[The following was posted on the AEI's Enterprise Blog yesterday.]
Margin of Error: Against a Persistent and Pernicious FallacyJanuary 29, 2010, 5:24 pm
In a pair of recent posts (here and here), Matt Yglesias embraces one of the most pernicious and destructive fallacies of economic thought: the proposition that prices “should” equal marginal cost. As my colleague Solveig Singleton explained in “Is Cheaper Always Better? Misusing the Concept of Marginal Cost in Policy Discussions,” the idea that “efficiency” is reached by the P = MC equation is true only in an abstract world of unrealistic and static assumptions, but the persistence of the myth continues to cause great damage.
Does the concept of static efficiency or marginal cost have *any* appropriate uses? Rarely. . . .
Models of perfect competition and the concept of marginal cost have some power to explain some of the forces at work in real markets, but they are not a sound normative measure of what the real world ought to look like.
For more discussion, see “Marginalized,” and for a real coup de grace see the eminent economist William Baumol’s 2006 monograph for AEI, How Regulators Can Be Misled By Simplistic Theory, which warns:
Only this year I heard a conference presentation dealing with the economic and legal principles of copyright suggest that the innovating Schumpeterian entrepreneurs are automatically to be deemed proper subjects for antitrust attentions because in the period before imitators enter the market, they can charge prices that exceed the marginal-cost levels of perfect competition. Never mind that this is a prescription for undermining intertemporal efficiency. Never mind that marginal-cost pricing would generally preclude recoupment of the research and development (R&D) costs of the innovations at issue, costs that will have to be incurred many times again if innovation is to continue.
Baumol is too kind in limiting his indictment to “some economists” who are “not as careful as they should be,” because the fallacy and its consequences are woven into a great deal of professional analysis and policy recommendations, not to mention most of antitrust.
Six years ago, the Competitive Enterprise Institute (CEI) did an excellent workshop on Declining Marginal Cost Industries, featuring talks by giants Ronald Coase and Lester Telser. (Disclosure: I helped Fred Smith put it together.) The descriptive blurb notes:
The declining marginal cost problem remains the key challenge to a range of industries. As Ronald Coase long ago noted, a declining cost industry must find some way to finance itself: either via creative multipart pricing (facilitated by bundling or contracts) or via some form of government subsidy. The markets solution has traditionally relied on distinct marketing strategies in different geographic regions and to different segments of the markets, with market segmentation facilitated by the high costs to consumers of transport and/or the difficulty of acquiring information about the prices paid by others. The government subsidy approach inevitably entails government regulatory and /or price controls (there are no “free” subsidies). Clearly, we prefer the market solution.