Revenue Maximization and Optimal Capital Policies of a Regulated Firm

Abstract

A well-known result in the theory of regulation, the Averch-Johnson effect [3], is that a profit-maximizing firm subject to a “fair” rate-of-return constraint uses an inefficiently high capital-labor ratio to produce its chosen level of output. While numerous contributions have clarified and generalized the model, these contributions have mostly been couched within a static framework. Recently, Niho and Musacchio [10] have investigated the dynamic behavior of a regulated firm whose investment plans at each moment in time are constrained from below by zero and from above by an amount proportionate to current (regulated) profits.1 Such an upper bound constraint is relevant when imperfections exist in the capital market such as credit rationing and/or the absence of a capital market in which firms may borrow.2