_10_ _Optimal departure from marginal cost pricing._ With scale economies in payment operations, a departure from marginal cost pricing that comes close to delivering the same information for efficient resource allocation is to relate the degree to which price exceeds marginal cost to the size of the own price elasticity of demand for payments (h). Here price is determined from (P - MC)/P = - 1/h." When demand is inelastic,'<sup>2</sup> price can exceed marginal cost and recover a larger portion of total costs (or even over-recover total costs), but not have much effect on reducing quantity demanded. This preserves the cost reducing effects from scale economies and supplies revenues to cross-subsidize other services.

Many banks implement pricing in this manner, using their best guess as to the price elasticity of demand (equivalen **t** o a judgment regarding the likely sensitivity of payment users to changes in prices). The U.S. central bank, an institution that processes a relatively large volume of retail payments in competition with banks, prices some of its payment services using such judgments and with the restriction (by law) that all costs are recovered, even those that would have been earned as profits by a private sector supplier.

To recover all payment costs, however, requires some cross-subsidization within or among payment services. Those separately priced services with scale economies and elastic demands will under-recover their expenses, requiring other services with less or no scale economies to overrecover their costs in order for there to be an overall cost-revenue match for payment services. The need to over-recover in some areas, however, provides an opportunity for "cream skimming" on the part of other payment suppliers. Competitors who merely price according to their average cost will both recoup all their expenses and have a competitive advantage over the supplier who crosssubsidizes. As payment volume shifts to these lower price competitors, the ability of the crosssubsidizing supplier to obtain an overall cost-revenue match is impaired. Ultimately, this can force the cross-subsidizing supplier to lower or eliminate the cross-subsidy or see its market share reduced.

The difficulty in accurately determining payment demand elasticities prior to implementing a pricing structure, the need for cross-subsidization when scale economies exist (as is common in many payment services), and the possibility of cream-skimming by competitors are the three main problems with this pricing method. These problems do not arise with two-part average cost pricing.

_Average cost, two-part, and benefit-flow pricing._ Average cost pricing is easy to implement: average costs are not difficult to determine and all costs can be recovered without

**_"_** _h is measured as the percent change in the volume of payment service demanded divided by the percent change in its price. h is negative because quantity demanded tends to fall as price rises, so -1/h is a positive value. The equation shown is also known as the inverse elasticity rule or market sensitive pricing._

**2** _Demand is inelastic when h < 1.0 in absolute value, so - 1/h is larger the more inelastic is demand (recall that the value of h is negative, so -l/h becomes positive)._