Marginal Cost Pricing Research Articles

Optimal Sin Taxation and Market Power

We study how market power impacts the efficiency and redistributive properties of sin taxation, with an empirical application to sugar-sweetened beverage taxation. We estimate an equilibrium model of the UK drinks market, which we embed in a tax design framework to solve for optimal sugar-sweetened beverage tax policy. Positive price-cost margins for drinks create inefficiencies that lower the optimal rate compared with a perfectly competitive setting. Since profits mainly accrue to the rich, this is partially mitigated under social preferences for equity. Overall, ignoring market power when setting tax policy leads to welfare gains 40 percent below those at the optimum. (JEL D62, H21, H23, H25, L13, L25, L66)

Endogenous innovation scale and patent policy in a monetary schumpeterian growth model

Abstract This paper develops a monetary R&D-driven endogenous growth model featuring endogenous innovation scales and the price-marginal cost markup. To endogenize the step size of quality improvement, we propose a tradeoff mechanism between the risk of innovation failure and the benefit of innovation success in R&D firms. Several findings emerge from the analysis. First, a rise in the nominal interest rate decreases economic growth; however, its relationship with social welfare is ambiguous. Second, either strengthening patent protection or raising the professional knowledge of R&D firms leads to an ambiguous effect on economic growth. Third, the Friedman rule of a zero nominal interest rate fails to be optimal in view of the social welfare maximum. Finally, our numerical analysis indicates that the extent of patent protection and the level of an R&D firm’s professional knowledge play a crucial role in determining the optimal interest rate.

Efficiency versus market power in the rail industry

Although an extensive literature exists that examines efficiency in rail markets, analyses that also study the market power of rail operators are scarce. We examine the effects of competition and vertical separation on efficiency and price-cost margins. In doing so we propose a two-stage procedure. Firstly, efficiency and Lerner indexes will be obtained for a sample of rail operators for the period 2000–2016. Secondly, the determinants of both indexes are jointly estimated. Results indicate that integrated incumbents not facing competition perform worst and exert the highest market power. Vertically separated and specialized in passenger services operators display the strongest improvements in efficiency levels, while integrated incumbents facing competition show the lowest market power indexes. Finally, more efficiency translates to smaller values of the Lerner index.

How Much Competition is Enough Competition for Regulatory Forbearance?

Abstract Critical loss analysis is used to define product markets for merger analysis and determine if market forces are sufficient to discipline prices in transitionally competitive regulated markets. Unlike the approval of a merger, however, regulatory forbearance is a reversible act. The threat of future (re)-regulation, or regulatory contestability, in combination with high price-cost margins and complementary demands can lower the critical loss (elasticity) necessary to justify the competitive classification of regulated services. This suggests that the intensity of competition sufficient to forbear from regulation can be considerably less than what regulators may believe is required a priori.

Price-Cost Margins, Fixed Costs and Excess Profits

Abstract This paper provides a new method to estimate price-cost margins in the presence of fixed costs of production. By exploiting properties of the primal and dual sales-based and cost-based Solow residuals, we are able to simultaneously estimate price-cost margins and the share of fixed costs in total costs for each input. Ignoring fixed costs in production underestimates price-cost margins and overestimates excess profit shares. Using a thirty-year panel of Belgian firms, we estimate price-cost margins, as a fraction of sales, of 25.4% on average, which can be decomposed between fixed costs of 22.9% and excess profits of 2.5%. Belgian price-cost margins have declined (−5.9%) in the past three decades due to a combination of falling fixed costs (−4.0%) and decreasing excess profits (−1.9%), suggesting that output markets have become even more competitive over time. While large firms have higher profit shares than small firms, they have lower fixed cost shares as well as lower price-cost margins.

Optimal Contracts for Time-Inconsistent Consumers with Heterogeneous Beliefs

In many markets (e.g., cell phones, video games), firms offer menus of contracts that include some tariffs charging per-use prices above marginal cost and others below marginal cost. We term this puzzling phenomenon as two-sided deviations from marginal cost pricing and present a potential explanation based on two well-recognized consumer characteristics. The first one is that consumers’ actual consumptions may depart systematically from their initial plans (i.e., time-inconsistent preferences). In addition, consumers can be either sophisticated or naive in their beliefs about their time inconsistency (i.e., heterogenous beliefs). We characterize properties of the optimal contracts for a firm to screen the time-inconsistent consumers with heterogeneous beliefs. We articulate the conditions under which the optimal menu may account for two-sided deviations from marginal cost pricing. We also show that, contrary to intuition, a higher degree of time inconsistency may reduce firm profit and increase social welfare. Meanwhile, reducing consumer naivete may harm the society. Moreover, we confirm that our main results are robust to the presence of time-consistent consumers. This paper was accepted by Dmitri Kuksov, marketing. Funding: This work was supported by the Hunan Provincial Natural Science Foundation of China [Grant 2022JJ40102]. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.02653 .

Cable cars: From optimal design to optimal pricing

Although cable car services have become an integral part of the transit system in many cities in the world, their specific technology has never been studied from the viewpoint of the links between optimal design and marginal cost pricing. Here we formulate, solve and apply a first model to represent the specific features of a cable car system considering operators' and users' costs. The links among cabins’ density, their speed and capacity, frequency, slope, and others, are formulated to obtain the optimal design variables as a function of demand volume, a system cost function, marginal and average costs, and first best money prices and possible subsidies. An application with sensitivity analysis illustrates the model.

Alarm probabilities of simple tests of merger control: An analytic derivation

<abstract> <p>For ten simple horizontal merger tests, I analytically derive the probability of blocking a merger. The assumptions are the symmetry of diversion ratios, price-cost margins, and efficiency gains, and the uniform joint distribution of these variables. The robustness analyses suggest that the limitations arising from the simplifying assumptions are only moderate. Based on these results, I provide an easy-to-use Excel calculator (without VBA macro), with which the probabilities associated with any product market and price increase threshold can be quickly calculated. Additionally, I propose a paired testing protocol for unknown demand systems by linking linear- and isoelastic-demand indicators through the threshold or the alarm probability.</p> </abstract>

Central Bank Rate Pass-Through Effects on Kenya’s Lending Rate

Several African nations, including Kenya, Nigeria, and South Africa, have seen dramatic shifts in their monetary policy framework and financial environment during the last two decades. To manage and stabilize the economy, the Central Bank of Kenya (CBK) stopped intervening directly in lending low interest rates at financial institutions and instead turned to indirect and market-based measures to carry out monetary policy. Even though it was predictable that a changing financial environment would have a substantial impact on the efficacy of monetary policies, there has not been sufficient research done to determine how IRPT affects lending rates. The purpose of this article was to analyze the pass-through effects of the central bank rate on lending rates in Kenya. The study adopted a non-experimental research design. Data was collected from the CBK, the Kenya Bureau of National Statistics, and the Nairobi Stock Exchange between 2010 and 2021 quarterly data. The study's theoretical underpinning was the loanable funds theory and cost of capital. The cost-of-funds method is based on the conventional marginal cost pricing model for financial markets and helps explain how market prices are transmitted to consumers. The error correction model was used to measure the short-term effect of bank rate changes on Kenyan lending rates. The findings showed that Kenya has an incomplete IRPT which means that increases in the lending rate would be less than proportional whenever there is a change of a specific percentage in the CBR. According to the study, this may be one of the causes of some banks' foreign ownership, their independence from the central bank's liquidity, and their slow reaction times to signals from the central bank to modify lending rates. The study recommends that since commercial banks are a very important component in the transmission mechanisms, they should follow suit in the adjustment of the lending rates.

Finding individual strategies for storage units in electricity market models using deep reinforcement learning

Modeling energy storage units realistically is challenging as their decision-making is not governed by a marginal cost pricing strategy but relies on expected electricity prices. Existing electricity market models often use centralized rule-based bidding or global optimization approaches, which may not accurately capture the competitive behavior of market participants. To address this issue, we present a novel method using multi-agent deep reinforcement learning to model individual strategies in electricity market models. We demonstrate the practical applicability of our approach using a detailed model of the German wholesale electricity market with a complete fleet of pumped hydro energy storage units represented as learning agents. We compare the results to widely used modeling approaches and demonstrate that the proposed method performs well and can accurately represent the competitive behavior of market participants. To understand the benefits of using reinforcement learning, we analyze overall profits, aggregated dispatch, and individual behavior of energy storage units. The proposed method can improve the accuracy and realism of electricity market modeling and help policymakers make informed decisions for future market designs and policies.

How does firms’ cost structure affect their quality–price mix? An experimental analysis

Experimental literature on product differentiation is scarce and mostly focused on horizontal product differentiation. This paper focuses on vertical product differentiation considering a quality-then-pricing duopoly game and exploring how firms’ cost structure affects firms’ decisions and market structure. Two scenarios are considered, differing in the way quality affects production costs: in the first, quality is costless, while, in the second, marginal production costs increase with quality. We explore the impacts on market coverage, qualities, product differentiation, prices, and intensity of competition (assessed by price-cost margins). Our experimental results confirm the (theoretically proved) need to endogenize the market structure, as a duopoly with full coverage emerges when quality is costless, but a duopoly with partial coverage emerges when quality is costly. We also find that quality differentiation is lower in the lab than what is theoretically predicted, and lower in the costless quality treatment. The intensity of competition is higher when quality is costly, as price-cost margins are lower in this case.

The emerging discipline of public economics in postwar France

After the Second World War, optimal pricing in the public sector became an important topic internationally. The welfare enhancing properties of marginal pricing were a key concern, yet, the technical computation of marginal costs also proved difficult. It was unclear how to compute marginal costs, mainly in view of the discontinuities of the cost function. In the context of post-war reconstruction and of practically implementing a marginal pricing policy, this technical debate was closely linked in France to the “Calais traveller paradox” and the emergence of a new generation of engineer-economists contributing at the same time to the theoretical debate and to the practical implementation of marginal cost pricing. Maurice Allais and Marcel Boiteux, as well as Gabriel Dessus and Roger Hutter contributed to developing national solutions that also spread theoretical thinking internationally. This debate connects with the history of economic calculus and the rise of public economics, as well as the possibility of computing optimal welfare enhancing prices in the face of market failures.

Taxation and Durable Goods Monopoly*

This paper studies the role of taxation in durable good markets with dynamic monopolies. By conditioning the marginal tax rate on the volume of trade, the regulator can provide incentives for the monopolist to accelerate trade. When marginal cost pricing generates a loss for the monopolist, strategic delay cannot be avoided under regulatory budget constraint and the effects of tax policy depend on the monopolist's ability to commit. In the context of binary consumer types, we find a tax policy involving “back‐loaded subsidy” that achieves the second‐best outcome with commitment. In contrast, without commitment, a “front‐loaded subsidy” improves welfare.

Do petrol prices rise faster than they fall? Evidence from the UK retail and wholesale petrol sectors

This study investigates the presence of price asymmetries in the UK retail and wholesale petrol sectors over the period of January 2020–July 2022. The scope of this research is to explore whether petrol prices rise faster than they fall according to changes in input costs, namely fuel and international crude oil prices for the retail and wholesale sector respectively. As the time sample considers the shocks of covid-19 restrictions and rising inflation, the presence of structural breaks is assumed which may contribute to asymmetric behaviour. The Autoregressive Distributive Lag (ARDL) approach is implemented in the pricing equation of the model by formulating four versions for each sector, according to the presence of asymmetries and price-cost margins. The results provide significant evidence of price asymmetries in the retail petrol sector; however, such asymmetries are less pronounced over high margin periods. The wholesale sector is found to be more flexible to changes in crude oil prices as asymmetries are less persistent throughout the sample. Therefore, consumers face rigid petrol prices because of retail firms’ decisions, which should be the focus of policy makers.

Energy Price Decoupling and the Split Market Issue

Load scheduling and dispatch by merit order on electricity generation networks has used a wholesale market electricity system operator model focused on system marginal pricing, in which the spot price of electricity at any point in time is equal to the system marginal cost given by the higher value of the price, which rations demand to capacity or the operating cost of the most expensive plant on the system, which is usually a fossil fuel price. This idea has come under challenge because renewable technologies such as wind power farms or solar power farms are treated as having close to zero operating costs. The challenges, under the general heading of energy price decoupling, include suggestions for operating split markets possibly overseen by a regulator, and the prediction that marginal cost pricing should be abandoned. This review evaluates these in terms of their economic impact, relating them to the policy debates on electricity market reform.

Ramsey pricing: a simple example of a subordinate commodity

AbstractWe present preferences exhibiting a so-called subordinate good, namely a commodity such that the willingness to pay for it increases when the consumption of all goods increases proportionally, and thus receives a negative price-cost margin according to Ramsey pricing. We also show that its Bertrand equilibrium price is above its Cournotian price.

Analysis of the Effect of Industrial Concentration on Profit of the Indonesian Plastic and Packaging Industry

The Indonesian plastics and packaging industry can have a considerable opportunity to continue to grow because the plastics and packaging industry has a significant role in the economic development of the industrial sector. This study aims to determine and analyze the effect of the level of industrial concentration on the profits of the Indonesian plastics and packaging industry. This research uses secondary data in the form of time series originating from the Indonesian Statistics for the period 2010 – 2019. The analytical technique used in this research is using qualitative and quantitative analysis techniques. The analytical method used is the calculation of the concentration ratio of 4 companies, profit calculation using Price Cost Margin and simple linear regression. The results showed that the plastic and packaging industry was concentrated with a concentration ratio of 16 percent. According to Joe S. Bain's theory, the plastics and packaging industries fall into the fifth level oligopoly category. The profit rate in this industry is relatively decreasing with an average of 34.76 percent. Based on the results of simple linear regression, it is stated that industry concentration is not significant to the profits of the Indonesian plastics and packaging industry.

Too many or too few? On the optimal number of firms in the commons

In this paper, we consider common-pool non-renewable resource industries and study the socially optimal industry size. Our analysis is conducted in terms of an infinite-horizon differential game (with either open-loop or feedback strategies). We derive two main results. First, we show that there exists a unique state-independent efficiency-inducing industry size, ranging between 1 and infinity, if and only if the elasticity of the price-cost margin (capturing static market power) and the elasticity of the difference between social and private resource rents (capturing the tragedy of the commons) are the same. Second, allowing for entry/exit, we show that the regulator can set a license fee to be paid by firms to get access to the resource such that the endogenous number of firms in the equilibrium with regulated entry is socially optimal.

Electricity Tariff Design: A Survey

In a perfectly competitive market, electricity is priced at the Marginal Cost (MC); MC pricing guarantees economic efficiency (Gunatilake, et al. 2008). In other words, efficient electricity tariffs consider all power supply costs. To a great degree, it also accounts for capital investments for future expansion and up-gradation (Kojima, et al. 2014). In a free market, market forces of demand and supply pushed for MC recovery. In contrast, for a regulated market, the regulator sets the tariff according to the costs and reasonable return determined through the regulatory process. The regulator followed pre-determined guidelines, parameters, and standards set by the government; it may or may not be MC pricing. When a regulated tariff is set at a low level, it distorts the development/ functioning of the market at both the wholesale and retail levels. “If regulated end-user prices are not in line with wholesale market conditions, suppliers without significant low-cost generation capacity or equivalent long-term contracts will not be able to make competitive offers that will allow them to recover their costs. Consequently, with a limited number of suppliers, there will be no development of the wholesale markets. Liquidity will remain at a low level. As a result, neither the wholesale nor retail markets will be competitive” (Cited from Suzzoni, 2009, p. 5).

Informative Industrial Analytic for Effective Retail Business Performance: A Case of Emerging Economy

This study analyzed the Indonesian retail industry’s structure, behavior, and performance in 2018-2020. It is essential because the potential of the retail industry in Indonesia is one of the most significant contributors to GDP and employment. Thus the retail industry has a very strategic role in the Indonesian economy. If a few companies dominate the market, it will become an obstacle for external companies to enter the retail industry, which can lead to a decline in the level of profits and the overall performance of the retail industry. This study aims to identify and analyze the structure, behavior, and industry performance of the retail industry in Indonesia in 2018-2020. This study uses data on public companies listed on the Indonesia Stock Exchange. The data were analyzed using CR4, industrial behavior, and Price Cost Margin analysis. The results show that the average value of CR4 in the Indonesian retail industry in 2018-2020 is 60.276%. It means the structure of the Indonesian retail industry is a tight oligopoly. This condition has led to several behaviors carried out by industry players in the retail industry in Indonesia to increase profits and expand their market share. These behaviors include product strategy (product differentiation), price strategy (second and third-level price discrimination), and promotion strategy. The overall performance of the Indonesian retail industry still needs to improve because the PCM value of the Indonesian retail industry in 2018-2020 is less than 50%. This study recommends that companies pay attention to strategies to increase their competitiveness. Government supervision is needed on business activities that are indicated to be too dominant in their position and make it difficult for new entrants to the retail industry in Indonesia. Companies also need to pay attention to production efficiency in their business, not only focusing on controlling market share so that the strategy can effectively create higher profits.