The "Optimal" Fair Rate of Return
Volume: Volume 2, No. 1
Issue: Spring 1971
Pages: pp. 122-153
Authors: Alvin K. Klevorick
Title: The "Optimal" Fair Rate of Return
Abstract:
A rather extensive literature has developed that analyzes the behavior of the
profit-maximizing regulated firm using the model introduced by H. Averch and
L.L. Johnson (A-J). Taking the value of the fair rate of return as exogenously
given, this set of papers has provided a rather complete and detailed analysis
of the (absolute and relative) input levels chosen by such a regulated firm and
the quantity of output produced by the company.
The question that appears to have gone unasked is whether the standard A-J
model offers any guidance concerning the level at which the fair rate of return
should be set. The present paper addresses itself to this question. While the
previous literature investigating the A-J model has taken the allowed rate of
return as a given, in the present model the fair rate is an endogenous
variable. The central question asked is: Given the way in which the A-J
regulated firm will respond to different values of the fair rate, at what level
should the regulators set this allowed rate of return in order to induce the
regulated firm to act in a way most conducive to the overall well-being of
society? This paper shows that embedding the behavior of the regulated firm in
such a broader social optimization structure - namely, maximization of a social
welfare function - leads to serious questioning of the conventional view that
the fair rate of return allowed to a regulated firm always should be equated to
its market cost of capital.