Uncertain Input Prices, Profit Risk, and the Rate-of-Return Regulated Firm: Comment

Abstract

Scott (1983) considers the effects of input price uncertainty on the selection of inputs by regulated firms. Specifically, he asks the question: How will the combination of input price uncertainty and continuous rate-of-return regulation affect the firm's selection of inputs? (p. 337). In attempting to answer this question, he considers a firm value maximization objective function based upon the capital asset pricing model and characterizes the regulatory constraint by proposing that the firm faces a constraint on the expected value of accounting profits. His conclusion is that when the effect of uncertain input prices on profit risk is considered, the continuously regulated firm has the incentive to use relatively less capital than when input prices are known with certainty. In this comment, it will be argued, firstly, that the specification of the regulatory constraint is inconsistent with the idea of modelling continuous regulation. Secondly, it will be pointed out that, even if the regulatory constraint formulation is accepted, the results are incorrect and, in plausible circumstances, the opposite of Scott's (1983) results will be found. This error is caused by a misspecification of the variables defined within the capital asset pricing model. Thirdly, it is asserted that a comparison between the regulated firm under certainty is not the only valid comparison. Presumably, in attempting to evaluate the effect of uncertainty on the Averch-Johnson effect, it would be more appropriate to compare the regulated firm under uncertainty with the unregulated firm under uncertainty. Such a comparison suggests that the effect of