Rate-of-return Regulation - Disadvantages of Rate-of-Return Regulation and Criticism

Disadvantages of Rate-of-Return Regulation and Criticism

The central problem with rate-of-return regulation, the reason most countries with economic regulation have switched to alternate methods of regulating such firms, is that rate-of-return regulation does not provide strong incentives for regulated firms to operate efficiently. The main form of this weakness is the Averch-Johnson effect.

Firms regulated in this manner will engage in disproportionate capital accumulation, which in turn will heighten the price level allotted by the government regulator, raising the firm's short-term profits. By spending on unnecessary capital and other extravagant expenses, the firm's revenue requirement (R) is raised as a result of both an increase in operating expenses (E) and depreciation costs (d). Depreciation costs rise due to the fact that as a firm obtains more capital, that physical capital will depreciate over time, therefore raising the overall depreciation cost. In order to subvert the system, regulated-monopolies can purchase capital they don't necessarily need or use, which will be left in the factory merely to depreciate, thereby raising their regulated price level as allocated by the government.