Unit – 2

Pricing of Public Sector

Ms. Jumie George
Assistant Professor
Dept. of Economics
Stella Maris College (Autonomous)
 Introduction
• The 1st best is Pareto Optimality which exists when all efficiency
conditions are met in every individuals i.e. P = MC
• If P ≠ MC distortions exists (monopoly, externalities, taxes)
• 2nd best theorem – sets pricing rules for the controllable sector (Public
Sector)
• Public sector will provide both public goods and private goods
• Assumption – 2 sector economy – Controllable (public) sector and
Distorted (private) sector (P ≠ MC)
• Is it worth to have P = MC in the Public Sector when P ≠ MC in the
Private sector??
 Introduction
• Social Benefit > Private Benefit
Under Supply (fiscal tool – subsidy)
• Social Benefit < Private Benefit
Over Supply (fiscal tool – tax)

Private Sector – inefficient level of output ( P > MC)

Public Sector – (P = MC) – inefficient - loss
covered by (1) deficit – deficit financing – inflation
(2) tax – cost of collection > yield of tax
 Tax concepts
• Yield of tax – amount received from a tax

• Base of tax – element on which tax is charged – income, profits,

property/wealth

• Rate of tax – percentage charged

• Avoiding is legal and Evading is illegal

 Pricing of the Public Sector
2
1

(Fig – 2) If the private sector provisions, supply is inefficient, P > MC i.e. Output = OXm, Price = OPm
Loss on net cost to society as inefficient output is produced and is provided at high price.
Private sector – OPmaXm

What if public sector provisions? i.e. P = MC (loss and inefficiency)

 Pricing of the Public Sector
3 4

(Fig – 3) If public sector provisions at P = MC (MC pricing), Price = OPo, Output = OXo – Pareto optimal i.e. P = MC met.
Best output compared to what private sector provides.
But, loss incurred by public sector as AC > AR (cost incurred marked with pink broken line)

(Fig – 4) If public sector provisions at P = AC (AC pricing), Price = OPa, Output = OXa.
 Pricing of the Public Sector
• MC Pricing
5 Public Sector = OPocXo (Private sector – OPmaXm)

Total Loss of benefits to consumers (AR as base) from

OXm output rather than OXo output = XmacXo

Total Gain by saving on cost of provisioning (MC as

base) by decreasing output to OXm = XmbcXo

Net Cost to society = (loss of benefits – cost saved) =

XmacXo - XmbcXo = abc

AC Pricing
Output = OXa, Price = OPa
Net cost to society = dec (comparing AC output and
MC output)
Area of ‘dec’ < Area of ‘abc’ i.e. AC pricing is more
efficient compared to MC pricing.
 Pricing of the Public Sector - Takeaways
• Pareto optimal or societal requirement – OXo
• Private provisions – OXm
• Therefore, Govt., provisions but decision on pricing strategy?
• Govt., provides OXa – with AC = P, gets normal profits
• Not Pareto efficient outcome but still there is reduction in loss
compared to MC pricing (OXo – output)
• Natural monopoly – goods or services subject to increasing returns, If
huge amounts are produced (decreasing costs) – oil, railways ,
electricity generation etc…
Special case of AC Pricing
AC curve lies throughout its length above the AR curve

P = AC hence cannot be fixed by Govt.

To produce positive levels of output, P = MC fixed i.e. P = Po

Total benefit to consumers = OadXo

Total cost = OCocXo

The production occurs as long as benefits > loss i.e. Output OXo
produced until OadXo > OCocXo (or) ∆ aCob > ∆ bcd

Common area = OCobdXo

Production stopped if ∆ bcd > ∆ aCob as cost to society > benefits to

society
 Pricing options for Public Sector
• P = MC (MC Pricing)
• P = AC (AC Pricing)
• P ≠ AC (AC fully above AR)
• Theory of 2nd Best
a) Constant Cost
b) Cost not constant
• Peak load pricing
 The Theory of 2nd Best - Constant Costs
Assumptions
• Economy is divided into 3 sectors (substitutes)
X1 – mass transit (controlled sector/public sector)
X2 – urban express (distorted sector/private sector)
X3 – all other distorted sector (held constant)
• All goods are produced at constant costs (MC – horizontal)

Should P = MC in the controllable sector even if else where P ≠ MC ?

Answer – NO – how??
 Constant Costs
• Constant-cost industry refers to an industry where input prices do not
change when industrial output changes.
• Reason - industry demand for input resources only covers a small
portion of the total demand for these resources.
• Also occur when an increase in demand does not affect production
costs (MC – constant and is equal to AC)
 Case of Constant Costs
CS
Area of gefd > abc proving that it is worth
while to reduce Price below MC in CS.
i.e. to fix P < MC
Industry -1 – Controllable Sector, Industry – 2 – Distorted
DS Sector
When P = MC at OP1 in CS, P ≠ MC i.e. P = OP2 in DS
In CS, output is OX1 at price OP1 (MC pricing)
If P < MC at OP1’, Demand drops in DS from D2 to D2 and that
led to increase in demand in CS from OX1 to OX1*
However, Price in DS do not change due to constant costs.
CS – increase in total resource cost (due to increase in output
arising from reduction in price) – X1abx1*
Increase in total benefit (TR) earned from increased output –
X1acX1*
Net reduction in welfare (loss) – abc
DS – saving in resource cost (due to fall in demand) – X2efX2
Fall in benefit (TR) – X2gdX2
Net gain in welfare – gefd
 Case of Non Constant Costs
• Real world cost issues – complicated
• MC – not always horizontal
• There may be more than one distorted sector
• Goods are not perfect substitutes

If price in industry 1 falls below MC, what happens in industry 1 and 2?

 Case of Non Constant Costs
1 2
a) P falls in industry 1
b) D rises in industry 1
c) D falls in industry 2
d) P falls and supply falls in industry 2
(simultaneously)
e) Consumers shift from ind 1 to ind 2
and cycle continues
Since goods are not perfect
substitutes, exact estimation not
possible of process
In industry 1,
• P = OPo and output = OXo (MC Pricing)
When P falls to OP1, output increases to
OX1
• Welfare loss area marked - abc
• Due to P fall in 1, Demand in 2 falls from
D2 to D2*
• And hence Supply falls from MC2 to
MC2* and P drops from OP2 to OP3
• When P =OP2, Output = OX2
• When P falls to OP3, output = OX3
• Welfare gain = area marked – gedh
P = MC not worth while as welfare increases when
P ≠ MC but no precise conclusion arrived at
 Peak load Pricing Vs Uniform Pricing
Short run Supply
Peak load DD
Off Peak DD
electricity
If OP2 is charged, there will be an excess production of
AB during the ‘off-load’ period (waste). If production is
restricted to OQ1, price P2 will be unfair.
During the ‘peak-load’ period, there will be a shortage
of BC, which can be produced only at an extra marginal
cost of CD.
Set price as per situation of DD or price discrimination
Different demand patterns at different points of time or uses–
day/night, summer/winter, household/industrial
Given the installed capacity their production can be increased
but at an increasing marginal cost (MC)
Peak time – consumption or demand is high
Off – peak time - consumption or demand is low
Price fixed with respect to peak load DD is OP3 and OP1 with
respect to off peak DD
OP2 is a uniform price (average of 2 prices)
If OP3 is charged at all times, unfair to consumers
If OP1 is charged at all times, output falls to OQ2 and less
supply during peak times. Leads to load shedding and
breakdowns
OP2 > OP1 (off peak demand) - fall
OP2 < OP3 (peak demand) – rise
 Pricing Strategy - Summary
• MC pricing – (P = MC) 1st best or Pareto optimal
• AC pricing – (P = AC) – break-even – normal profits – close to social
optimum – govt.’s will provide
• Special case of AC – AC fully above AR - (P = MC)
• P ≠ MC – 2nd best theorem – increase welfare with constant MC
• P ≠ MC – 2nd best theorem – increase welfare with increasing MC
• Peak load pricing