Introduction

Pricing by a public enterprise is labeled “second-best” when the enterprise must depart from ideal marginal cost prices for some accepted reason, such as to avoid too great a financial loss, and does so in a way that minimizes the consequent loss in economic welfare. The traditional “natural monopoly” faced precisely this problem. Since further economies of scale could be realized even after all demand was met, marginal cost would lie below average cost, and pricing at marginal cost would result in a deficit. For two main reasons such a deficit might be regarded as unacceptable even in a welfare-maximizing public enterprise. If price is set at marginal cost and general tax revenue is used to meet the resulting deficit, some nonusers may be forced to contribute to the cost of the service, and that seems unfair. In addition, a general tax probably will introduce price distortions elsewhere in the economy, since only a lump-sum tax would not move prices away from marginal cost levels, and a perfect lump-sum tax is infeasible. So pricing above marginal cost may be proposed for the public enterprise as an alternative way to avoid the deficit.

If more than one good or service is produced by the public enterprise, the question then arises, How are departures from marginal cost prices to be made? Second-best pricing provides one answer, for it defines the most efficient prices that are possible given any specific constraint that must be satisfied, such as a budget constraint requiring total revenue to equal total cost.