Averch-Johnson Effect

Definition

The Averch-Johnson effect is an economic concept that describes the tendency of regulated monopolies to over-invest in capital in order to increase their allowed rate of return. This phenomenon occurs when regulators set a rate of return that is higher than the firm's actual cost of capital, incentivizing the monopoly to expand its capital stock beyond the cost-minimizing level.

5 Must Know Facts For Your Next Test

1. The Averch-Johnson effect leads to an inefficient allocation of resources, as the monopoly over-invests in capital rather than minimizing costs.
2. Regulators set a rate of return that is higher than the firm's actual cost of capital, which creates an incentive for the monopoly to expand its capital stock.
3. The Averch-Johnson effect can result in higher prices for consumers, as the monopoly passes on the costs of its over-investment in capital to customers.
4. The Averch-Johnson effect is particularly prevalent in industries with high fixed costs, such as utilities and telecommunications.
5. Policymakers can mitigate the Averch-Johnson effect by setting the allowed rate of return closer to the firm's actual cost of capital, or by implementing other regulatory mechanisms that encourage cost-minimization.

Review Questions

• Explain how the Averch-Johnson effect arises in the context of regulating natural monopolies.
  • The Averch-Johnson effect occurs when regulators set a rate of return for a natural monopoly that is higher than the firm's actual cost of capital. This creates an incentive for the monopoly to over-invest in capital, as the firm can increase its allowed rate of return by expanding its capital stock, even if this is not the cost-minimizing level of investment. This leads to an inefficient allocation of resources, as the monopoly prioritizes capital expansion over cost minimization, ultimately resulting in higher prices for consumers.
• Describe the impact of the Averch-Johnson effect on the pricing and production decisions of a regulated natural monopoly.
  • The Averch-Johnson effect causes the regulated natural monopoly to over-invest in capital, as the firm can increase its allowed rate of return by expanding its capital stock. This over-investment leads to higher production costs, which the monopoly then passes on to consumers in the form of higher prices. Additionally, the monopoly's production decisions may be distorted, as it focuses on maximizing its rate of return rather than minimizing costs. This can result in the monopoly producing at a level that is higher than the cost-minimizing output, further contributing to the inefficient allocation of resources.
• Evaluate the effectiveness of different regulatory approaches in mitigating the Averch-Johnson effect and promoting cost-minimization in natural monopolies.
  • Policymakers can employ various regulatory strategies to mitigate the Averch-Johnson effect and encourage cost-minimization in natural monopolies. One approach is to set the allowed rate of return closer to the firm's actual cost of capital, reducing the incentive for over-investment in capital. Alternatively, regulators can implement alternative mechanisms, such as price-cap regulation or yardstick competition, which provide stronger incentives for cost-minimization. Additionally, regulators can require natural monopolies to justify their capital investment decisions, or introduce performance-based incentives that reward cost-efficient operations. The effectiveness of these regulatory approaches depends on the specific market conditions, the regulator's ability to accurately estimate the firm's cost of capital, and the overall regulatory framework in place.

Related terms

Natural Monopoly: A natural monopoly is a market structure in which one firm can produce the entire market output at a lower cost than two or more firms, due to economies of scale and high fixed costs.

Rate of Return Regulation: A form of economic regulation where the regulator sets the maximum allowable rate of return that a monopoly can earn on its capital investment.

Cost-Minimizing Level of Capital: The level of capital investment that minimizes the firm's total costs of production, which is typically lower than the level of capital investment under the Averch-Johnson effect.