Does marginal cost equal price?

We’re all taught that in a competitive industry price will equal marginal cost.  Well, what is a competitive industry?  There are lots of Chinese restaurants in or near Fairfax, and with a few noble exceptions they have more or less the same menu.  Each could serve an extra diner at essentially zero marginal cost, yet the price of the food is not zero.  Not even marginal meals are given away for free, except perhaps to the staff.  If price is equal to marginal cost, we have to ask equal to which marginal cost?  The marginal cost of one more Kung Pao Chicken?  The marginal cost of being known for giving some meals away?  The marginal cost of possibly setting off destructive price competition with rivals?  The concept of marginal cost relies on a definition of time horizon, strategic assumptions, and the counterfactual against which real world action is being compared.  Yikes.

Armen Alchian and Fischer Black are the guys to read on what cost really means (Buchanan and the Austrians only get you so far).  If you really want to get dizzy read Lester Telser on when there is a core, and wonder whether the industry you have in mind meets his screwy but essentially correct standards for MC, AC, and no coherent equilibrium.  It’s not just the airlines.  So when is price equal to marginal cost, average cost, or some blend of the two?  And which definitions of average and marginal cost? 

What about "reality"?  Toss a bone to social frictions, then ask for some micro-studies of how "competitive" industries price in the short run.  Use interviews and ethnography to supplement the formal models.  In practical terms, you might end up with some understanding of a) why prices can be sticky in apparently competitive industries, and b) why few businessmen — including high IQ types — will admit to pricing at marginal cost or even understand what that means.

The bottom line: I’ll say that MC is flat if truly all inputs are replicated.  But that’s never the case, so MC is usually zero under one set of counterfactuals and sloping upward dramatically under another set.  That’s not the end of the world, live with it.

The second bottom line: When it comes to teaching the students, just tell them that marginal cost slopes upward at some point.  After all, sooner or later they all stop studying.

The third bottom line: #13 out of 50.


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