When does marginal cost pricing lead to Pareto efficiency?

Abstract

It is well-known that Pareto-efficiency requires, at least in many cases, that prices be set equal to marginal costs. For this reason economists often argue in favor of the marginal cost pricing rule as long as no overly large deficit results. If strongly increasing returns to scale cause a deficit which is considered too large, the marginal cost pricing rule is appropriately modified. To cover the deficit partly or fully, necessary conditions for optimal departures from marginal cost pricing are derived and their implementation is recommended. Normative considerations of this kind lead to what is called Ramsey pricing or pricing ~t la Boiteux. The normative character of Boiteux-Ramsey pricing is the starting point of a large part of the industrial organization literature and the basis for many specific policy recommendations, a typical example being proposals for the structure of telephone rates. Even if one is aware of the fact that quite often first best optimality requires marginal cost pricing and second best optimality requires Boiteux-Ramsey pricing, a further thought leads to the question of what the final outcome will actually be if such pricing rules ate adopted. Leaving distributional aspects aside, although they can be of great relevance, and focusing on efficiency only, o n e