Review of Industrial Organization 18: 175–182, 2001.
© 2001 Kluwer Academic Publishers. Printed in the Netherlands.
Regulation and Cost Inefﬁciency
University of Oregon, Department of Economics, College of Arts and Sciences, Eugene OR 97403
Abstract. The well known Averch Johnson effect states that rate-of-return regulation will induce
cost inefﬁcient production. This paper examines regulation induced inefﬁciency in broad set of
environments including arbitrary regulatory mechanisms, multiple outputs/inputs, uncertainty, time
dynamics, price discrimination, and more. I show that the Averch Johnson effect applies throughout
a wide variety of settings. Despite the generality of framework, my analysis is truly elementary and
does not rely on Kuhn–Tucker analysis or three dimensional graphics. I also provide results and
discussion which clariﬁes the limits to Averch and Johnson-like insights in practical applications.
Key words: Inefﬁciency, regulation.
One of the best known results in regulatory economics was ﬁrst presented by
Averch and Johnson (1962). Their simple model of a regulated monopolist demon-
strated that rate-of-return regulation induces cost inefﬁcient production, a result
commonly known as the Averch Johnson (AJ) effect. (See Baumol and Klevorick,
1970; Sherman, 1985; and Train, 1991 for surveys of the literature.) This paper
reexamines this result in the context of a much broader set of environments than
that conceived in the traditional literature – including nonlinear regulatory mechan-
isms, uncertainty, time dynamics, multiple outputs/inputs, price discrimination, and
more. Despite this added generality, my proofs are truly elementary and highlight
the essence of the AJ effect without the use of Kuhn–Tucker analysis or geometric
My work offers fresh insights in several dimensions. The ﬁrst lesson is a ped-
agogical one. The AJ effect is traditionally established either by solving a formal
constrained optimization problem with Kuhn–Tucker methods (as in Averch and
Johnson’s seminal paper), or through the use of three dimensional geometric argu-
ments (as in Zajac, 1970; and Bailey, 1973). I argue that the driving force of the
result is both more transparent and more general if one instead clearly identiﬁes
the two fundamental assumptions that are imposed. In particular, capital must be
replaceable with labor local to the regulated optimum and, secondly, the regulated
optimum is not itself an unconstrained local optimum. By bringing these two
pivotal assumptions to the forefront, proof of the AJ effect becomes transparent