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What Is Marginal-Cost Pricing?

Business are sometimes required to base product prices on the marginal cost of production.
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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 07 October 2014
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Marginal-cost pricing is a pricing strategy that requires businesses to determine the prices for goods and services based on what is known as the marginal cost of production, or MCP. MCP is a relatively simple figure that represents the expense associated with producing one extra unit of a given product. While this particular pricing tool can be used in just about any type of business setting, it is not unusual for the approach to play a role in setting prices for utilities and other situations in which there is not a great deal of competition for consumers of a given good or service.

One of the reasons that marginal-cost pricing is worthy of consideration is the fact that marginal costs usually decrease as more units are produced. When applied to situations in which there is no real need to generate profits, this approach helps to make sure that all expenses are covered while still offering the products at the lowest rate possible without incurring a loss. This can be important when a government is attempting to deal with an economic crisis by invoking limitations on how much is charged for services like electricity, water, sewage, and natural gas to consumers living within that particular jurisdiction.

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Businesses that must operate at a profit to survive also find it helpful to consider the marginal-cost pricing model when setting retail and wholesale prices for their products. Since the idea is to earn at least a small amount of profit off each unit produced and sold, knowing the marginal cost associated with each finished unit makes it possible to set prices at a level that is slightly more than that cost of manufacturing. As a result, the business has a benchmark that can be used when negotiating volume discounts with a customer or group of customers that are willing to purchase certain amounts of the products over the course of a contract in exchange for discounts off the published retail price.

By determining the amount of marginal-cost pricing, a company can also have some idea of how to adjust retail pricing during some type of economic crisis and still generate some amount of profit. For example, a restaurant may need to lower the prices on menu items during a recession in order to attract cash-strapped consumers to continue eating at the establishment. By understanding the marginal-cost pricing involved with each serving of a menu item involved, it is possible to arrive at a lower price that is competitive enough to bring customers back, while still allowing the restaurant to cover its expenses and avoid losing money on the operation.

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