Raymond E. Lombra, Raymond G. Torto; Discount Rate Changes and Announcement Effects*, The Quarterly Journal of Economics, Volume 91, Issue 1, 1 February 19

Harvey Averch and Leland Johnson in their pioneering paper on regulatory modeling found that a firm regulated by a maximum allowed rate of return on capital would generally find it advantageous to substitute capital for other inputs to produce its output in an overly capital intensive manner. However, they and others have suggested that this misallocation of inputs would not exist if the firm's production function was of the fixed proportion type so that the firm could not substitute inputs.' This paper examines the behavior-of the regulated firm with a fixed proportion production function. It concludes that the firm produces efficiently only if demand is sufficiently elastic so that marginal revenue exceeds marginal noncapital cost. Lowering the allowed return on capital in an attempt to increase output beyond the point where marginal revenue equals marginal noncapital cost will prompt the firm to acquire idle capital and will not bring forth any increase in output. The L-shaped isoquant associated with fixed proportion production functions may be particularly relevant to public utilities. The complex technology utilized involves both limited substitutability of other inputs for existing plant and equipment, and long lifetimes for this capital.2 Even if the Lshaped isoquant is not applicable to new capital investment, it may be applicable for existing capital plant and equipment. Thus a significant part of the firm's capacity can be considered to have minimal input substitution possibilities over a substantial period of time. The firm without factor substitutability can react to regulation by being overly capital intensive only by padding its rate base with idle capital. To develop the condition under which the firm with a fixed proportion production function would produce inefficiently, the following notation will be employed: r = profit q = output R(q) = revenue function K = physical units of capital L = physical units of labor3 q = q (min (K/a, L/b) = the fixed proportion production function with a > O and b > 0 r = cost of obtaining funds, the unit cost of capital4 *Assistant professor of economics, Kansas State University. I am grateful to C. F. Christ, P. J. Gormeley, B. L. Jaffee, and F. T. Sparrow for their comments on an .earlier draft of this paper. I also acknowledge the very useful suggestions made by the anonymous referee. I They write: If it [the production function] involves fixed proportions, . . . the regulated firm is constrained to the efficient expansion path (p. 1057). Gordon Corey echoed their result in a recent article in which he states, If there were fixed proportions in production, the expansion paths of the regulated and unregulated firm would be identical (p. 364). Frederick Scherer also agrees, the limiting case of zero substitution elasticity (associated with L-shaped isoquants) there will be no departure from the socially optimal capital/labor ratio (p. 532). While David McNicol (p. 432, fn. 10) questions the Averch-Johnson result that no misallocation would occur with a fixed proportion production function, he provides no conditions for its occurrence or nonoccurrence. 2For example, the Federal Power Commission (pp. 1-29) reports steam electric plant equipment life is estimated to about thirty to thirty-five years. Also, depreciation rates for regulated industry, while admittedly conservative, suggest long lifetimes for physical capital. Alfred E. Kahn (p. 118) gives depreciation rates for regulated industries in the 2 to 5.4 percent range which implies physical capital lives in excess of fifteen years. 3The term labor is used here by convention, but can be thought of more generally as including all noncapital inputs. 4The cost of capital is equal to its acquisition cost multiplied by the cost of obtaining funds. In the following, capital units will be measured so that the acquisition cost of a unit of capital is equal to unity.

A recent article in this Review by Joan Haworth, James Gwartney, and Charles Haworth (hereafter H-G-H) presented some significant findings on the source and structure of improvements in the relative economic status of nonwhite males during the 1960's. Specifically, H-G-H concluded that approximately one-half of the increase in the nonwhite/white earnings ratio (NWER) during the 1960's was simply . . attributable to the exiting of older nonwhite workers with low relative earnings combined with the entry of younger, better-prepared nonwhites who have high relative earnings' (p. 167). The balance of the gain in relative nonwhite earnings was the result of a decline in employment discrimination against nonwhites and improvements in the relative productivity of nonwhites. If correct, these findings have several important implications for the prospect of black and white earnings equality. First, they suggest that the effects of past discriminatory practices in both employment and the acquisition of human capital continue to reduce the earnings power of older black males still in the labor force. These past practices are an important source of current differences in the average earnings of blacks and whites in aggregate. Hence, they constrain the success of policies to achieve racial earnings equality. This brief note presents some additional evidence consistent with the H-G-H conclusions. We are mainly concerned with their data in Table 3 (p. 164) on changes in the NWER within age cohorts between 1959 and 1969. The H-G-H hypothetical identical productivity' ' NWER measures the nonwhite-white earnings gap caused by factors other than measured productivity variables, such as racial differences in occupational structure which are unrelated to productivity differences. Since the relative occupational distributions indirectly revealed by these hypothetical NWER underlie some of the major H-G-H conclusions, a more direct examination of changes in the occupational distribution of blacks and whites during the 1960's may prove a useful check on their findings. A group's index of occupational status can be calculated by weighting the proportion of the group employed in an occupation by the mean earnings for the occupation and summing across major occupational categories.' The higher (lower) a group's index, the greater the proportion of the group in higher (lower) paying occupations. Therefore, the ratio of nonwhite to white occupational status (NWOS) will measure solely racial differences in the distribution of workers among occupations. The higher (lower) the NWOS, the more (less) favorable the occupational structure of blacks relative to whites, ceteris paribus. Estimates of the male NWOS for age cohorts in 1959 and 1969 are presented in Table 1, along with the corresponding NWER.2 In aggregate, the NWOS increased by 10.2 percent during the