Competitive firms play an important role in ensuring that resources are allocated efficiently, while monopolies behave in ways that lead to resource misallocation. To a large degree, this difference in outcomes follows from the difference in their pricing rules: competitive firms engage in marginal cost pricing while monopolies do not. The efficiency of other market structures will likewise hinge upon the pricing rules that they follow.

This chapter begins with a discussion of the role played by marginal cost pricing in generating efficient outcomes. It then considers some alternative market structures, with an emphasis on the pricing rules. While the results are somewhat mixed, they do show that competition among price-taking firms is the only market structure under which marginal cost pricing is ensured.

MARGINAL COST PRICING

An economy reaches an efficient allocation if marginal social benefit is equal to marginal social cost in every market. This condition is satisfied if

1. 1) The private marginal benefit of consuming any good is equal to its social marginal benefit, and the private marginal cost of producing any good is equal to its social marginal cost.

2. 2) Production and trade continue until there are no further mutually beneficial trades.

Competitive markets can be the mechanism that ensures that 2) is satisfied. Competitive firms engage in marginal cost pricing – that is, each competitive firm expands its production until private marginal cost is equal to the market price.