AN EMPIRICAL TEST OF REGULATORY EFFECTS

1. AN EMPIRICAL TEST OF REGULATORY EFFECTS BY H. CRAIG PETERSON DUAH AMPONSAH ISAAC

2. OBJECTIVE OF THE STUDY Prove or otherwise empirically that as regulation(rate of return) tightens: • The regulated firm has a higher unit costs • The firm spends a larger portion of total cost on capital.

3. APPROACH • The averach-Johnson contention of the overuse of capital beyond what optimization requires is the basis of this empirical analysis. • The regulated firm does not behave differently from the unregulated firm but rather since s>r, make optimization decision based on a subsidized capital cost,(subsidy= s- P(k)) • The regulated firm's objective is stated in terms of cost minimization subject to a regulatory constraint . • The effect of changes in the allowed return on capital on costs and input choice is evaluated to show whether or not costs increase for the production of any given level of output as the allowed return approaches the cost of capital

4. Intuitive explanation of A-J • The regulated firm is constrained on the amount of profit it can earn(rate of return); seeks ways to circumvent it. This is accomplished by overutilizing capital. Since the firm is assumed to be allowed to earn more on each additional unit of capital employed than the cost of that capital to the firm, up to some point profits are increased by substitution of capital for the other input, labor.

5. THEORETICAL MODEL • The necessary condition for profit maximization for an regulated firm is that cost must be minimized subject to the constraint imposed by the existing technology.

6. THEORETICAL MODEL • -PLL +XL + VQL = O (5) • - FPL + XPF + VQF = 0 (6) • -PK + XS + VQK = O (7) • R-PFF-PLL-sK=0 (8) • Q-Q(K,F,L)= O (9) • K > O, L > O, F > 0, v > O, X > 0 (10)

7. Cost model • The lagrangian is formulated The first order conditions:

8. THEORETICAL MODEL can be written as Since v, Q P >0; 1-λ ≥0, if λ =1, then .L(K)…… SO 0<λ<1 Since s>p(k) The shadow price of capital which the regulated firm .

9. Model contd…. The effect of s on the cost of the firm is given as

10. THEORETICAL MODEL

11. Consisitent with A-J contention

12. STATISTICAL MODEL The cost function for the total cost estimation The model for the estimation of percentage of cost that goes to K

13. DATA • The sample consists of 56 steam generating plants which experienced at least a 50% expansion during the period 1960 to 1965. These are observed over the three-year period, 1966 to 1968. • The selection of plants which significantly expanded capacity is dictated by the theoretical model which is in marginal terms and the possibility of capital-other inputs substitution.

14. DATA CONT’D • The dependent variable used in estimation of (38) is the log of cost of production per unit of output in terms of dollars per thousand KWH. • The dependent variable associated with (39) is the % of total cost going to capital. • Output is in terms of millions of KWH of power. • Fuel price is given as cost per million British Thermal Units of energy. • The wage rate is expressed as dollars per year per employee. • The capital price is formulated in terms of the annual rental price of capital as suggested by Jorgenson. PK= q (r + δ - ф), q= price of equipment, r = interest rate, δ = rate of depreciation, and ф rate of price change for equipment. An index of technology is constructed by determining the computed average time that capital had been in service. A dummy variable is included to distinguish plants which are owned by firms which are part of interstate holding companies. Participation in holding companies may be considered to be an additional scale variable.

15. MEASURES REGULATION TIGHTNESS • Dummy variable representing states with state commissions and those without. • Dummy separating states with original cost from fair value(increased cost of capital overtime.; 5-50% more) rate base. • A measure of the actual difference between the allowed rate of return and the cost of capital .An index of the difference between allowed rate of return on equity and cost of equity.

16. =dividend, =dividend pay-out ratio, • =book value of equity, stock price, and • g=expected growth rate in dividends.

17. ESTIMATION RESULTS UNIT COST(CD cost function) • LCOST' = -0.1717 + 0.0880NH - 0.1008LQ' + 0.0590LQ'LQ' + (3.85) (-8.11) (8.42) 0.6237LF'+ 0.1784LL' + 0.2680LK' - 0.0189TC - 0.0006Y (15.26) (2.75) (2.18) (-4.45) (-0.06) + 0.0701REG + 0.0013FAIR (3.04) (0.08) N=168,R-squared= 0.82

18. ESTIMATION RESULTS REGRESSION B LCOS T'=-0.0185 -0.116OLQ' + 0.0409LQ'LQ' – (-7.81) (4.19) 0.0127TC -0.0020Y+ 0.5299LF' + 0.3260LL' + (-3.20) (-0.23) (9.15) (4.79) 0.4088LK'-4.763LK'LK+ 0.8516LF'LF' + 0.6055LL'LL' (2.44) (-3.29) (4.04) (1.36) + 1.704LF'LK'- 1.277LF'LL' +0.0846LF'LQ'- 5.874LK'LL' (2.76) (-4.69) (1.06) (-5.88) +0.4102LK'LQ' + 0. 1943LL'LQ' - 3.625SS' - 275. 1SS'SS' (2.00) (1.90) (-3.73) (-4.93) N=141, R-squared=0.87.

19. ESTIMATION RESULTS -REGC • = - -3.627 - 550.2(SS')<0 but at a decreasing rate. % of cost paid to capital. PC = -0.0502 - 0.0114LQ' + (-2.40) 0.0132LQ'LQ'- 0.1510LF' + 0.0675LL'- (4.89) (-9.63) (2.71) 0.0037LK' - .0003TC - .0083Y (-0.29) (-0.20) (-2.30) + 0.0223NH + .0267REG + .0026FAIR (2.53) (3.02) (0.38)

20. Estimate of PC using SS • PC = -0.0036 - 0.0095LQ' + 0.0132LQ'LQ'- 0.1878LF‘ (-1.80) (4.62) (-9.09) + 0.1023LL' - 0.0253LK' + 0.0013TC - 0.0090Y (3.53) (-0.41) (0.70) (-2.20) - 1.336SS’ (-2.96) N= 141 R-squared 0.50

21. Summary and conclusion • The result is statistically significant using the state commission versus no state commission dichotomy and also using the continuous measure of the allowed return minus the cost of capital. • It is also found that the percent of cost going to capital increases with more stringent regulation. This result is also statistically significant when the same two measures are used. • Empirical evidence support the Averch-Johnson contention .