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The Averch-Johnson Effect

The Averch-Johnson Effect. Averch and Johnson developed a model to illustrate that public regulation creates an incentive for the firm to over-invest in tangible assets . Since the "allowed profit" is based on the rate base (RB), the firm has an incentive to augment its capital stock.

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The Averch-Johnson Effect

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  1. The Averch-Johnson Effect Averch and Johnson developed a model to illustrate that public regulation creates an incentive for the firm to over-invest in tangible assets.Since the "allowed profit" is based on the rate base (RB), the firm has an incentive to augment its capital stock. H.Averch and L. Johnson. "The Behavior of the Firm Under Regulatory Constraint," American Economic Review, December 1962.

  2. Over-investment (or over-capitalization) has obvious implications for rates paid by consumers and also for the efficiency of resource allocation.

  3. The model Choose quantities of capital and labor to maximize the following profit ( ) function: [1] subject to [2] is profitR is the revenue functionK is the quantity of capitalL is the quantity of laborw is the wage rater is the cost of capitals is the allowed rate of return

  4. Averch Johnson assumption: s > r Meaning the allowed rate of return on capital (expressed in dollars per unit of capital per time period) exceeds the cost of capital (also dollars per unit of capital is the same time interval). This would seem a logical assumption--why would the firm take positions in tangible capital goods (like nuclear plants) ifr > s?

  5. Maximizing [1] subject to [2] using the Lagrangean method yields the following first order condition: [3] Note that: [4] MPkis themarginal product of capitalMPLis the marginal product of laborl is the Langrangean multiplier (a constant).

  6. Moral of the story • It can be shown that  > 0 • We assume that s > r • Therefore,  > 0 The regulatory constraint in effect makes capital cheaper relative to labor and therefore induces the firm to substitute capital for labor.

  7. Averch Johnson effect illustrated using the theory of the firm • Definitions: • An isoquant (meaning “equal quantity”) is a collection of points giving all possible labor/capital combinations that yield the same quantity of output. • An isocost (meaning “equal cost”) is a collection of points giving all possible labor/capital combinations that enatil the same cost.

  8. Isoquants Labor (units)  is a labor intensive technique   is a capital intensive technique  Q = 300 Q = 200 Q = 100 0 Capital (units)

  9. Intercept = C/w = $1000/10 Labor (units) 100 Let C = wK + rK, where: C = $1,000w = $10r = $50 Slope = -w/r Intercept = C/r = $1000/50 r = 40 0 20 25 Capital (units)

  10. The Averch Johnson Effect Eis an efficient point A is the Averch Johnson point Labor (units) M N E Slope = -(r - )/w A Slope = -r/w isoquant 0 M’ N’ Capital (units)

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