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Marginal cost pricing

'Marginal cost pricing' expresses the theory that the net benefits of an economic activity are maximised when prices are equal to the marginal cost of production. This is because prices measure consumers’ marginal willingness to pay, and therefore the value, of a commodity or service. The marginal cost is the quantity of resources, which must be employed to produce a single extra unit of the commodity. When price equals marginal cost, it indicates that the cost of the marginal unit of production is just equal to, and therefore justified by, the value of the extra consumption. In the case of water resources, the ‘cost of production’ should be interpreted to include the impact on the environment. Damage to the environment can lower welfare directly (e.g. through reduced amenity), or indirectly, through the need to spend more on water treatment. Also, any current use must reduce the amount of water available for use in future periods. This would apply to any store of water, such as an aquifer or lake, being used in excess of its recharge rate. Continued exploitation must at some time lead to exhaustion. Hence, current use of the resource has an opportunity cost which is the cost of use foregone in the future. Various formulae exist on which marginal cost pricing policies can be based, which take into account the indivisibilities, which are a feature of water resources, investment.

Further information: Pricing of Water Services. OECD, 1987.

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