The ‘Averch-Johnson effect’ is related to the economy of the company and is named after two economists who developed a styled model depicting the rate of return in a regulated firm. A regulated firm is an enterprise whose all strategies and investments are in accordance with the pre-specified and set norms of the country.
It was found that when firms are subject to the rate of return regulation where the actual allowed return is much more than the return that was required on the capital, the firm then aims to over-invest in terms of capacity. This incentive in which one aims to increase the level of capital beyond the one that is needed for a production to be economically efficient involves many numbers of assumptions about the future expected and allowed returns along with the future cost of the entire capital.
The Averch-Johnson effect was founded by Averch and Johnson in the year 1962. The Averch-Johnson effect explores some business-related consequences of a fair rate of return and its regulation. Such regulation may cause the firm to select such technologies that are much more capital-intensive, and hence do not produce its output at a minimum social cost. We can say that the main Averch Johnson result is that the ratio of capital and labor as selected by a regulated firm that is aiming at profit-maximizing. This ratio will be greater than that consistent one which aims at cost-minimizing for any output it chooses to produce.
If in case the rate of return is greater than the cost of capital, a firm will have an extra reward to invest as much as it can consistent with its possibilities of production because when we take the difference between the allowed rate and the actual cost of the capital then what we get is called as pure profit. One of the principal limitations that have come up for the kind of rate of return regulation is that the incentive or the reward for the efficiency in terms of production is reduced. In particular, the choice of input in the regulated firm will be damaged.
The main aspect in considering the rate of return regulation is that there really is some restriction on a regulated firm. The main restriction that we can consider on the regulated firm is that the rate of return which it earns on capital is mainly restricted to some fixed value. Consider a case where a farmer wants to finance all its operations, it needs some secure funds sources for its investment, then he might also consider that the firm has to be able to earn a good return that is almost equivalent to its cost of capital. Although we saw that the Averch-Johnson effect had a tremendous impact on economic thinking then, but still it is ignored or misunderstood often in the present-day regulation practice. The Averch-Johnson effect is known to produce when there is a fair rate of return regulation. If there is a fair rate of return it will obviously encourage a firm to invest more than its present consistent value with the aim to minimization its costs. This can happen when the allowed rate of return is much more than the actual cost of the capital.
1960 PAPER ON CAPITAL REGULATION
Averch and Johnson published their famous paper from around the 1960s. In the paper, they assumed that if the regulation in a firm acts to instant adjusts prices in order to maintain a constant targeted rate of return on a firm’s capital stock, then in such case what reward will the firm have to choose for an efficient combination of inputs? Averch and Johnson thus showed, using much straightforward mathematics, that if the firm’s regulator sets the regulatory rate of return above the true cost of the capital, then the regulated firm has a chance to choose much more capital when compared to labor, i.e, there will be an inefficient capital to labor ratio.
The model of Averch Johnson assumed an extreme form of components like the rate of return or cost involved in the service. This somewhat deals with the regulation in which the prices are continuously and rapidly changed and adjusted accordingly. This is done so that the firm may give a yield of the desired return on a firm’s capital stock. In real cases, the rate of return regulation as it was historically practiced since time, always involved some element of regulatory lag. A regulatory lag may be called as a period of time before prices were adjusted according to the changes in costs.
PAPER CONTROVERSY & RELEVANCE
Averch and Johnson also stated that it is seen both in an industry as well as in a regulated firm that allowing a return to be produced in excess of cost gives a firm some incentive by which they can develop and adopt the techniques that are cost-minimizing for them. If the firm has only one part that is, they only have a wide range of activities and no such incentive for cost minimization for any given activity, then the firm is left as indifferent amount all other firms.
Averch and Johnson’s paper became very famous and in fact very widely known, in most cases, it might be incorrect. This Averch and Johnson effect later came to be known as the gold-plating with a general inefficiency of any regulated firm. But we cannot say that these ideas are strictly regarded by Averch and Johnson. Because Averch and Johnson only highlighted a tendency of the firm to inefficiently mix the capital and labor, they did not mention the tendency to spend too much capital on all the inputs hence it is called the “x-inefficiency” also.