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RATE OF RETURN REGULATION AND THE REGULATED FIRM’S CHOICE OF CAPITAL- LABOR RATIO: FURTHER EMPIRICAL EVIDENCE ON THE AVERCH- JOHNSON MODEL -Paul M. Hayashi - John M. Trapani Eco.- 435 April 9, 2013 Presentation by Tej Gautam Introduction Three articles presented empirical evidence concerning with the rate of return regulation consistent with Averch- Johnson model. • Spann R. tested the A-J implication using Lagrangian multiplier procedure with the range 0-1 when regulation is effective. • Courrville L. estimated production relation to compare the ratio of MP of capital and fuel inputs to the ratio of their respective prices. • Petersen H.employed firm’s minimum cost function derived subject to a rate of return constraint and the empirical result is consistent with A-J effect. • Tested: regulated monopolists employ a ratio of capital to non-base inputs > 1, that minimizes cost for a specified rate of output (A-J effect) Introduction contd. • This paper presents an alternative test of the A-J model employing the implicit demand function for the firm's choice of capital and labor production. • This procedure permits to analyze many comparative static properties of the A-J model. • Estimation of the derived demand function provides direct tests of the related proportions: the regulated monopolist's capital-labor ratio increases if the allowed rate of return is decreased (regulation is tightened), and the rising costs of nonbase inputs cause the firm to produce more efficiently. Introduction contd. • It consists of derivation of implicit demand function for the firm’s capital-labor ratio and develop its comparative statics using A-J Model. • Estimates empirical model using cross section sample of 34 privatively owned electric utility firms. • In the empirical analysis Cobb-Douglas and CES type production function are employed. Theoretical framework Firms assumed to maximize profit ∏ = R - wL- rK Where R = P(q). q q = q(K, L); w and r are wage rate and market cost of capital, K and L represent capital and labor, The firm faces a rate of return constraint R - wL < sK where s is the allowed rate of return of capital ,then using Lagrangian multiplier, FOCs for profit maximization gives Rk r R L w (s r ) (1 ) ….. (1) ……….(2) and R-wL = sK ……….(3) Theoretical…Contd. Rk and RL are MRP of capital and labor . Equation 1 implies that regulated monopoly firm seeking to maximize profit should employ capital equal to equation(1) and fraction part only is viewed as distortion factor for the cost of capital to the regulated firm. So the firm employ capital beyond the unconstrained profit maximizing point. Criteria for the firm’s choice of capital- labor ratio is obtained as Theoretical…Contd. E is the point for unconstrained Profit maximization M E N N is for constrained profit maximization determinants of constranined maximization is K/L = f(w/r, q, s) For unconstrained profit maximization K/L = f(w/r, q) Theoretical…Contd. increases in the cost of capital can be used to substantiate increases in the allowable rate of return implies that the regulators are interested in limiting economic profits to some premium on capital equal to Subject to So the criterion for the firm’s choice of capital- labor ratio is sr Theoretical…Contd. constrained unconstrained Empirical model For the estimation , following empirical model are used for Conventional A-J model For the estimation using Regulatory variable sr If regulation is effective, coefficient of s and Would be negative and significant Result Tab. I-IV represent the conventional A.J model. I - II for C-D type and IIIIV for CES, historical rate is r1 and recent is r2 Result contd. Result contd. Result contd. Result contd. Table V-VIII represent the estimation with regulatory variable First two are for C-D function and remaining two for CES type Result contd. Result contd. Result contd. Conclusion • Result shows that C-D type production function has better explanatory power for the relation estimated based on F- level. • Three proposition: a) firm produces with k-L ratio > cost min. b) tightening regulation increase the distortion in the firm’s choice of inputs , c) Rising cost of non base inputs increase the production efficiency. Proposition a and b are consistent with the estimation however c is not confirmed. • Regulation in the electric utility industry is effective and the induced economic inefficiency of rate of return regulation may be a serious cost borne by the customers of the regulated utilities.