Retrospectives: The Marginal Cost Controversy

From 1938 to 1950, there was a spirited debate about whether decreasing-average-cost industries should set prices at marginal cost, with attendant subsidies if necessary. In 1938, Harold Hotelling published a forceful and far-reaching proposal for marginal cost pricing entitled "The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates." After several years and many pages of discussion, Ronald Coase gave a name and a clear formulation to the debate in his 1946 article "The Marginal Cost Controversy." We will tell much of the story of this controversy by comparing the frameworks of Hotelling and Coase, while also bringing in other contributors and offering some thoughts about contemporary relevance. The arguments marshaled by Coase (and his contemporaries) not only succeeded in this particular debate, as we shall see, but more generally served as part of the foundation for various fields of modern economics, particularly institutional, regulatory, and public choice economics as well as law and economics. Yet the underlying issues are quite difficult to resolve, and the strengths and weaknesses of the arguments for marginal cost pricing can turn on specific elements of the industry.