The Averch–Johnson effect is the tendency of
regulated companies to engage in excessive amounts of
capital accumulation
Capital accumulation is the dynamic that motivates the pursuit of profit, involving the investment of money or any financial asset with the goal of increasing the initial monetary value of said asset as a financial return whether in the form o ...
in order to expand the volume of their profits. If companies' profits to
capital
Capital may refer to:
Common uses
* Capital city, a municipality of primary status
** List of national capital cities
* Capital letter, an upper-case letter Economics and social sciences
* Capital (economics), the durable produced goods used f ...
ratio is regulated at a certain percentage then there is a strong incentive for companies to over-invest in order to increase profits overall. This investment goes beyond any optimal efficiency point for capital that the company may have calculated as higher profit is almost always desired over and above
efficiency
Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...
.
Excessive capital accumulation under
rate-of-return regulation Rate-of-return regulation is a system for setting the prices charged by government-regulated monopolies, such as public utilities. Its main premise is that monopolies must charge the same price that would ideally prevail in a perfectly competitive m ...
is informally known as gold plating.
Mathematical derivation
Suppose that a regulated firm wishes to maximize its profit:
where
is the revenue function,
is the firm's capital stock,
is the firm's labor stock,
is the wage rate, and
is the
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
. The firm's profit is constrained such that:
where
is the allowable rate of return. Assume that
. We may then form a
functional
Functional may refer to:
* Movements in architecture:
** Functionalism (architecture)
** Form follows function
* Functional group, combination of atoms within molecules
* Medical conditions without currently visible organic basis:
** Functional sy ...
to find the firm's optimal action: