Averch–Johnson Effect
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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:\pi = R(K,L) - wL - rKwhere R(K,L) is the revenue function, K is the firm's capital stock, L is the firm's labor stock, w is the wage rate, and r 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:\sigma = where \sigma is the allowable rate of return. Assume that \sigma > r. 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:J = R(K,L)-wL-rK - \lambda (K,L)-wL-\sigma K/math>where \lambda is the
Lagrange multiplier In mathematical optimization, the method of Lagrange multipliers is a strategy for finding the local maxima and minima of a function subject to equality constraints (i.e., subject to the condition that one or more equations have to be satisfied ex ...
(also known as the
shadow price A shadow price is the monetary value assigned to an abstract or intangible commodity which is not traded in the marketplace. This often takes the form of an externality. Shadow prices are also known as the recalculation of known market prices in o ...
). The derivatives of this functional are:\begin &= (1-\lambda)R_ - r + \lambda \sigma \\ &= (1-\lambda)R_ - (1-\lambda)w \endTaken together, this implies that:R_ = , \quad R_ = wThe ratio of the
marginal product of capital In economics, the marginal product of capital (MPK) is the additional production that a firm experiences when it adds an extra unit of capital. It is a feature of the production function, alongside the labour input. Definition The marginal produ ...
and the
marginal product of labor In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. It is a feature of the production function, and depends on the amounts of physical capital and labor already in use. Defi ...
is: = , \quad \alpha = (\sigma - r)Since this new cost of capital is perceived to be less than the market cost of capital, the firm will tend to overinvest in capital.


See also

*
Law and economics Law and economics, or economic analysis of law, is the application of microeconomic theory to the analysis of law, which emerged primarily from scholars of the Chicago school of economics. Economic concepts are used to explain the effects of laws ...
*
Public utilities commission In the United States, it is a governing body of a utility. In Canada, it is a utility, not a regulatory body. Canada In Canada, a public utilities commission (PUC) is a public utility owned and operated by a municipal or local government under t ...
*
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 ...


References


Further reading

* Greer, Monica (2012).
Electricity Marginal Cost Pricing: Applications in Eliciting Demand Responses
'. Waltham, MA: Butterworth-Heinemann. * Lesser, Jonathan A.; Giacchino, Leonardo R. (2013).
Fundamentals of Energy Regulation
' (2nd ed.). Public Utilities Reports, Inc. * Willis, H. Lee; Philipson, Lorrin (2019).
Understanding Electric Utilities and De-Regulation
'. Power Engineering. Boca Raton, FL: CRC Press.


External links


Body of Knowledge on Infrastructure Regulation: Incentive Features and Other Properties

The Averch Johnson Effect
{{DEFAULTSORT:Averch-Johnson effect Economics of regulation Law and economics Mathematical economics Public utilities