How should marginal costs be considered when determining prices?
The basic rule of setting prices is that a firm must produce a quantity of goods or services that allows the marginal revenue to be equal to the marginal cost. This is called the profit-maximizing point. From this point of view, a firm should determine the optimal quantity of products to make and should then set its price so as to sell all of those products.
However, there are cases in which firms should vary their prices. There are instances in which a firm should set prices for some people higher than marginal costs and sell to other people at a price that is lower than marginal costs. This is called price discrimination and should be used when it is not possible for someone to buy at a lower price and then turn around and resell the thing they have bought.
For example, let us say that an airline has empty seats on a given flight on the day that the flight is scheduled to leave. The empty seat will cost the airline money. Therefore, the airline should sell that seat cheaply to anyone willing to buy it so long as the price is higher than the marginal cost of carrying that passenger.
Determination of prices is done in many different ways based on many different considerations. Even when prices are set on the basis of cost, there are different methods used by different companies, and by the same company under different situation. The marginal costs are usually considered for pricing decisions that involve decisions on changing prices from a given level. This involves comparing the impact of any price changes on marginal cost and marginal revenue. When the value of marginal revenue minus marginal cost is positive the planned change will result in increase in the profit.
Marginal costs are also used for long term capacity and pricing decision in the form of break-even analysis. This analysis permits taking decisions on production capacity based on considerations of fixed costs, variable or marginal cost, manufacturing capacity, and required minimum levels of sales to break-even.