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Dynamics of Rate-of-Return Regulation

Citation

Publication Date: 
January 26, 2012
Format: 
Journal Article
Bibliography: Alexander Nezlobin, Madhav V. Rajan and Stefan Reichelstein, Dynamics of Rate-of-Return Regulation, Management Science (available online January 26, 2012).

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Under rate-of-return regulation, a firm's product prices are constrained by the requirement that investors not earn more than an allowable return on the firm's assets. This paper examines the dynamic properties of the rate-of-return regulation process when the regulated firm periodically undertakes new capacity investments. Our analysis identifies prices that correspond to stationary values of the regulation process. It is shown that the underlying depreciation rules for property, plant, and equipment determine whether these stationary prices will be above, equal to, or below the long-run marginal cost of providing the regulated service. We provide conditions under which the rate-of-return regulation process is dynamically stable so that prices indeed converge to their stationary values. The overall efficiency of this regulation method is shown to depend on how well the applicable depreciation schedule matches the productivity pattern of the assets in use.