The Averch-Johnson Effect
Economics of Competition and Monopoly

1

Rate of Return Regulation

This form of regulation in its purest form takes costs as exogenous and observable and forms prices on the basis of observed costs included and appropriate rate of return on capital.
One of the principal criticisms that have arisen for the kind of rate of return regulation practised in the United States is that the incentive for productive efficiency are reduced. In particular the input choice of the regulated firm will be distorted. While this effect is widely quoted there are a number of misunderstandings regarding the nature and significance of the theoretical result and there has been a fairly substantial empirical literature that has questioned whether it is relevant in practice. We will look at the theoretical result to illustrate what it does or does not show and look at the empirical relevance. The key aspect of rate of return regulation is that the principal restriction on the regulated firm is that the rate of return it can earn on capital is restricted to a value s. In order for the firm to be able to finance its operations, secure funds for its investments, the firm has to be able to earn a return equivalent to its cost of capital r. As it is difficult to determine the exact cost of capital and there is a hard constraint that the permitted rate of return should not be less that r the permitted rate s will typically be above r.
The usual (and somewhat misleading) statement of the Averch Johnson result is that because s > r there is an incentive for the firm to overinvest in capital to earn higher absolute values of profit. This can lead to a number of conclusions (some true some false). These can be characterised as.
Proposition 1 The input choice chosen by the firm subject to rate of return regulation will not be the cost minimising choice.[TRUE]