Rate of Return Regulations and Factor Bias in Innovations

Abstract

The literature on the Averch-Johnson (A-J) effect focuses on the distortion that is introduced into the capital-labor ratio employed by a regulated firm as the result of rate of return regulation. This paper considers a related question, namely that of the effect of rate of return regulation on the mix of labor and capital-augmenting innovations produced and employed by a regulated firm. The regulated firm is assumed to possess "in house" capabilities for producing such innovations, and it is the responsiveness of its innovative activities to regulation that is the central theme of this paper. But the mix of innovative activities also affects the firm's choice of a capital/labor ratio in producing its final product. This more conventional notion of factor bias is also explored in the paper.