Factor demands, adjustment costs and regulation

Abstract

Received theory regarding the economic efficiency of public utilities suggests that regulation may result in a distortion of the economic ratio of input usage. Such a distortion would result in allocative inefficiency and possibly a scale inefficiency. This occurs as the regulating agency often imposes a rate-of-return limitation on the utility which is calculated against a rate base which, in turn, is generally some measure of capital stock. The regulated utility may overinvest in the rate base stock to assure achievement of the maximum net present value of profits (see Averch and Johnson, 1962; Baumol and Klevorick, 1970). This overcapitalization results in a higher than allocatively efficient capital-labour ratio, and perhaps a change in output which may be associated with scale inefficiency. These effects of regulation became known as the Averch-Johnson effect (ME). Baumol and Klevorick (BK) refined the concept when they suggested that two distinct interpretations of the AJE were that (1) the capital-labour ratio of the regulated firm will be larger than that of the unconstrained profit-maximizing monopolist; or, (2) the capital-labour ratio of the regulated firm will be larger than the one that minimizes costs for the output level that the firm selects to produce. The first interpretation compares the capital-labour ratios regardless of the output level, whereas the second requires that the comparison be made when the output level is constant. Fig. 1 helps explain this difference. A non-regulated profit maximizing (cost minimizing) firm will operate at point A or A' depending upon output. The first interpretation suggests that when regulated, the firm moves from point A to point B or to B'.' BK showed that this interpretation cannot always be considered economically inefficient and it is thus not always true that the AJE exists as a phenomenon of economic inefficiency. The 'Operation at B(B') under rate-of-return regulation has two characteristics of interest. First, while it is not total cost minimizing and hence allocatively inefficient, it is profit maximizing within the limits of the rateof-return regulation (Smithson, 1978). Second, in order to test for the existence of the WE we must examine how the firm behaves under constant or exogenously given output. Under regulation, output can be considered exogenously set as the regulator sets the price (calculated on the basis of allowed rate-ofreturn) and the market demand schedule in turn then determines output. Further, as regulators require public utilities to meet all demand, we can consider output to be exogenous.