The question of how much of a good should be produced and what its price should be can be examined by considering the benefits and costs of various levels of production as shown below.

The level of production that is socially best is the one at which maximum net social benefit is achieved, as is shown below.

The level of production that produces the maximum net social benefit is that level of production such that the marginal social benefit (private benefit plus any externality benefit) is equal to the marginal social (private cost plus any externality cost such as that of pollution). The market price is equal to the marginal private benefit. In the absence of any externalities in the production and consumption of the product the situation would be that which is shown below.

Thus economic efficiency or social optimality involves the market price being equal to the marginal cost. This is called the marginal cost pricing principle. It can be justified by another concept in economic welfare analysis, which is called Pareto optimality. The name Pareto is from the Italian sociologist Vilfredo Pareto who first articulated it. According to Pareto a general definition of economic inefficiency is a situation in which there exists a way of making some people better off without making any other people worse off. Pareto optimality or efficiency is where there are no ways to improve the lot of some without making other worse off.

A situation in which the market price is greater than marginal cost would not be Pareto optimal because another unit of the good could be produced for someone willing to pay the cost of that additional unit, the marginal cost, and that person would be better off since the marginal benefit is greater than the marginal cost and no one else would be worse off.

Although the marginal cost pricing principle is valid principle of economic welfare analysis there are some problems involved with its application. First there is the problem of how to precisely define the relevant marginal cost. This involves the question of long run versus short run marginal cost. There is also the matter of externalities referred to above. There is the matter of indivisibilities and the question of how many production units there should be. This problem is illustrated below.

Consider the cost function of an airline (total cost versus passengers carried between two points). There is a small increase in cost for each additional passenger and a big discontinuous increase when an additional plane has to be put into service. An incorrect interpretation of the marginal cost-pricing rule would suggest that for economic efficiency the passengers should be charged the negligible cost of carrying one more passenger on a partially filled plane or the enormous cost of putting another plane into service. The correct interpretation of the marginal cost pricing principle is that for economic efficiency the passengers should be charged the average cost per passenger of another planeload of passengers.

As is demonstrated elsewhere, the relevant marginal cost for economic efficiency is the minimum average cost of the marginal plant (production unit) rather than the intra-plant marginal cost. When the market price is equal to this quantity it is equivalent to the condition that the marginal plant is earning no economic profit. This condition prevails when there is freedom of entry and exit to and from the industry. Thus freedom of entry and exit from an industry is sufficient to establish economic efficiency in that industry.

The economist Ronald Coase rightly pointed out that the marginal cost pricing principle does not in principle guarantee that the average cost will be covered. If the average cost of production were not covered by the market price then there would have to be subsidies and if there are subsidies then there must be taxes. Any such taxes would have to be paid by the firms in the industry in question as well as firms in other industries. The above analysis indicates that in industries in which there are many plants in production the marginal cost pricing principle leads to market prices that exactly cover the costs of the marginal plant for the industry.