Average-cost Pricing, Increasing Returns, and Optimal Output: Comparing Home and Market Production

Abstract

A model with both market production and home production is used to show that, ignoring administrative costs and indirect effects (such as rent-seeking), even if both the home and the market sectors have the condition of increasing returns and there are no pre-existing taxes, it is still efficient to tax the home sector to finance a subsidy on the market sector to offset the under-production of the latter. This under-production is due to the failure of price-taking consumers to take account of the effects of higher consumption in reducing the average costs and hence prices, through increasing returns or the publicness nature of fixed costs. Within market production, it is efficient to subsidize more the sector with a higher fixed cost, a lower elasticity of substitution between goods (higher value of diversity), and a lower degree of importance in preference which all increases the degree of increasing returns.