Efficiency of Marginal Cost Pricing Equilibria

In an economy with increasing returns to scale the concept of a competitive equilibrium is no longer appropriate. What is the appropriate concept of equilibrium? No fully satisfactory answer has yet been given. Following the efficiency considerations put forward by Dupuit (1844) and Hotelling (1938), the early literature concentrated on a partial equilibrium analysis of marginal cost pricing by the sector with increasing returns. It was clear from the start that while such pricing might enhance productive efficiency, it created another problem, namely that of covering the costs of production. More subtle issues associated with marginal cost pricing only became apparent more recently when Guesnerie (1974) gave the first general equilibrium treatment of marginal cost pricing. In particular he provided a striking example, subsequently simplified by Brown and Heal (1982), of an economy with two goods, two consumers, one nonconvex firm and a rule for distributing income, which has two equilibria both of which are inefficient. To be sure, there exist some income distributions such that at least one associated equilibrium is efficient; this follows from the second welfare theorem which is still valid in non-convex economies (see Cornet, 1986; Guesnerie, 1975; Khan and Vohra, 1987; Quinzii, 1988; Yun, 1984). But this phenomenon greatly complicates the problem of finding an efficient allocation of resources.