Political economy and public-utility inefficiency: Inputs, constraints, and prices under a politically motivated regulator

Whereas the normative regulatory economics literature is rich with efficiency discussions on the operations of regulated public-utilities, positive theories in political economy remain sparse. Despite this lack of attention, political economy has much to offer this area by providing a better positive understanding of why public-utility inefficiencies persist. Combining insights from Sam Peltzman (1976) and Lewis Evans and Steven Garber (1988), a model of a politically motivated regulator is adopted. From this model two general theories are developed: (1) A positive theory of input selection and regulatory constraints; (2) A positive theory of regulatory price structure.;The first set of theoretical results under a general specification reveals that the regulator desires the inefficient use of capital. This capital input bias, however, is less than that chosen by a profit-maximizing firm constrained in rate of return ("Averch-Johnson effect"). The regulator's optimum in the general case is then shown to be induced by a combined form of regulation in which both a constraint on the firm's rate of return and a direct price constraint are invoked. Profit maximizing behavior fails to coincide with regulator objectives when either type of constraint is used in isolation. The combined form of regulation appears to be consistent with previously observed regulator behavior when either "rate of return" or "price-cap" regulatory regimes are adopted. Whereas the results indicate a partial mitigation of the Averch-Johnson effect, they also cast doubt on the purported cost-efficiency of "price-cap regulation".;In the multiproduct case, with consumer advocates for each product, we consider the issue of regulatory price structure. The regulator is shown to deviate from efficient (Ramsey) pricing for two reasons. First, the "Peltzman effect" is due to the regulator's desire to optimally balance political support from the various consumer groups. Second, the "profit effect" is due to the regulator's desire to augment the rate base thereby, allowing for the realization of a higher profit level for a given rate of return. Finally, evidence from the Federal Communications Commission's movement toward the cross-subsidization of local residential telephone service supports the theory of regulatory price structure.