Incremental Costs and Efficient Prices with Lumpy Capacity

The Single Product Case

by Rolla Edward Park

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This report discusses the relationship between incremental costs and efficient prices when capacity must be added in costly "lumps," as much of it must be in the telephone business and other capital-intensive industries. It emphasizes comparison of various pricing rules, using numerical results from an abstract computer simulation model. The author provides some quantitative comparisons of prices and their effects on aggregate economic welfare and consumer surplus under the three pricing rules. He uses computer simulation models to determine the relationship between capacity costs and optimal prices; how the lumpiness of capacity affects prices, welfare, and consumer surplus, and how the effects differ for smaller or larger lump sizes; and what is gained by using more elaborate pricing rules when capacity is lumpy. The findings indicate that more complex variable prices offer large efficiency gains over simpler pricing schemes.

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