An Empirical Test of Regulatory Effects

Averch and Johnson have provided analytical support for the assertion that rate of return regulation causes insufficient production because of the overuse of capital. Empirical evidence in support or refutation of their thesis is just beginning to appear. This paper provides additional evidence. The regulated firm's objective is stated in terms of cost minimization subject to a regulatory constraint. The effect of changes in the allowed rate of return on capital are evaluated. It is shown that as the allowed return approaches the cost of capital, costs increase and the percentage of total costs paid to capital also increases. These are testable implications of the revised A-J model. Data on costs, input prices, and output are collected for electric power production. Three measures of regulatory policy with regard to the allowed return are formulated. Econometric analysis suggests that lower allowed rates of return are significantly associated with higher costs and larger proportions of cost going to capital. These findings are consistent with the revised A-J model and with those of other recent investigators.