The Theory of Hedging and Speculation in Commodity Futures Get access Leland L. Johnson Leland L. Johnson Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 27, Issue 3, June 1960, Pages 139–151, https://doi.org/10.2307/2296076 Published: 01 June 1960

Ten years ago Harvey Averch and I developed a model of the firm's behavior under the constraint that the return on capital investment not exceed a given level, specified by a governmental regulatory body. Major assumptions of the model are that (a) the firm seeks to maximize profit, (b) the market cost of capital is constant, (c) the allowable or fair rate of return exceeds the cost of capital, and (d) no regulatory lag exists. Under these assumptions the model leads to conclusions that the capital-labor ratio is greater than that which would minimize cost at the level of output selected by the firm, and that the firm may have an incentive to serve competitive markets even if revenues fall below incremental cost in those markets, with the difference more than compensated by increased net revenues permitted through price increases in its monopoly services. This formulation has attracted numerous comments, critiques, and replies. However, virtually all the discussion has remained on theoretical grounds. Unfortunately, little empirical analysis has appeared to suggest the importance of these distortions in the real world. The purpose here is briefly to note major developments in the theory, to examine bits of evidence that have come to light, and to address possibilities for further empirical work.

A recent article by Akira Takayama discusses an earlier paper by Harvey Averch and Leland L. Johnson on fair rate of return regulation of public utilities. Although Takayama (p. 255) agrees with Averch and Johnson's general conclusions a firm will tend to increase its investment with the introduction of an active constraint on its rate of return, he criticizes the argument as being confusing, ambiguous, and in error. Takayama then attempts a clarification, and presents a new formulation which leads to the result quoted above. This comment will discuss several of Takayama's criticisms in addition to showing that the so-called A-J cannot be derived from the basic assumptions made by both Averch and Johnson and Takayama.1 We will show that the very assumptions used to prove the Effect, by defining the region of X, require an assumption that the Effect exists in the first place.