Averch-Johnson Effect - Essay Example

Student’s name) (Course code+name) (Professor’s name) (University name) Introduction It has come to the realization of the economists that the market outcome with regard to natural monopolies leaves a lot to be desired. As a matter of fact, there has been a high price but compromised output which is lower than the social optimum. This problem has generated, among other aspects, attempts to regulate regulation of monopolies. In particular, in the past few decades, Australia has been under revolution in terms of management, regulation of public utilities and ownership. Due to such policies, firms such as energy, telecommunication and transport have been privatised due to what has been seen as profit maximising monopolists producing output with an inefficient combination of inputs. Furthermore, firms that have been owned by government have also been corporatised with an aim of ensuring that through such policies, managers of the public sector are judged based on quasi-profit performance. All these efforts have been brought by the underpinnings of Averch-Johnson effect. This is the point of departure for this assessment. Since the theory, as held by Averch and Johnson tend to bring effects that are undesirable within the context of Australian public policy, the assessment will also validate if the effect holds true with Australian public policies. Averch-Johnson Effect Beginning with Averch-Johnson effect, for the sake of judging the levels of prices that have been changed by organisations for services that should be subjected to public control, AUSTEL as Australian regulatory body come up with affair rate of return as policy. Basically, what happens is that after these organisations get the differences between their operating expenses and gross revenue with regard to their investment in equipment. Therefore if the rate of return of the rate base (ratio of net revenue to that of value of equipment and plant) is deemed to be excessive, AUSTEL gives pressure to Australian firms through policies to bear on the firm to reduce prices (Armstrong et al., 2009). On the other hand, if the rate is deemed to be low then AUSTEL advises these organizations to increase prices. As Armstrong et al. add, the purpose here it to ensure there is a developed theory of the monopoly organisation aiming at maximising profit but subject to such a fixed or constraint on its rates of return. Putting Averch-Johnson effect within the context of Australia public policy, utility regulation has been given dynamic acronyms and names. For instance, there is revenue regulation, incentive regulation and prices caps policies (Averch and Johnson, 1962). But almost all policies within Australia have been sought to regulate on rate-of-return. Therefore as Averch-Johnson effect posits, policies guiding rates of return have been static tool that limits the profits that organisations with market power should be able to extract from its market. The idea has been simple for these firms---as Averch-Johnson effect posits, in cases where Australian firms are faced with a static perfectly competitive market equilibrium, they tend to earn null economic profits or rather, earn exactly the risk-adjusted market rate-of-return which is based on their stock capital. Therefore to avoid what is termed as ‘profit maximising monopolists producing output with an inefficient combination of inputs’ they are made to mimic the demands of a perfectly competitive organization if it is forced to make profits not exceeding this rate-of-return. Australia has currently introduced a regulatory scheme that has been viewed to be unlikely to lead to efficient production in either the long-term or short-term. This is why basic rate of return is often augmented, more so in the case of multi-product organisations. For such organisations, policies are used to further distribute allowed profits over types of groups of customers or products. For instance, with presence of price cap regulation there exists baskets of products that have been individual products covered by sub-caps and those covered by a cap. This is the case of Australian telecommunications (Walsh, 2008). Walsh argues that for revenue regulation, the permitted one can be allocated to different customer groups. Recent research from Australian Local Government Association (2010) has compared Averch-Johnson effect with regard to public policies implemented in electricity transmission. In this case, it is unlike the situation in telecommunication since it is done on the basis of the amount of projects or infrastructures need to service the particular group. Reports have suggested that such public policies operate differently in other institutions where the allocation are based on ability-to-pay, political alignment and beliefs of fairness (Train, 1999). A good example of such policy is with regard to New South Wales rail access regime treats coal lines uniquely compared to other railway lines. Baumol (2008) sees Averch-Johnson effect to be affecting allocation rules in Australia in a unique way. Baumol believes that allocations are purely to augment rate of return type regulation. These policies as created are moving towards exacerbating the problems related to rate-of-return regulation so as to limit the ability of firms operating efficiently thus creating a profit maximising monopolists producing output with an inefficient combination of inputs. To paraphrase what William Baumol once said, in the event of Averch-Johnson, ‘we need allocation rules because they snatch defeat from the jaws of victory’ (p. 69). The question Baumol asks instead is that if indeed regulations with regard to rate of return have these well-known issues why is Australia continuing to embrace it? The answer Thomadakis (2009) provides lies with its lack of regulatory experience. This regulation appears equitable and fair and can easily be justified as a move aimed at avoiding excessive profits, it the short –term when it is known that problems still persists. Thus far, the assessment has drawn examples from electricity and telecommunication firms within Australia and related such to Averch-Johnson theory. One thing that can be added with regard to such is that at one point, telecommunication were having incentive that could make it expand into other regulated markets even if doing so made it operate at a long term loss. In so doing, it justifies ‘profit maximising monopolists producing output with an inefficient combination of inputs’ by driving out other firms or to some extent, discourages their entry into the same markets even if their terms of operations seem to be lower in terms of cost production. Applying the same to the telegraph and telephone firms within Australia, Baron (2003a) noted that this model actually brings issues related or relevant to the evaluating market behavior. Basing on telecommunication industry or rather, telegraph and telephone firms as case study with regard to a situation of a single-market model, a geometrical framework as shown in figure 1 below has been developed to show the impact of the regulatory constraint on the cost of the curves of these firms if they are using two factors. This aims to demonstrate significant characters such as; whether the rate of return permitted by the AUSTEL is greater compared with the cost of capital but such said to be less than the rate of return that can be enjoyed by these organisations in the event that they were at liberty to maximize the intended profit without constraints from AUSTEL. If this is the case then the organization will be able to substitute capital for other factors of production thus operating at an output where there is no minimization of costs. Considering the figure above with regard to the aspects of Averch-Johnson underpinnings, it suggests the firm’s production where capital denoted as W1 has been plotted on the horizontal axis whereas W2 denoting labour on the vertical axis. Consequently, the isocost curve represented by R has been generated by market cost of labour and capital thus meaning that the unregulated organisation and or firm will have a movement along the expansion path denoted by 1 and at the same time one experiencing market cost being minimized for any given output. Applying the same diagram with regard to regulated firms in Australia, it can be noted that the cost of capital to the firm (in this case the private cost) will no longer be equivalent to the market cost. When there will be any additional unit with regard to capital input, the same firm will be allowed to earn a profit Bailey (2000) explains that must be equal to the difference existing between the rate of return and the market cost of capital allowed to be the AUSTEL that it otherwise would have to do away with. To conceptalise the above statement, private cost will be assumed to be less than what the firm accrues in terms of market cost by a figure equal to this difference. An important issue to mention with regard to the figure above is that the impact of regulation is equivalent to that of making a change to the relative prices of capital W1 and labour W2---though isocost curve T will be relevant and this firm will move along expansion path 2 (the path along which there is no minimization of market cost for any given output). Contrariwise, the firm will realise that path two offers more advantage since it is established along the path that the firm will be able to maximize the total profit owing the constraint on its rate of return. Assuming that one of the firms taken to be working in a single market also gets into other regulated markets, and in this case, AUSTEL then it will base its criteria of fair rate of return on the over-all value of the firm with regard to equipment and plant for all markets taken together instead of getting a separate rate of return for every market. When such cases arise Averch and Johnson argue that the firm may resort to incentive so as to enter such markets, even though the cost of making such a move is more than the additional revenues. Studies have shown that such steps make firms inflate their rate base so as to meet demands of constraints thus allowing it to gain even bigger constrained profits compared to how it would have been when second markets were not there. A noteworthy implication is that Australian firms such as Telecom Australia that have been operating in oligopolistic second market are likely to have advantage with regard to competing firms since it will drive away lower-cost producers. This statement is unlike what Baumol (2008) describes with regard to monopolists who may decide to temporarily cut prices in outside competitive markets with an aim of driving out unwanted competition or rivals thus raising prices to fit their levels and demands. However, Baumol (2008) further advises that monopolists can only make such a move if they are expecting to make more profits in such additional markets. Victoria gas industry is a good example of this case where its consumption has been dominated by household use. In as much as there seem to be a situation where private integrated gas producers are having market powers, in Victoria substitute fuels is likely to limit the abuse of any market powers. Basically, within the contexts of the firms cited above, it is noted that policies that have been crafted effect regulation and all regulation affects incentives. While Averch Johnson effect when it comes to rate of return regulation, it needs to be noted that generally, incentives are likely to degrade the quality of service or product especially under cap regulation. Conclusively, even though Averch-Johnson has been hugely hypothesised, rate of return regulation is often one sided regulation with just a few benefiting from it. As has been seen with some firms in Australia, it is easy to introduce and tend to solve market failures but at the long, its costs go beyond any benefits associated with its application. For instance, the regulated firm may not a convincing incentive to help it seek out least cost method to bargain with a union regarding wages. Unfortunately, this is the regulation that has been adopted in Australia. With what can be termed as ‘hybrid’ approach, the country has managed to create sterile framework threatening to undermine any benefits of reforms within microeconomic reform. References Armstrong, M., Cowan, S. and Vickers, J. (2009). Regualtory reform: economic analysis and the British experience, MIT Press, Cambridge, MA. Australian Local Government Association (2010), Submission to the Senate Select Committee into Reform of the Australian Federation. Averch, H. and Johnson L (1962). "Behavior of the firm under regulatory constraint", American Economic Review, 52, 1052-69. Bailey, E. (2000), ‘Innovation and Regulation: A Reply’, 5 Journal of Public Economics, 393-394. Baron, P. (2003a), ‘Regulation of Prices and Pollution under Incomplete Information’, 28 Journal of Public Economics, 211-231. Baumol, J. (2008), ‘Some Subtle Issues in Railroad Regulation’, 10 International Journal of Transport Economics, 341-355. Thomadakis, B. (2009), ‘Price Regulation under Uncertainty in an Asymmetric Decision Environment’, 97 Quarterly Journal of Economics, 689-698. Train, E. (1999), Optimal Regulation: The Economic Theory of Natural Monopoly, Cambridge, MA, MIT Press. Walsh C. (2008). Fixing fiscal federalism. in Carling R., Where to for Australian Federalism? Sydney, The Centre for Independent Studies, pp. 43-62. Read More