Regulatory Policy Under Uncertainty: How Should the Earned Rate of Return for a Public Utility be Controlled?
Much of the analysis of the effects of rate-of-return regulation on public utilities has centered on the ‘Averch-Johnson (A-J) problem’ first introduced in 1962. Simply stated, the A-J problem saw the firm choosing its inputs — labour and capital — so as to maximise profits subject to rate of return regulation in a static and deterministic environment. Within this framework they demonstrated that if the allowed rate of return exceeds the cost of capital the firm will choose to employ a higher capital-to-labour ratio than it would under cost minimisation. In other words, the regulatory process will cause social welfare inefficiencies.
KeywordsCovariance Expense Monopoly
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