquently put it, is ‘private affluence and public squalor.’

Ironically, economic theory also makes economists essentially ‘anti-capitalist,’ in that they deride real businesses for pricing by a markup on cost, when theory tells them that prices should be set at the much lower level of marginal cost. Industrialists who have to cope with these attitudes in their dealings with government-employed economists are often among the greatest closet anti-economists of all. Maybe it’s time for them to come out of the closet.” (Keen 2011: 123, 124).

Excepting those public goods that are, and should be, free at the point of delivery, other public goods for which a price will be charged will make losses if they equate price with marginal cost, so that the government will have to subsidise them.

Even if they charge a mark-up over marginal cost, that may not be enough to turn a profit, since the relevant cost of production for most businesses is total average unit costs, not marginal cost.

There is a strange paradox at work if a public utility is forced to charge prices at marginal cost: the public will get a much cheaper good, but the government will need to subsidise it and provide the money needed for investment and growth, and the losses will be used by critics of public goods as an argument that they should be privatised, even though the problem stems from the rotten economic theory that such critics themselves hold.

That is to say, if public goods are priced at marginal cost, then losses are most probably inevitable and there is no “failure” involved when governments must subsidise these public utilities.

Keen’s last point is also a crucial one (and was made by Galbraith in the The New Industrial State): businesses are sometimes accused of having unfair prices or “price fixing,” but that charge often makes no sense once we see that the marginalist pricing theory on which it is based is mostly rubbish and irrelevant to real world businesses.

BIBLIOGRAPHY
Galbraith, J. K. 1985. The New Industrial State (4th edn.). Houghton Mifflin, Boston.

Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.