Averch–Johnson effect explained
The Averch–Johnson effect is the tendency of regulated companies to engage in excessive amounts of capital accumulation in order to expand the volume of their profits. If companies' profits to capital 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.[1]
Excessive capital accumulation under rate-of-return regulation is informally known as gold plating.[2]
But the so-called Averch-Johnson effect of overcapitalization does not as a general case involve "gold-plating".[3]
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. The firm's profit is constrained such that:
where
is the allowable rate of return. Assume that
. We may then form a
functional to find the firm's optimal action:
where
is the
Lagrange multiplier (also known as the
shadow price). The derivatives of this functional are:
Taken together, this implies that:
The ratio of the
marginal product of capital and the
marginal product of labor is:
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.
[4] See also
Further reading
External links
Notes and References
- Averch . Harvey . Johnson . Leland L. . 1962 . Behavior of the Firm Under Regulatory Constraint . . 52 . 5 . 1052–1069 . 1812181 .
- News: West. Michael. 'Gold plating' rife, assets in for a hiding. 6 January 2015. The Age. 31 January 2013.
- Johnson. L.L.. 1973. Behavior of the Firm Under Regulatory Constraint: A Reassessment. American Economic Review. 63. 2. 1817057.
- Book: Viscusi, W. Kip. Economics of Regulation and Antitrust. Harrington, Jr.. Joseph E.. Vernon. John M.. The MIT Press. 2005. 9780262220750. 4th. Cambridge, MA. 433–436.