The Averch and Johnson Proposition: A Critical Analysis
Volume: Volume 2, No. 1
Issue: Spring 1971
Pages: pp. 358-373
Authors: Gordon R. Corey
Title: The Averch and Johnson Proposition: A Critical Analysis
Abstract:
The central thesis under consideration is the proposition by Messrs. Harvey
Averch and Leland L. Johnson that "if the rate of return allowed by the
regulatory agency is greater than the cost of capital but is less than the rate
of return that would be enjoyed by the firm were it free to maximize profit
without regulatory restraint, then the firm will substitute capital for the
other factor of production and operate at an output where cost is not
minimized."
Similar earlier theories are discussed so that basic differences in the A-J
proposition can be determined. In addition, two alleged corollaries of the A-J
proposition can be discounted; court action has not allowed consideration of
imprudent investment in rate-making cases, while the option of uneconomical
purchases has been negated by recent regulatory directives.
The A-J model essentially calls for the (socially) uneconomical substitution
of capital for the other factors of production, under a particular regulatory
climate. The nature of such a climate is analyzed to determine the implied
assumptions; it is those assumptions which are found invalid. The author
concludes that if the Averch and Johnson effect exists at all, it is probably
negative, tending, with the help of the tax structure, to discourage both plant
expansion and plant modernization.
This paper is derived from lectures given at the Massachusetts Institute of
Technology and the University of Wisconsin in the spring of 1969.