AP MicroeconomicsMarket Failure & Government
Marginal-Cost Pricing (Socially Optimal Price)
Marginal-cost pricing regulates a monopoly by forcing price down to where demand meets marginal cost (P = MC), the allocatively efficient 'socially optimal' output.
Setting P = MC maximizes total surplus because the last unit's value to buyers equals its cost to produce, eliminating deadweight loss. For a natural monopoly, though, MC lies below average total cost across the relevant range, so charging P = MC means price is below ATC and the firm earns a loss—requiring a government subsidy to stay open. This trade-off (efficiency vs. solvency) is why regulators often retreat to fair-return (average-cost) pricing instead.
Formula / Example
Set P = MC; for a natural monopoly this gives P < ATC ⇒ economic loss (subsidy needed).