Regulatory Policy Under Uncertainty: How Should the Earned Rate of Return for a Public Utility be Controlled?

Much of the analysis of the effects of rate-of-return regulation on public utilities has centered on the ‘Averch-Johnson (A-J) problem’ first introduced in 1962. Simply stated, the A-J problem saw the firm choosing its inputs — labour and capital — so as to maximise profits subject to rate of return regulation in a static and deterministic environment. Within this framework they demonstrated that if the allowed rate of return exceeds the cost of capital the firm will choose to employ a higher capital-to-labour ratio than it would under cost minimisation. In other words, the regulatory process will cause social welfare inefficiencies. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.