Is Capital Investment Indeed Not Affected by the Market Cost of Capital in the Regulated Energy and Utility Industry? A Reexamination of the Averch-Johnson Model

Abstract

The Averch-Johnson model provides a classic depiction of the behavior of a regulated monopoly firm. It has become one of important models and has found wide applications especially in energy and utility industry. The traditional A-J model assumes that regulated or fair rate of return is exogenous to but not affected by the market cost of capital, therefore, demand for capital (hence output) is not responsive to the change in the cost of capital, a result that contradicts well-established phenomenon in business world. In this paper, we show that the capital investment could indeed respond to a change in the cost of capital if such a change affects the fair rate of return. Consequently, the traditional Averch-Johnson model is only a special case of a more general outcome.