Introduction

Even if rate-of-return regulation can be effectively implemented according to guidelines from the Hope decision, it may not achieve ideal results, for it can have perverse side effects. The firm has substantial control over the capital input, which serves to determine its allowed profit, so its capital choice may be biased. For instance, if regulators respond immediately with price decisions, the firm may favor capital relative to other inputs if it is allowed a return on capital higher than capital cost. Or if it is allowed a return less than its cost of capital, the firm may try to avoid additional capital use. If there is a long lag before regulators respond, during which prices cannot change, the firm may have more incentive to operate efficiently. But unchanging output prices cause other problems for the firm when input prices change.

Our purpose here is to describe how incentives can induce technical inefficiency in public utility firms when they are regulated by rate-of-return constraint. With immediate responses by regulators, the rate-of-return constraint may cause a public utility to serve society well through its capital choices, but the utility will continue to have the incentives of a monopolist in all its other input decisions. By acting partly as a competitive industry and partly as a monopoly industry, the regulated firm develops a split personality. Such schizophrenia in the regulated firm is the underlying cause of inefficiencies that have been called “regulatory bias” and “overcapitalization.” We examine this behavior in the next three sections.