Background
The Averch-Johnson effect is a phenomenon in regulatory economics highlighting the behavioral response of firms subject to profit regulation based on their capital investment. Named after economists Harvey Averch and Leland L. Johnson who first described the effect in 1962, it illustrates the counterintuitive consequences of regulatory measures aimed at controlling monopoly profits.
Historical Context
In the post-World War II era, particularly during the 1960s, there was heightened scrutiny of monopolistic and oligopolistic firms, especially in utilities and other natural monopolies. Regulators sought to curb excessive profits and ensure fair pricing, leading to various profit regulation measures. The Averch-Johnson effect emerged from these efforts, highlighting the pitfalls and unintended consequences of regulating firms based on the rate of return on their capital.
Definitions and Concepts
- Profit Regulation: The practice of controlling or capping the profits that a firm can earn relative to its invested capital.
- Rate-of-Return Regulation: A specific type of profit regulation where firms can earn a predetermined rate of return on their investments.
- Capital Over-Investment: An inefficient level of investment beyond what would be economically optimal for a firm in an unregulated competitive market.
Major Analytical Frameworks
Classical Economics
- Classical economists advocate for minimal government intervention, suggesting that markets naturally find an optimal distribution of resources, including capital investment, free from regulatory constraints.
Neoclassical Economics
- Neoclassical economics builds on classical principles, incorporating marginal analysis to derive efficiency conditions. The Averch-Johnson effect is seen as a deviation from optimal marginal conditions due to regulation-induced distortions.
Keynesian Economics
- While Keynesianism emphasizes active government intervention to stabilize the macroeconomy, the theory recognizes that micro regulations (like profit caps) can have unintended microeconomic distortions, such as those described by the Averch-Johnson effect.
Marxian Economics
- Marxist economists may view the Averch-Johnson effect as an example of how capitalist firms manipulate regulatory frameworks to maintain capital accumulation and profit motives, further entrenching capitalist inefficiencies.
Institutional Economics
- Institutionalists would focus on the role of regulatory agencies and the regulatory environment in shaping firm behavior, contributing to phenomena like the Averch-Johnson effect through institutional failures or misaligned incentives.
Behavioral Economics
- Behavioral economics might examine the cognitive and behavioral responses of managers facing regulation, including potential biases and heuristic-driven decisions leading to capital over-investment.
Post-Keynesian Economics
- Post-Keynesians emphasize the institutional and dynamic aspects of the economy. They may interpret the Averch-Johnson effect through the lens of structural influences and the path dependency of investment decisions.
Austrian Economics
- Austrian economists criticize regulatory interventions that alter free market processes. The Averch-Johnson effect exemplifies how such interventions disrupt the competitive equilibrium, leading to resource malallocations.
Development Economics
- From a development perspective, understanding the Averch-Johnson effect is crucial in crafting regulations in developing economies where rent-seeking and over-investment in certain sectors could hinder balanced economic growth.
Monetarism
- Monetarists, focused on monetary policy’s role over direct regulatory interventions, would likely point to the Averch-Johnson effect as evidence of the inefficiencies introduced by regulatory controls on investment.
Comparative Analysis
Analyzing the Averch-Johnson effect across different sectors and regulatory regimes can reveal varying degrees of capital over-investment. For example, regulated utilities offer a classic demonstration of the effect, in contrast to competitive technology sectors that experience less regulatory distortion in investment behavior.
Case Studies
Case studies might include regulated utilities such as electricity providers where rate-of-return regulation led to significant and observable over-investment patterns.
Suggested Books for Further Studies
- “Regulation and Its Reform” by Stephen G. Breyer
- “The Economics of Regulation” by Alfred E. Kahn
- “Capitalism and Regulation” by Kenneth Downey and Gordon C. Rausser
Related Terms with Definitions
- Rate-of-Return Regulation: A regulatory framework in which firms are allowed to achieve a specified rate of return on capital investments.
- Regulatory Capture: A situation where regulatory agencies are influenced or controlled by the industries they are supposed to regulate.
- Cost of Capital: The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile.
- Natural Monopoly: A market structure where a single firm can supply the entire market at a lower cost than two or more competing firms.
