Pricing to Cost - But Which Cost?

Pricing to marginal cost may not cover fixed cost.

In an efficient market, price is supposed to be set to marginal cost. The reason appears to be straight forward. If price is above marginal cost, it means that some frustrated buyers value the good more than it costs the seller to produce. Therefore, more economic surplus (balloon note here) can be generated by selling more units at lower prices until price equals marginal cost.

But marginal cost consists of only variable cost. If price covers only marginal cost, there is nothing left over to cover fixed cost. A business that does not cover its fixed cost may be efficient to economists, but it is a dead business for the seller.

Pricing to marginal cost would cover fixed cost under only three circumstances; namely, perfect price discrimination, two-part pricing, and perfect competition.

Under perfect price discrimination, each buyer is charged his reservation price (balloon note here) and each unit is therefore sold at a different price. Price equals marginal revenue. When that happens, sellers capture the entire economic surplus with no consumer surplus left over. When selling finally stops where price equals marginal cost, both variable cost and fixed cost are likely to be covered unless the fixed cost is very high and the market very small (see Profit maximization under high fixed cost). Perfect price discrimination can only be practiced by natural monopoly with perfect buyer information selling unique products.

Two-part pricing consists of a lump-sum upfront charge and per unit price. The upfront charge helps to cover the fixed cost, and the price covers the marginal variable cost (see A la carte or Set Menu?). Two-part pricing can be practiced by any price searcher with a downward-sloping demand curve.

Under perfect competition, sellers are price takers charging a constant market price for homogeneous products. When price equals marginal cost, price may not cover fixed cost except when sellers are making positive or zero economic profit. In other words, fixed cost is covered not as a result of the pricing-to-marginal-cost strategy, but as a by-product of market equilibrium where every firm is eventually making zero economic profit (see Firm vs industry output under free entry).

In the short run, of course, fixed cost need not be entirely covered. As long as price covered marginal cost and some part of the fixed cost, it may make sense to continue selling while hoping for better time (see Short-run supply curve for price taker).