Tests of perverse input demand behavior by the rate-of-return-regulated firm

Abstract

This paper tests the possibility, raised in several recent theoretical works, that the demand for a non-rate-base input by a cost-minimizing, rate-of-return-regulated firm may increase (decrease) as the price of that input increases (decreases). Confirmation that regulated firms may increase their employment of labor when they are faced with higher wages may help to explain the relatively high level of cooperation between labor and management in compensation bargaining among regulated firms. The paper briefly reviews the theory of cost and input demand for regulated firms. Then it describes the empirical model used in the test. Using data from the electric utility industry, the paper estimates cost and input demand functions in a three-input long-run model. Parameter estimates from the empirical cost and input demand functions are used to calculate own-price elasticities of demand for labor and fuel. The tests for perverse input demand behavior are based on the signs of the estimated own-price elasticities. The results of this study are mixed. The demand for fuel is unambiguously negatively sloped. But the demand for labor, especially in medium-sized firms producing between 0.5 and 1.7 billion kilowatt hours of electricity a year, may be upward sloping.