How harmful is the rate of return regulation? Averch-Johnson critique revisited

The seminal paper by Averch and Johnson (1968) demonstrates the distortionary effect of the rate of return regulation. Although this paper has had a major impact on economic thinking and the regulation practice, there is surprisingly little quantitative evidence about the magnitude of the distortion. This paper reexamines the Averch-Johnson effect both in theory and by means of numerical simulations. We show that rate of return regulation generally decreases the monopoly profit, increases the output, decreases the price, and hence increases consumer surplus compared to the unregulated monopoly. Our numerical simulations reveal that relatively light handed regulation suffices to yield the main benefits. The simulations provide several practical insights, and prove robust to changes in the parameter values and the functional form of the production function. We argue that computer simulations could be more effectively utilized in the practical design of regulatory instruments applied in the real world.