Input Choices and Rate-of Return Regulation: An Overview of the Discussion

This article reviews the substance of the literature stemming from the Averch-Johnson model of the firm under rate-of-return regulation. It examines a number of propositions, among them the following: (1) The profit-maximizing firm under rate-of-return regulation will tend to use a capital-labor ratio greater than that which minimizes cost for its output level; (2) The profit-maximizing firm under regulatory constraint will use a capital-labor ratio and produce an output greater than it would in the absence of regulation; (3) The closer the "fair rate of return" is to the true cost of capital, the greater the quantity of capital the firm will want to use; and (4) The sales (total revenue)-maximizing firm under regulatory constraint will use a labor-capital ratio greater than it would when unconstrained. The second of these propositions, which has been widely taken to have been proved by Averch and Johnson, is shown to be false. The paradoxical assertion in the third proposition is explained and its regulatory implications discussed. Two models involving regulatory lag are described along with their implications for policy. Finally, some evaluative comments are offered on the entire issue of what has come to be known as the "A-J effect" and its importance in regulatory economics.