A New Theory of Pricing and Decision-Making for Public Investment

Edna Loehman and Andrew Whinston

Bell Journal of Economics, 1971, vol. 2, issue 2, 606-625

Abstract: This paper presents a theory for price-setting in public utilities, of which public goods will be considered a special case. Both public goods and utilities are cases of joint supplies and costs, where a good is to be supplied to and paid for by several users, and any increase in the quantity of the good is equally available to all users. The pricing system proposed will be based on the idea of each user's paying the social incremental costs due to his demands. To a certain extent, Coase proposed a similar idea, but it was not worked out except in special cases. The concept has been difficult to apply due to problems in defining incremental cost when there are joint costs. A meaningful definition of social incremental cost will be given here. Where the classical assumptions hold, our theory reduces to marginal-cost pricing; however, in the case of decreasing costs, results different from marginal-cost pricing are obtained. Since users may have quite different demands, incremental-cost charges will not be uniform. However, the incremental-cost system does posses certain equity properties. Furthermore, this system of charges will cover the complete costs of supplying a public service. Finally, the concept of incremental cost implies that, at the optimum investment, the marginal unit should be charged marginal cost, which is the condition necessary for welfare maximization.

Date: 1971
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