chapter  2
29 Pages

The Averch-Johnson Model

The current debate concerning the effects of rate-of-return regulation was initiated in the classic 1962 article by Harvey Averch and Leland Johnson entitled 'Behavior of the Firm Under Regulatory Constraint'. Averch and Johnson were not alone in making this argument. Stanislaw Wellisz (1963) and Fred Westfield (1965) also investigated the impact of rate-of-return regulation and came to very similar conclusions. The original model by Averch and Johnson is primarily mathematical in both setup and execution, relying on nonlinear programming and the Kuhn-Tucker theorem. In modeling a rate of return regulated firm, Bailey and Malone accept many of the same assumptions as Averch and Johnson. Averch and Johnson assume that the allowed rate-of-return is greater than the cost of capital. The lone attempt to investigate the impact of rate of return regulation on the technological innovation of firms is that of V. Kerry Smith (1974), with a subsequent discussion found in Smith (1975).