LEON COURVILLE Regulation and Efficiency in the Electric Utility Industry

Introduction : Rate of Return Regulation Rate- of – return regulation is a distinct feature of the public utility environment. More than ten years ago, it was argued that this form of regulation might induce utility companies to operate inefficiently. This idea has been characterized via economic relation by the “Averch- Johnson effect.”

Averch- Johnson Effect The Averch-Johnson effect is the tendency of 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.capital accumulationcapital  In spite of being the subject of widespread discussion, this has never been assessed through formal quantitative analysis. Such an analysis and evidence on the existence of the A-J effect was investigated via cross- sectional analysis of electric power plants.

How the A-J Effect applies Theoretical implications assert that the regulated monopolist will not be efficient in choosing its inputs. Much of the discussion of the Averch and Johnson proposition has been theoretical in nature. No formal quantitative evaluation of either the existence or importance of the A-J effect was attempted 2.

Where the Heck is the Empirics Dued? Surprisingly enough, the authors go on to lecture that “given the frequent appeal by some writers to the necessity of such investigation, and given the causal empiricism to which it was subjected, and given its denial by public utility officials,” this has..STILL, never been done? Hence the motivation behind Leon Courville’s approach.  The aim and underlying motivation of the study was to examine the Averch- Johnson proposition and relate this hypothesis to the regulatory context it assumes so as to verify empirically and quantify its importance.

Key Issues Discussed The effect if a rate- of return constraint on the monopolist’s decision process is to render optimal, from the monopolist’s point of view, a form of behavior that is yet inefficient. To see that the marginal productivity of any capital input to the marginal productivity of any “non- capital” input is smaller than the ratio of their respective prices.

Paper Outline 1) Introduction 2) Presentation of the A-J model (constrained by monopolist rendering inefficient behavior) 3) Electric Utility Choice 4) Approach for testing and Evaluating A-J approach 5) A-J Proposition is actually tested: test confirms existence of inefficiency of inputs 6 and 7) Conclusive findings and remarks

Kid In the Toliet

Electric Companies Activities An electric company is basically engaged in three activities:  Generation of Electricity  Transmission of Electricity  Distribution of Electricity It is argued that in order to infer the existence of input distortion one need only consider the generation of electricity.  This is done namely to examine the relation between marginal productiveness of the inputs to electricity generation and their respective prices.

Averch- Johnson Approach Details of this approach was not reviewed in great detail, since it has already been widely discussed. However, it is appropriate to consider its empirical proposition on input combination. The original analysis concerns a monopolist whose decision process is constrained by the imposition of a constraint on the rate of return it can earn on its capital.

The Firm’s Monopolist’s Problem: Profit Maximization

Continued…

Section 3: The Electric Utility Industry The regulation of electric utilities is for most purposes carried out at the state level. At present, 47 State Commissions have jurisdiction over electric companies.

Electric Industry Structure The Electric utility industry has a complex structure: there exists a wide variety of suppliers ranging from small rural cooperatives usually providing power service for their community exclusively to large corporations distributing power to a huge network of residential and commercial users and to industrial users whose activities depend on electricity.

Overcapitalization

More on the Model….

Section 4: Testing In testing the overcapitalization proposition, we shall consider the power plant as an entity that sells output to the other activities of the utility company. Since overcapitalization is expected to be present in the generation of electricity, the objective of the plant manager is to minimize costs with respect to some output level associated with relevant transfer prices.  Overcapitalization is tested by comparing the ratio of the marginal productivities to the ratio of prices. The null hypothesis is represented by equation (6) and H a by (7).

The Problem Authors Perspective of “the problem”  Recognize that for a given input consumption, the higher would the annual output be, the lower the variability in output, or that, for a given annual output level, the smaller the input consumption would be, and the smaller the variations in output. THUS, variability in output affects factor productivity.

Section 5: Cobb- Douglas Model Used

Further Assumptions

Results

More Results

Annnnnnnd More Results…

Test and Measure of Overcapitalization: Super Size Me!

Table Results: H 0 Rejections

Differences The only difference between Table 4 and Table 5 is that overcapitalization tests presented in Table 4 correspond to the empirical production function estimated using the deflated measures of capital, while Table 5 test’s are based on using the deflated measure of capital.

Conclusive Findings The Averch- Johnson proposition attempts to describe the behavior of monopolists under the rate of return regulation. The results are consistent with the hypothesis that this form of regulation induces overcapitalization. These results have been obtained by estimating a production function for electricity generation and by comparing the implied ratio of the marginal productiveness of capital and fuel to the ratio of their relative prices.

Conclusion Presumably, regulation induces benefits by forcing firms to operate at a greater output than the pure monopoly output. Thus, in principle, one should compute the gains to consumer due to regulation and compare them to the increased costs generated by inefficient production induced by rate- of- return regulation.

The End