Dynamics of Rate of Return Regulation

Abstract: It is commonly accepted in the industrial organization literature that rate of return regulation leads to inefficient outcomes. Since prices are calculated so as to cover the regulated firm’s average cost, which includes the periodic fixed costs associated with plant property and equipment, the conventional argument is that prices must exceed the marginal cost of production. This paper examines the dynamic properties of the rate of return reg-ulation process when the regulated firm periodically undertakes new capacity investments. Our analysis identifies prices which can potentially emerge as equilibria of the regulation process. It is shown that the underlying accounting (depreciation) rules determine whether these equilibrium prices will be above, equal to, or below the long run marginal cost. We provide conditions under which the rate of return regulation process is dynamically stable so that prices indeed converge to their equilibrium values.