The Effect of Lagged Regulation in an Averch-Johnson Model

Abstract

The analysis seeks to determine the impact of lagged regulation on a profit-maximizing firm subject to a rate-of-return constraint. We are particularly interested in the effect of lag on the accomplishment of two regulatory goals: minimum-cost production, and an output greater than that of an unconstrained monopoly. The extend to which these goals are reached depends on whether the fair rate of return is equal to the cost of capital or somewhat higher. If the two are equal, lagged regulation accomplishes both goals; this contrasts sharply with continuous regulation, where the firm is indifferent among all methods of production or levels of output that let it break even in its operations. If the rate of return is above the cost of capital, it will not always pay for the firm to alter its resource allocation from the overcapitalized level indicated by Averch and Johnson. There will, however, be some length of the lag interval above which the firm will overcapitalize by successively smaller amounts, with attendant increases in output from the Averch-Johnson level.