Question

C) Explain the concept of a reservation price. For a producer, why is the marginal cost equal to their reservation price?

Answer 1

For a consumer reservation price is the maximum price she is willing to pay for buying a particular product. For a seller it is the minimum price that at which the product can be sold.

For a producer the marginal cost should be equal to the reservation price because in that case the reservation price becomes the minimum acceptable price below which the product could not be sold. This price is also equal to the minimum of average variable cost.

The producer will not be willing to sell any output below this price level because that the revenue earned in that case will not be able to cover the variable cost of production. Due to this reason the supply function for a producer begins with a reservation price equal to the minimum average variable cost. Marginal cost should at least be equal to this value because only then the sales could be made.