THE AVERCH-JOHNSON EFFECT

AVERCH, HARVEY (+) LELAND L. JOHNSON.

Behaviour of the Firm under Regulatory Constraint.

[No place], The American Economic Association, 1955. Lex8vo. In the original printed wrappers. In "The American Economic Review", Vol. VII, December, No. 5. Entire issue offered. Light wear to extremities, otherwise fine and clean. Pp. 1052-69. [Entire issue: (5), 996-1258 pp. + advertisement].

First printing of Averch and Johnson's seminal paper in which they introduced in what was to become known as the "Averch-Johnson effect". The paper was one of the most cited and influential papers in microeconmocs during the 60ies.

"The Averch-Johnson effect is produced when fair rate of return regulation encourages a firm to invest more than is consistent with the minimization of its costs. This can happen when the allowed rate of return exceeds the cost of capital, since the difference between the two represents pure profit. Detailed descriptions of actual regulatory processes may be useful in suggesting guides for action, since actual outcomes depend as much on political and bureaucratic necessity as they do on economic analysis and 'rational' benefit-cost estimates." (The New Palgrave).

"Averch and Johnson's famous paper from the early 1960s asks the simple question: If we assume that regulation acts to instantaneously adjust prices so as to maintain a constant target return on a firm's capital stock, what incentives does the firm have to choose an efficient combination of inputs? Averch and Johnson show, using fairly straightforward maths, that if the regulator sets the regulatory rate of return above the firm's true cost of capital, the regulated firm has an incentive to choose too much capital relative to labour - that is, there will be an inefficient capital-labour ratio. This observation sparked off a large empirical and theoretical literature exploring what came to be known as the 'Averch-Johnson' or 'A-J' effect.
The Averch-Johnson model assumed an extreme form of what is known as 'rate of return' or 'cost of service' regulation in which prices are continuously and rapidly adjusted so as to yield the desired return on capital stock. In reality, rate of return regulation as it was historically practiced in the US always involved an element of 'regulatory lag' - that is, a period of time before prices were adjusted to reflect changes in costs. This regulatory lag gives rise to some desirable incentives, as discussed further
below. Even in 1962 it was recognised that allowing higher ex post rates of return was necessary to induce desirable incentives. Averch and Johnson note:
"We have been told by representatives in both the industry and in regulatory agencies that justification exists for allowing a return in excess of cost to give firms an incentive to develop and adopt cost-saving techniques. If the firm is left only indifferent as among a wide range of activities it has no positive incentive to minimize costs for any given activity."
Averch and Johnson's paper was, for a while at least, very widely cited, often incorrectly. The A-J effect later came to be synonymous with 'gold-plating' and with general inefficiency of the regulated firm. But these ideas cannot be strictly attributed to Averch and Johnson. Averch and Johnson only highlighted a potential tendency towards an inefficient mix of capital and labour - but they made no mention of the tendency to simply spend too much on all inputs - so-called 'x-inefficiency' as discussed further below." (biggar, The Fifty Most Important Papers in the Economics of Regulation).

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