Averch-Johnson effect

3 Key Takeaways

• The Averch-Johnson effect occurs when regulated companies overinvest in capital to boost profits.
• This behavior is incentivized by rate-of-return regulation, which sets a cap on profits relative to the capital base.
• The effect can lead to inefficiencies and higher costs for consumers.

What is the Averch-Johnson Effect?

The Averch-Johnson effect is named after economists Harvey Averch and Leland Johnson, who formulated the theory in 1962. It posits that when a company’s profit rate is regulated, the company has an incentive to increase its capital base, even if it means investing beyond the point of optimal efficiency. This is because the regulated profit rate is applied to the total capital invested, meaning a larger capital base can lead to higher overall profits, even with a lower rate of return.

Importance of the Averch-Johnson Effect

• Regulatory Economics: The Averch-Johnson effect is a significant concept in regulatory economics, as it highlights the potential unintended consequences of rate-of-return regulation.
• Efficiency Concerns: The effect raises concerns about the efficiency of regulated industries, as companies may overinvest in capital, leading to higher costs for consumers.
• Alternative Regulation: It has prompted discussions about alternative regulatory approaches, such as price-cap regulation or performance-based regulation, that may incentivize efficiency.

How the Averch-Johnson Effect Works

The Averch-Johnson effect works through the following mechanism:

1. Rate-of-Return Regulation: A regulatory agency sets a maximum allowable rate of return that a regulated company can earn on its capital base.
2. Incentive to Overinvest: The company realizes that it can increase its total profits by increasing its capital base, even if the rate of return on that capital is lower than the market rate.
3. Overinvestment: The company invests in additional capital assets, such as new plants or equipment, even if these investments are not economically justified.
4. Higher Costs: The overinvestment in capital leads to higher costs for the company, which are ultimately passed on to consumers in the form of higher prices.

Real-World Applications

The Averch-Johnson effect has been observed in various regulated industries, particularly in the utility sector, where rate-of-return regulation is common. For example, electric utilities may invest in excess generating capacity or expensive transmission lines to increase their capital base and thereby their allowed profits. This can result in higher electricity rates for consumers. The Averch-Johnson effect highlights the importance of carefully designing regulatory mechanisms to avoid unintended consequences and promote efficiency in regulated industries.