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The rationale of marginal-cost pricing
Vinod Anand | 05 Jul 2012

Before talking about an improvement in the allocation of resources we require certain ethical premises on which judgments of better or worse are to be raised. In the West they have usually been of a libertarian character: nothing is good for society unless it is held to be good by the individuals who form that society.

AND WHILE it is true that there are people who appear to be incompetent judges of their own interests, this is usually regarded as an argument for education rather than for paternalism. Be this as it may, since there is no providential method of skies-mining the true interests of any persons who would command general assent, it would be impolitic at this early stage to premise propositions about social welfare on anything other than each man's view of his own interest.

Though aware then of its occasional falsehood we follow, provisionally, the liberal convention of regarding each man as the best judge of his own welfare. Let me define an improvement in the allocation of society's resources in a way familiar to economists - as an economic re-organization of those resources, involving a change in the collection of goods produced and in their distribution, which could make some people better off (in their own estimation) without making anyone else worse off.

An 'optimal', or 'ideal', or 'summit' position's the adjectives are used interchangeably- is therefore defined as one from which no economic reorganization can qualify as an improvement in resource-allocation: in other words, an optimal position is one from which no economic reorganization is possible that makes some people better off without in the process making at least one person worse off.

Alternatively, an optimal position may be interpreted as one that does not contain any ?slack?, inasmuch as there is no way of reorganizing production and distribution as to make everyone better off than he is.Such an optimal position of the economy has associated w, it a well-known property: that the collection of finished goods valued at the prevailing prices has a higher value than that any alternative collection of goods that could be produced WI the existing resources of society. This property is indeed a corollary of the definition of an optimal position. For if it were otherwise, if one could reshuffle the existing resources so as to produce a collection of goods with a yet greater value at the initial prices then it would, after all, be possible to give everyone the same value of goods as he enjoyed before and still have some goods left over. The value of these goods left over could then make one or more persons better off. But this implies that an allocative improvement is still possible.

Therefore the so-called optimal position was not, after all, optimal as defined. It cannot then be otherwise than as stated: an optimal position has the property that, valued at its prevailing prices, no other collection of goods producible with the same total resources of society can be worth more than the optimal collection.How can we know when the economy is at an optimal position? In general, when no resource?no type of labour, or of machinery, or of land ? can be made to yield a higher value when transferred to some other employment. If we follow the custom of regarding these resources as divisible into very small units ? an expository convenience?and also, to some extent, substitute for one another, this highest-value property of an optimal position, mentioned above, can be expressed by saying that the value contributed by a unit of any type of resource will be the same at the margin for all goods in which it is used.

For example, in an optimal position, the value contributed by an additional, or marginal, unit of a given type of labour in textile production, in fishing, in barley cultivation, and in every other process in which it is used, must be the same. If it were otherwise: if it were still possible to transfer a resource from its current occupation to some other occupation in which the value of its contribution were larger, we should have succeeded in increasing total value at the prevailing set of prices. It would, therefore, follow from our first optimal property that we could not have been in an optimal position to start with. Hence the standard optimal rule, or allocation rule, that the marginal value contributed by any type of resource be the same in all its uses to which it can be put.