Introduction

Rate-of-return regulation of a profit-seeking firm not only invites an inefficient choice of inputs to produce any given level of output, it may also cause output levels to be chosen inefficiently. Much attention has been accorded the technical input distortion discussed in Chapter 8. We focus in this chapter on the second distortion, the inefficient output levels resulting from nonoptimal relative prices for multiple outputs. Our approach is to see whether firms will adopt second-best welfare-maximizing prices when seeking profit or other goals while subject to profit regulation. We shall find that pricing efficiency is not reliably motivated in firms regulated under Hope guidelines.

An early analysis of rate-of-return regulation by Wellisz (1963) stressed the resulting economic inefficiency in pricing, specifically between peak and off-peak prices. Averch and Johnson (1962) also described a pricing distortion that rate-of-return regulation might induce in a multiproduct firm. Bailey (1973) extended Wellisz's peak-load pricing analysis and asked whether input distortions beyond those due to inefficient pricing would arise and whether inefficient pricing between peak and off-peak periods would result if firms sought to maximize output instead of profit. Waverman (1975) has since confirmed that, along with peak and off-peak pricing distortions, the Averch and Johnson (1962) type of bias between capital and other inputs would also result. Needy (1975) provided a systematic description of output distortions in the profit-maximizing, rate-of-return regulated firm. Pricing distortions due to both monopolistic reliance on demand elasticities and bias toward capital were set out in Bailey and White (1974), Eckel (1983), Sherman and Visscher (1979, 1982a), and Srinagesh (1986).