Ramsey Pricing

If an enterprise has common costs, marginal cost pricing may not be feasible. Ramsey pricing is the second best alternative that allows the firm to recover its costs while minimizing adverse effects of allocative efficiency. In case of common costs, an unregulated profit - maximizing firm may decide which products should be priced above incremental costs and how much above. But for regulated firms limited to a maximum rate of profit and for non-profit enterprises expected to just cover costs, Ramsey pricing provides answers.

A simple version of Ramsey pricing specifies that deviations of prices from marginal costs should be inversely proportional to the demand elasticites of goods and services. Thus, prices of goods for which demand is elastic should be priced near the marginal cost. Conversely, where demand is inelastic, prices should be lower in relation to marginal cost.

If demand is elastic, increasing the price causes a substantial reduction in quantity demanded. But if demand is highly elastic, large changes in prices will result L. lesser change in quantity demanded. In the extreme case of totally inelastic demand, there would be no change in quantity demanded as price is increased. Hence, if deviations from marginal cost are greatest for goods with inelastic demand, the resource misallocation is minimized. 

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