Welfare Aspects of a Regulatory Constraint: Note
Abstract
Government agencies commonly employ the rate of criterion in the regulation of monopolies: after the firm subtracts its operating expenses from gross revenues, the remaining revenue should be just sufficient to compensate the firm for its investment in plant and equipment, at a rate which is considered to be fair. It has been argued by Harvey Averch and Leland Johnson, and now rigorously proved by Akira Takayama, that such constraint induces the firm, subject to regulatory control, to increase it-, investment and output and also to deviate from the optimal allocation of inputs, because the regulated firm does not equate marginal rates of factor substitution to the ratio of factor costs. Therefore, cost is not minimized at the output selected by the firm.' Since the fair rate of return criterion leads to a nonoptimal state in the sense of Pareto, a basic question is whether it improves the performance of the economy, from a welfare point of view, as compared with the unregulated monopoly situation (where output is too small). This is a second best problem in which we have to choose between two situations, each deviating in one way or another from optimality. Here we show that from the point of view of efficiency, disregarding income distribution aspects, some regulation via the fair rate of return is always advantageous. We also derive the rule for the optimal degree of regulation, i.e. the regulation that maximizes social welfare.
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