Who Are You Calling Irrational? Marginal Costs, Variable Costs, and the Pricing Practices of Firms
Russell Pittman, EAG 09-3 July 2009
Economists sometimes decry the persistence with which firms set prices
above marginal cost and thus, according to the economists, fail to maximize
profits. But it is the economists who have it wrong – first, because
variable accounting costs are not always a good proxy for marginal economic
costs, but more importantly because in an industry with U-shaped cost
curves, a firm at a long-run sustainable equilibrium faces increasing
marginal costs – i.e., a rising shadow price on some
constrained input – i.e., in general, acost of capital.
A corollary is that in such an industry the equilibrium mark-up over
variable cost varies directly with capital intensity.
JEL classifications: B21, D24, D43, K21, L11, L40
Keywords: market power, price, mark-up, marginal cost, variable cost