The Econornics of Regulation
Princip/es and /nstitutions
Volume I Economic Principles
Volume II Institutional Issues
Alfred E. Kahn
The MIT Press
Cambridge, Massachusetts
London, England
CHAPTER 2
The Traditional Issues in the Pricing
Public Uti lity SerVic
The essenceof regulation is the explicit replacement of compet ition .
governm ental orders as the principal institutionaLdevice for assuri~ \Vi
,performance. Th e regulatory agencydetermines specificallywho shall
permitted to serve; and when it licensesmore than one supplier, it typi
imposes rigid limitations on their freedom to compete. So the =-"'--.IlllW
__ITQ uirementsof competition as the governing market institution-freedom
entry and independenceof _j!ction-are deliberately replaced. Instead
_government determines ~ ualit and conditions of service, andim
an obligation to serve.
The licensureof entry in most public utility industries tendsto be
infrequent, once-and-for-all or almost-a ll determination. Franchises legall
may have to berenewed, and new firms may seekto belicensed;inradio an
television, and truckingthis is a frequentoccurrence.But eveninthose cases.
and even mor e so in others, the tendencyis to rely on the same chosen
instruments,year after year and decade after decade; the structure or tbc
market and identity of the firms selected to serve remain essentially un
changing. And what publicutility comm issions ma inly do (tho ugh not'
broadcasting) is to fix the pricesthe chosen instruments may cha rge-n
justa ceiling,as inthe caseof perm issible interestrates paid on time deposi
or as prescribedinusury laws, or a floor, suchas a minimum wa ge-but
set of specificprices. It is throug h the regulation o f price that the limitatio
ofprofits ispurportedly achieved; it is incidentto the regulation o fpricetha
the levels and permissible kindsof cost are controlled, by allow ing or .
allow ing payments for various inputs,by supervising methods o f financi.
and controlling financialstructures. Price regulation i~ the heart or ubli
\ltilit~gulation.
Th is assertion might strikea constitutio nal lawyer or anyone who h
read Chap ter 1 as strangely o ld-fashioned. It so unds likesome thing the
United States Supreme Court wou ld have said 40 to 50 years ago, W?
it was systematically strikingdown legislative attempts to regulate ~fl
or wages outside the traditiona l "industries affected w ith a public lnt
est" on the gro und that the right to set pricesfree o f public contro l W d
at the heart of the freedo m of contract protected by the Fourteenth Amen
T he Tr aditio nal Issues inthe Pricing o f Public U tility Services
21 I I .
93
4 in Nebbia v. New York, the Suprem e Co urt finally rejected
t 1ln I , .' . II bout nrim en.. ha t there was anythmg co nstitutrona y sacro sanct a out pnvate
rhe notJOnt. tion and declared that if any industry could, fo r go od and
. _determma , ., .
pflce ns be subjected to publicregulation, there wa s no constituffiientreaso
, ....
su c it being subjected to pnce regulatlOn inparticular.š
. 1bar to 1S .
H ona ti n m ay seem irratio nal also to the econorm st. And to so me
Our asser 10 li .
. . Onepurpo se of regulation is to prote ct buyers from monopo IStlC
xtentit IS. . cc.: :»: 1 b .. h
e . ' -but buyers can be explo ited Just as ertective y y glvm g t em
PIOltatlO n . .,
ex fe serviceas by chargmg them excessive pnces. Another purpose
o or or unsa , . .
P t destructive competition-e-but rt would seem that sellers can
.s to preven . .
I . t as destructively by offenng better or mor e servicefor the same
compete JUs . . II h
. b offering the same serviceat lower pnces. Pncerea y ~ no
pnce as Y li f . ., .
. except in terms of an assumed qua Ity o serVlCe; pnceISa rat io,
m eamn ~ . hvsi I . f'zi d. y in rhe numerator and some p ysica unit o glVen or assume
with mone .....
. d quality inthe denom inator. EnceregulatlOn alone ISeconomlcquantlty
an bl' T
I
'nglessMor eover the nature of our dependence on pu icutl rty
al y meam -" . d .
<--- • • typically suchthat customers may correctly be more intereste m
serVlcesIS . .. . ., d
the denominator than inthe numerator -m the reliability, contmuity, an
safety of the servicethan inthe pricethey have to pay.š . f . .
Th is relatively greater concentration on price than on quality o servlce.ls
one refiectionof the severe limitations of regulation as an institution of social
control of industry. Inthis chapter we examine the major traditiona l co.mpo
nentsof that effort. Inaddition to laying the ~ecessa:y~actual found~tlOn
fo r our subsequent analysis, the purpose of thlS prehmmary survey 18 to
suggest (1)the limited resemblancebetween what :egul~tion, as tra~itiona lly
practiced,tries to do and the principles of nor~atIve mlCrOeC?nOmlCtheory,
thus providing the justificationfor our alternatlve ~pproach, l.n~art II,.and
(2)the severe limitations of this institutional devlce for achlevmg optImal
economic results,which provides the backgroundfor Vo lume 2.
TH E LlMITED ATT EN TION TO QUALlTY OF SERVICE
The regulatory process devotes considerable attention to the denominator
o f the money-quantum-of-service ratio. 4 The governing statutes genera!ly
empower comm issionsto investigate and issuefindingson whether the serVlce
offered under their jurisdictionis "unjust,unsafe,improper, inadequate or
insufficient," and to promu lgate rules for its improvement. The rules adopted
1~ ~ot es 11-20, Chapt er 1. In Adkins v.
O!ifdren s Hospital, the Court struekdown a law
ftrcingminimum w ages for women inthe Distriet
:vfColumbia inthese terms:
shall see that it differs from them in every
mat erial respeet. It is not a law dealing with any
businesseharged wit h a publie interest. ... It
has nothing to do w ith the eharaeter, methods,
or periods of wag e payments. It does not p~eseribe
hours of labor o r eonditions under wh leh
labor is to be done .... It is simply and exclusivelya
priee-fixing law .... " 261U.S. 525,
553-554(1923).
2291U.S, 502,531-532,536-537(1934).
3See Irston R. Barnes, The Economics oj Public
Utility Regulation (New York: Appleton-CenturyCrofts,
1942),742-743.
4 For a useful survey, see Cha rles F. Phill ips,
Jr.,op. cit., 400-438.
"n .e .essenhal characteristies of the statute
::: underconsideration, whieh differentiate it
thelathelaws fixinghours oflabor .... [are] that
IIlent~er: .,deal with ineidentsof the emp loy ""lb
aVlng no necessaryeffeet upon the heart
~ e Contract·th .
"If "at IS,the amount ofw ages ....
~~ow , In the light furnishedby the foregoing
-v-~onsto the general rule forbidding legis~
IUterfer .
~ encewlth freedom of contraet we
e andanalyze the statute inquestion: we
22 / I The Institution of Regul
ated~OIl
cover matters such as safety standards, minimum physical sp .
(accuracyofmet ers, volt age of electricity, heating value of gas),t~clfi.cati
m ents of prompt m eeting of custom er demands, extensio n o f servie req .
I b d f servi .. Cetocustomers, contro s o na an onment o service, provi sio n of spec'I
ia fa 'liand arrangements, and certification ofnew entrants.š Cl
But it is far more true of quality of servicethan of price that the .
responsibility remains with the supplying company instead of ~rl
regulatory agency, and that the agencies, inturn, have devo ted rnWlht h
. Uc
attention to the latter than to the fo rm er. The reasons for this are fairl !ll
Servicestandards are often mu ch ~ore difficultto specify bythe prornui cl.
of rules.Where they canbe specified, they are oft en essentially U ga
versial. Where they cannot-and this is particularly the case when ~con
to innovations,to the dynamic improvem ent of service-in a system inco.
the private companies do the managing and the governm ent the super:~
there isno choice but to leave the initiative with the company itself.Th ISI
role the regulatory commission can typically play is a negative :o
formulating minimum standards and usingperiodic inspectionsto Seen
they are met; investigating customer complaints and issuing orders w~
serviceha s beenobviously poor, when managem ent or subordinates ha
beenblatantly inefficient or unfair, or when it wish es to insistthat
companies take on or retain unremunerative business.6
This authority is by no m eans negligible. Th e aggressive commission
availabl e to it the ability to penalize offending companies by ho ldi
permi ssible rates at less remunerative levels than it w ould otherwise
prepared to alIow -subject to the constraint,howev er, that it woul d
self-defeatingto punish them so severely as to impair their financialcapaci
to institute the desired improvem ents. And commissions frequentlydo
this weapon. 7
StilI,their rol e is essentialIy a negative one and this raises fundamental
questionsabout the efficacyofth e entire process. lf,as far as quality ofservi~
is concerned, the principal responsibility rests with the private monopolist,
5 "Public utility commissions are constantly
passingupon questions of service.Th e determination
of a rate w ithout a determ ination of
the quality of the service rendered would
be similar to an individual's agreeing to pay a
stipulated sum of money for a commodit y without
specifying the kindOl' grade of commodity
he expects to receive in return 'for his outlay .
A very large port ion of the commi ssions' tim e
is,then, necessarily devoted to the determination
of the quality of service rendered by the utilities
under their jurisdiction.Most stat es whi ch have
active commissions now ha ve stat e-w ide service
standards .... Wh ere there are departures from
these standards the utility is obviously derelict
in the performance of its duties, and unless
excused by the commission because of unusual
circumstancesis subject to its disapproval."
Charles Stillman Morgan , Regulation and tm
Management oj Public Utilities (Boston: Houghton
MifHin, 1923),270-271.
6 The question of whether and in what circumstancesa
utility company may be required to
extend service to new customers and areas,or
forbidden to discontinue servicesmay of cou
be regarded as an aspect o f the regulation
service and is usually so treated. But the iss
here is usually quite explicitly one of priceor
the relation of revenues to costs, present
prosp ective: to what extent m ay utilities
required to take on new, or continue to. se
old markets that they think are or Wi ll
unremunerative' to what extent should profitabl
business 'subsidize unprofitable extensions
continuations? Th ese issues are thus ernbrac
(som etim es explicitly, som etim es irnplicitly).
our later discussionsof cost-price relationshlplo
Of course, as w e have alr eady suggested,
regulations of service quality are in eeo nom
effect also regulations of price.
7 For exampl e,
"Th . ,. h s servÍceC
e testlmon y glven ln t e ga th~
I · that
hearing at N eenah was concUSlve . adequality
of service rendered is totall~ 10tha t
quate .... Th e Commission findsthere ore
4. T he compa ny has virtually compl eted 64 per
cent o f its current 3-year (1967-1969) impro
vem ent prog ram and, thus, has been
able to bring abo ut substantial imp ro vem ent
inservice. On that basis,it is fair and reasonable
to allo w the utility 64 per cent of the
requested increases inlo cal exchange rates....
5. T he em ergency increases autho rized by this
ord er w ill no t result at this tim e ina fair and
reasonable return for U nited Te lephone
Co mp any, but will impro ve its financial
position so that it should be able to finance
the remainder of itsim pro vem ent prog ram .... "
23/ I
T he T raditio nal Issuesinthe Pricing of Public U tility Services
shou ld be given
for gas ,
rellSe in r~tes e servicerendered ln the
tion unul th fiorm in a reasonable
era hall con b h
departrnents dard laid dow n y t e
tO rhe stan increasein rates for
er Th at no f
jssion.. . . 'Iway departments o
d street ral . .
etrie an ted until the serviceln
e Idbe gran bl
utllity sho u b ho wn to be reasona y
ofthern shall :u:den of proof of so doing
and rhe " M or gan
tory, rhe eornpany. . . . ,
be put on
,272. re recent examp les:
to turn to rno m ero us com plaints from
, eeiving nu II
e are re , erved by So uthern Be .
f rhe terntory s h
o . tallation intervals, or t e
eas .. ms lbie ar '. t IIservice fall we l e o w a
'red to ms a , "
requI d d Operator answe rmg tlm e
ble stan arB·ll's requirem ents but do es
dy rneets e b h'
n dards reeently ado pted y t IS
eet the stan "
ID B r: the biggest eomp lamt ... IS
. ion. y,ar .'
f
. equired to o btam servlce....
len th o hrner
g blernsthat can and mu st be
are pro d 'fi
ved We have recently ado pte um orm
d
· f, telephone service, and ha ve
~ar s or ,., ď
'bedadrninistrative rulesreqUlr ~ngpeno IC
h ·h tog ether w ith field lnSpectlOns,rts w le , ,
"w k the eornmission fully advIsed concernÍĎÍ.:p
quality and sufficiency of telepho ne
íervicebeingpro vided ....Anyrate a?Justments,
kIcludingthe one in this doe ket, w I.ll be O? a
temporary basisfor a rea~o nable peno d ~f tlm e
pendingany ne~essary Im~ro vem ents m the
qualityandsufficlencyof servlc~.... .
"Southern Bell will be reqUlred to furmsh a
aoodand sufficientsurety bond conditio ned on
tbcprompt and full refund of the difference,if
any,between the rates collected by it on a
temporary basispursuant to this order, and the
ratesultimately prescribed or appro ved .... as a
rault of anyfurther o rder that m ay be entered
m this docketreducing such temporary rates
becauseof serviee deficiencies."
&Southern Bell Telephoneand TelegraPh Company,
Florida PublicService Comm ission, Order N o .
4462,Novemb er 26, 1968, 76 Public Utility
&;orts 3rd,412-413.
""Wemakethe followin g findings:
L Tbe presentearnings o f United Te lephone
Company of Florid a are far below a reasonab~elevel
and said utility is entitled to some
rehefon a te d .• U . mpor aryan emergency basls.
.. nltedT eleph ' .one s present earnmgs o f 3.15
rr c~ntwill not Support the additional
nancmgthat is necessary to enable it to
Complete .t '
.. Tb I S Improvement progra m.
e telephone '
dered servlcepresently being rensubst...'byU
m ted Telephone has imp ro ved
bUl .antlally dUl 'ing the past several mo nths
IS not s ffi ' ,
tojustif lh u clently adequate and efficient
y e full m creases requested ....
Re United Telephone Company oj Florida, Florida
Public Service Co mmi ssion, Order No. 4451,
N ov ember 12,1968,76 PU R 3rd,471.
For other exampl es, see ibid., 441-451 and 461.
"After years of deliberation, the Federal
Communica tions Commi ssion has decided to
tackle the controv ersial question of how fast
W estern Union T elegraph Co . sho uld be
required to deliver telegrams ....
"Commu nications experts say the commi
ssio n's involv em ent could lead to the first
G o vernment-mandated standards regulating the
speed of dom estic telegram deliveries ....
"W estern U nion Tel egraph has com e under
increasing fire in recent years from critics who
compl ain that the cost of telegram s keeps going
up whil e the quality of service declines ....
"Th e FCC's decision to consider the speed-ofservice
issue cropped up as a little-noticed part
of the FCC's current investigation o f telegram
rate increases propo sed by W estern Union
T elegraph. Inannouncingthe inquiry, the FCC
said it would consider not only the rate boosts,
but also the 'speed, quality and adequacy' of the
com pany's telegram service.
"FCC offi cials say this phrase m eans the
commis sion pro bably will deal with a number of
service-related telegram issuesinits investigation,
such as how many telegraph offi ces W estern
U nion Tel egraph should maintain, and wh ether
it should be investingmor e mon ey inits telegram
service. But a key question, these sou rcesmaintain,
is wh ether the FCC should force W estern
U nio n to m eet certain speed requirem ents inits
telegram deliveries. " Wall Street Journal,
October 18,1968.
Again, in 1969 the Ne w York Stat e Public
Service Commi ssion ord ered the PennCentral
Compan y to take mor e than a do zen specific
steps to pro vide "safe, adequate, just and
reasonable service" on its H arlem and Hudson
com mu ter lines,including the purchase or lease
of at least 80 new cars and 24 new engines,
assuring that each of its 340 w eekday trains runs
o ntim e at lest 80% of the tim e each mo nth, and
pro viding enough telephone lines and emplo yees
24 / I
The Institution of Re I
clth
'. gu ated l\fOIl
an e government supervisor canmtervene on ly where ob' .
~ectlVe
canbe set or, after the event,when the monopolist's perfor stand
boi l b d 8 cl h rnanceho VZDUS y a, o we ave an aclequate assurance-corn as. .. . para bl
assurance provided by compention m other sectors of the eCon e to
performance will be positively good and continuously as gOo:~Y- that
If poor serviceis economically the equivalent of high price h ~ Possib
. dancerthať ,wY1S thJustas great a anger that monopoly power will involve the o ere
If ' ~Q~
monopoly carnesthe clangerof sluggishnesswith respect both e Oth
cl cl . cl" to effi .
an to ynamic cost-re uction,lS there not the danger of slug .h CI
.. . he ouali gls nessm lmprovmg t e quahty and extendmg the scope ofservice? as
These problems are real. Although, as we shall see later th
b h II I
.. ' ey can
e w o y so ved within the regulatory framework, they deserve n
d acti . fl . . rnore crean actrve attention rom comrmssions than they now receive.9 Bu a
another reason why public utility commissions have been will' t there
. ifi cl I Ing,andsome extent justi e ,to eave the quality of service,far more th .
h . h an pnce
t e compames t emselves-the latter will typically have astro ' ,
idi ngInterest
prOVl mg goocl, ample, and expanding service,as long as they
. . h . can reco
ltS costs m t e pncesthey charge. Inthis respect far more than i th
f
. . 'n e mat
o pnce,the mterest of the monopolist on the one hand and thc c
. '. onsumer
the other are more nearly comcldent than m conftict.IO Why so?
1.Maintaining and improving the quality anclquantity of servicet .
. I A ypl
IScost y. ny regulated monopolist who is prevented by regulatio fl
fully exploiting the ~nela~t~cityo: his demancl but assured (albeit :.,~~
regulatory lag) of hlS abIllty to mcorporate these aclditional costs' .
f . m
cost-o -ser~lceand henceof recouping them in his price,will presumab
be lesshesltant than a nonregulatecl monopolist to incurthem,ll
2. Improvement and extension of servicewill often involve an expansion
the company's invested capital-that is, its "rate base"-on wh ich itit
entitled to a return. The regulated monopolist therefore will have som e
so that passengersphoning to checkon train
schedules"receivea prompt response."The New
York Times, June6, 1969,I. Inresponse,the
company ·petitioned for a rehearing. lbid.,
July4,1969,I.
For a more general discussionof the way in
which servicestandards and orders may be
enforced and particularly of the authority of
commissions to condition rate increaseson specified
improvements or extensionsof service,see
"The Duty of a Public Utility to Render
Adequate Service:ItsScope and Enforcement,"
Columbia Law Rev. (Feb. 1962),LXII: 312,
327-331.
8 See the astonishing intention of Senator
Pastore, chairman of the U.S. Senate Subcommittee
on Communications, explicitly to
confinethe powers of the Federal Communications
Commission in preciselythis manner in
decidingwhether or not to renew broadcasting
station licenses.He would prohibit challengesto
renewals unlessthe FCC first determines that
the station has violated the "publicinterest."
Daniel Zwerdling, "FCC Impropriety," The
New Republic, June21, 1969,lO-11.See also
note 134,Chapter 2, Vol ume 2.
9 For the caseof radio and television,andfor a
novel caseinvolvingthe quality of passengerrail
service,seeChapter 2 of Volume 2.
10Indeed,the greater danger might bethal the
companies place excessive'insteadof inadequate
emphasis on providing high-quality serviee,a
the expenseof economy, for reasons that follow .
See also the discussioninChapter 5,V olume 2,
of whether the publicutilities reflecta general
tendencyfor limitations on pricecompet ition.to
be associated with an intensificationof quabty
competition.
II The unregulated monopolist also will have ~
incentiveto improve his product or diversifybil
product offerings,to .the extent that his demand
is sufficientlyresponsiveto offset the additio.na1
costsof his so doing. But if he isa profit rnax~rnizer
presumably he will have set his pneequality
combination at the pro fit-m a :.Il
point, beyond which superior servicew.t.~
brutJh!Y,more to coststhan to revenues.A pu le, t
. 'f fi' 't pnceam contrast,I prevented from xmg Is ať
the profit-maximizing level, has a "rese~vene
incompletely explo ited monopoly powerj lnt
25 / I
The Traditional Issuesinthe Pricingof PublicVtility Services
REGUlATING THE RATE lEVEl
Public utility commissions spend the major part of their time, by far,
directly or indirectly regulating price. This task has two major aspects and
the commissions have tended typically to treat them quite distinctly. The
first has to do with the level of rates, takenas a group. The second has to do
with the structure of rates-the specificcharges on different categories of
Ilrne cireumst '.
diain . aneesIt will therefore have less
centlVe t .
additio nI o. Improve service,sinceany
tio nfor a .costslllvolved canserveas thejustifica••
ralSlDg p . .
"'OnIh' . ncecorrespondmgly.
th ISpartJculad' ,e "A--JW r IstortlOn,seethe sectionon
USte ft - Effect,"inChapter 2 Vol ume 2.
lIJ ,Or exampl T '
tililies 464- e, roxel, Economics oj Public
, 465,557-560.
P
tation to err in the direction of expanding and improving his
tem .' hi b b d h . f .ices and thus mcreasmg lS rate ase eyon t e pomt o economicserv! ,
timality instead of the reverse.U
ipublic utility company.is peculiarly. e~posed to public critic.is~.if its
3. service is inadequate. This exposure ISmcreased by the possibility of
customers complaining to regulatory commissions. Po ssibly associated
with this consideration may be a tendencyfor managers ofsuch companies
to assume a quasi-professional responsibility for giving the best possible
service,evenat the expenseof profit maxirnization.Iš Although customers
may have very definite opinions about whether the prices they pay are
too high, the determination of whether in fact they are doing so is a
complicated matter, as we shall see.But they need no complex investigative
and adjudicatory processes to tell them when they are suffering
from a power failure, or a refusal of a railroad to make freight cars
available to them, or when they keep getting busy signals or wrong
numbers on the telephone.l+ Adequate levels ofservice canbeguaranteed
more satisfactorily than price by customer complaints, on the one hand,
and the "conscienceof the corporation," on the other,15
It is doubtful that these pressures are as reliable as those exerted by
competition; and an unregulated monopolist will surely be subjectto similar
influences.StilI, motivations such as these do to some extent take the place
of competition in inducingthe franchised monopolist to have a favorable
attitude toward providing good and ever-improving service to his captive
customers.
The customer may have a fair not ion of whether the service he gets is
satisfactory. He is likely to find it much more difficult to judge whether its
quality and variety are improving at a satisfactory rate, because in making
suchajudgment it would not be pertinent to compare the quality ofwhat he
is receivingwith what he has beenaccustomed to expect. But it is precisely
these questions about dynamic performance, with respect not only to the
quality of servicebut also to costs and price, that the regulatory commission
also is least competent to answer decisively.Although it is inthis respect that
there may be the greatest danger of inadequate monopoly performance-or
excessiveperformance, for the reason suggested under (2),above-this danger
is not one to which the commissions have typically been able to devote
effectiveattention.
14See the fiurry of complaints inNew York City
inJuly of 1969over the annoyingfrequencyof
busy signals in the New York Telephone
Company's Plaza 8 exchange. See,for instance,
New York Times, July 14,1969,22.
15 But see Glaeser, op cit" 115, emphasizing
the needfor regulation, to overcome consumer
ignoranceand managerial inertia.
26 / I The Institution of R egulated 1\1
ollopo l
serviceand the relation ship between them, Outside of the tranSPort ' }'
field, the former taskha s claimed much the greater share of corrllr/t~oll
att ention, ISSIOIl
"The rate level,"like"the general price level," is a statistical abstra '
ct1ol1It could be expressed only as some sort of index number, summariz' '
the numerous individual rates fo r the vario us classificati o ns o f se 1,I1g
, h h 43 '11' 'I d rV1ceprovided by eac com pany:t ere are some tn IOnrai roa rat es Onfil
with the Interstate Co mm erce Commiss ion !16Its real economic m eanin ,e
disclosed when these separate prices are translated into total cornp: IS
revenuesor into total profits expressed as a percentof owners' investrnen~Y
ActuaUy the regulatory processworks the other way around. Th e commissio s,
decidewhat to tal revenues the companies are entitled to takein, then adju~:
permitted "rate levels,"either selectivelyor across the board, to yield these
totals.
They typicaUy do this by undertakinga thorough examination and
appraisal oftotal company costsina recent,"test" year,17In this wa y,item
by item, they build up an estimate of totaI permissible "revenuerequire_
ments,"On the basisof this total, adjustedas much as possible for knownOr
readily predictable changesbetween the test year and the period for whic h
rates are to beascertained,the company is ordered or permitted to propose
the required adjustmentsinits rate schedules. Therefore, discussionsof rate
levelsare reaUy discussionsof totaI revenues.
The processof determining permissible revenuesfaUs traditionaUy into the
foUowing three parts or steps,each of them involving an enormous variety of
problems and boasting a correspondingly rich history of legal and economic
controversy.
Supervision and Control of Operating Costs and Capital Outlays
Justas competition issupposed to hold prices down to the costofprodu ction
(ignore for a moment the question ofprecisely w hat that m eans)so regulation
takescost as its standard of the "revenue requirements" of publicutility
companies, hencethe "justand reasonable" rates that the typical controUing
statute enjoinsthem to maintain. It became clear that if the commissions
w ere to be something more than rubber stamps they had to exercisetheir
own judgment about the propriety of the items presented to them as the
major components of the cost of service. To do so ,first,they had to require
the companies to keepuniform systems of accounts,according to procedures
and rules stipulated by the commissions, and subject to their audit.l8 Th en
they needed to make determinations about which costs they w ere prepared
16C, F. Phillips, op, cit" 314,
17They may do so regularly or only oncein a
long while , ina major general rate investigation,
or never. Ifonly occasionally, they may employ
more limit ed checksin the intervening years,
possibly permitting rate changeson the basisof
estimates of cost changessincethe "test year,"
For an illuminating casestudy of "Th e Ceneral
Passenger Fare Investigation," the first undertaken
by the Civil Aeronautics Board , about
15 years after passage of its enabling act (a
delay for which it was criticized), see the case
study of that title by Emmette S, Redford, in
Edwin A, Bock,ed" Govemment Regulation oj
Business,' A Casebook (Englewood Cliffs:PrenticeHall
, 1962),336-411.On the Federal Communications
Commission 's "continuous surveillance"
ov er the telephone industry,see Chapt er
2,Volum e 2,at note 37,
'18 Comm issions cannot review costs unlessthe
regulated companies keeptheir records insom e
uniform and prescribed fashion. Accounting
regulations becom e necessary also to prescribe'
thos e elem ents of outlay that are to be charged
" 1I inthe Pricingof PublicUt ility ServicesT he T'ra dit.iona ssues 1
h ted com panycost-o f-service; and,o f, i:' ' I io nint e comp u h
to authonze ror mc USIO d di tl as opera ting expenses and t us
these w hich could be charge ~recY t do llar fo r doll ar, and whi ch
" I ue reqm reme n s
included m annua reven f servi the fo rm o f annual all ow ances
' the cost o servicem
capital ized, thus entenng denreci ted por tio n o f the investm ent.
, d t on the un epreCla
for depreciatlOnan re urn , I ft the fact could have the effect
, f ertam o ut ays a er
Sincem ere dlsallowa nce o c " f turn andhenceo f threaten,
I h m pam es rates o re ,
of reducing excessivey t e co ,, 'I mm issionscame to insist also
'I' tt ctadditio nal capita ,co ,, d
ingtheir abi rty to a ra diture inadvance,supervismg an
o nthe authority to contro l comp any expen
, heir budzets lves Jpassing on t eir u ge . " to involve them se ves m
, b y for cornrrussrons
W hy sho uld it e,necessar blicutilit companies? Presumab~ y even
Passingon the opera tm g c~sts,~f pu I'Yt uld wi sh to hold his costs
d fi m izm g mo no po IS wo issionsthan unregulate pro t-maXI, , ", C uld not the comrms srons t en
, ' I nhis own initiative. o I ?
to a mimmum, entrre yo , f h mpany mana gers thems e ves,
h m a tters to the self-mterest o t e coleave suc I
b f d t severall eve s. ,
Answers can e ram e a I t of profit s by exaggeratlOn
, 'I d nger of concea m en d
First, there ISthe slm p e a 1ft 't obviou sly pays a regulate
o f co sts,Wh atever his actual le~e o co s S,fl 'ceAs long as regulation
, his estlmat ed co st o servI ,
mo no po hst to exaggerate I h they o therwis e could be, he can
, h Id' h' rofit s o wer t an " ,
is effective m o mg ISp b i:'oolin gthe commlSSlOn mto
I 'h' nopo ly powe r y II
m o re compl etely exp Olt ISm o , I t J'ustify,Suchexaggerations
, 'h t than hls actua cos s ,
Permitting hlm hlg er ra es f h ent inexcessive rates of earnmgs.
d h P ater t e ev ,
m igh t beexpecte to s o w u , t' g record s' if there are no
d ly from accoun m , ,
But profits can be co m pute on b ted and record ed, expendlb
h osts are to e compu
understandings a out ow c 'I I f the sto ckho lders' investm ent to
d' d d the caplta va ue o I
tures to be au Ite ,an " those record s and supernorma
h ' way of appralsmg , 'ft d
bemeas ured, t ere ISno 'dded expensefigures and mat e
f pro fit canbe concealed m parates o ,
capital accounts, "esents not an o bjective datum but
h i:' depreClatlOnrepr ,
Second the c arge lo r d ' 'nany given accountmg
, 'b' t the pro uctlOnI
an imput at ion, an attn utlOn o , bsol escence of capital assets,
'bT f, the usm g up or o 'd
perio d o f responsl IIty ~r I' If-tha t is,the requisite retum on mv este,
Sim ilar to the cost of caplta It,seI d d' the cost o f produ ction-there IS
I'k ' be m cu e m , h
capital that mu st I eW Ise 'er level Itisobviousl y m t e
, f' d ment abo ut ItSpro p, , I
ro om fo r dlfferenceso JU g te its gros s co st o f caplta -
1 d m pany to exaggera d '
interest o f the regu ate co, d i:'or the commi ssion to holit to
nInvestment-an II
depreciatio n plus retum o re full resently, ,
the minim um, as we s~all se~m o o /t~e compan y-al w ays assumm g that
T hird, it m ight be m the I~ter~st fi b I w the levels that the market
, "h IdngItS pro ts e o "b
regulation ISeffectlve m o I II reater costs than ISm the est
wo uld ot herw ise perm it-to i~~U~ ~c~U~h ~ngpermitt ed to incorpo rate tho se
interestof the consum er, prov l e It IS I Idbe heavy expenditures for
d ' One exam p e wo u
costs inthe regulate pnce: ' h om panies m ight receive numerou s
advertising andpublicrelatlOns,sm cetec
27 / I
d h e lhat are to bedirectly to income an t os _ fo r de'
J' d T h approp nat e chalges
caplta lze, e _ ined and review ed
prcciation cannot be detel m
'I - 'ty accounts areunless the depreClab e pl op el _
h 'bl [shion Accountll1gkept insom e co mpr e enSI e a, h
'th respect to t erules are also necessary W I
hich lays an extrem ely
valuation of property , W , , p the final co st of
important ro le m d~termm ~~ey are similarl y
service, as we sha, see, any itself or the
necessaryif the utlhty cO~Ptelligently in the
com m ission is to use cos t m
devising o f rate structures,
28 / I
The Institutionof Regulat edMonOpoly
be.n.efitstherefr.om while .pa~singthe costson to the consumingpublic. PUblic
utility compa me s advertise m the hope ofinfluencingregulatory commissio ns
to treat them generously, and electriccompanies have financedexpensi
p~o~aganda campaigns inopposition to comp eting publicpower projects~~
Simila r purposes might be served by large charitable contributions' wíh
h ith ad ,ll~ ese,a~ w it a vertisingoutlays, commissions have had to decidehow much
ífany,IS properly charge~ t~ the consumer and how much should be born~
by the stockholders. A similar need for regulatory supervision could b
d ' e
create by the possible temptation of utility companies-to which we ha
. . Ve
already all~ded , and ~hlCh w e ~IlIanalyze more fully below-to usecapital
wastefully m order to mflate their rate basesand hencetheir total permissible
profits.
Fourth, the regulated companies-even more, their promoters and
managers-have extracted some of these potential monopoly profits b
. '. . y
paymg excessrvepncesto affihated, unregulated companies for equipment
supplies, financialadvice and underwriting, engineering,and manageria l
services-charges included in the cost of service and recovered from
customers.š?
Fifth: ~incethe publicutilities are typically not subjectto intensiveprice
competrtion, they are probably not under the same pressuresas firms inmore
competitive industriesto hold their costs down. It is understandable,therefon~,.that
regulatory commissions, charged with taking the place of compet~tlOn,.should
.makesome efforts in the same direction. The necessityfor
their domg so IS accentuated,finally, by the unusually high degree o f
19See Ernest Gruening,The Public Paqs : A
Study oj Power Propaganda, rev.ed.-(New York:
Vanguard, 1964),passim. Gruening includes
(xxix-xliii)the Memorandum Opinion ofthe Federal
Power Commission, In the Matter oj Northwestern
Electric Company et al., Docket No . IT-5647,
OpinionNo. 59,1941,reporting on itsinvestigation
of the accountingdispositionof expenditures
for political purposesbyfiveelectriccompanies.
Merle Fainsod and LincolnGordon report an
estimate that the costs of the "educational"
campaign by utility companies after World
War I "to 'sell'their industryto the publicand
to convincethe Americanpeople ofthe adequacy
of existingregulatory techniquesand of the
dangersof further penetration of go vernment
into the utility business"ran $25-30millions a
year, "all charged off as prop er advertising
expenses... and computed inthe rates which
the publicwas requiredto pay."Government and
'Tke American Economy (New York: Norton, 1941),
308.Andthose were Coolidge and Hoover not
Nixon, dollars. The problem, although an~ient,
has not disappeared: "Five Manhattan State
Senators protested yesterday what they called
the Consolidated Edison Company's 'gigantic'
advertisingand promotion campaignsinconnectionwith
its requestfor high er electricity
charges."Accordingto the Company's own
estimate, its expendituresfor institutional
advertisingwould hav e come to some $2.1
millions in 1965.New York Times, August23,
1966,27.
Utilit y companiesengage in comm ercial as
well as political and "institutional" advertising,
and the former expendituresmay well be
economically legitimate (see,for example, note
16, Chapter 4). American Telephone and
Tel egraph (AT&T )andits affiliated companies
rankedfourt eenthamong the nation'sadvertisers
in 1965w ith total expendituresof $70 million .
But this was a relatively modest 0.6% of
the system'stotal revenues,of $11.3billion.
Advertising Age, August29,1966,44,61.
For a summary of the regulatory treatment of
suchexpenditures,seeA.J. G. Priest,Principles
rif Public Utility Regulation, 59-65; also "Trends
and Topics , Promotional Programs," Public
Utilities Fortnightly (June23,1966),LXXVII: 65.
20 See,for example, Louis D . Brandeis,Other
People' s Money and How the Bankers Use lt (Washington:The
McClure Publications,1913);James C.
Bonbrightand Gardner C.Means, Tke Holding
Company .' lts Public Signijicance and its Regulation
(New York: McG raw-Hill ,1932),esp.Chapter
6.The holding company insome ways has contributed
to greater efficiency;but it was also
used as a devicefor milkingthe (controlled)
operating companies,and through them the
rate-payers.The relation of the various Bell
System companiesto their parent, AT&T , and
to its wholl y-ownedsubsidiaryand equipment
29 / I The Traditional Issuesinthe Prieingof Publie Uti lity Serviees
separatio n o f owners hip and manageria l control in these com panies.ě! T his
fact,taken inconjunction wit h the lesser pressureso f price compet ition and
the possibility of recouping higher costs in higher pricesalo ng an inelastic
dema nd curve, creates a particular danger that, inthe absenceof regulator y
scrutiny, manageme nts m ay vote themselves unusually large salaries, expense
accounts and ot her perquisites, as we ll as engage inother met ho ds of explo iting
their posi tio n for their ow n perso nal pro fit or no npecuniary advantage,
as infact they have from time to tim e inthe past.22
Ma nifestly, the o perating expenses and capital o utlays of public utility
com panies are by far the most im por tant comp o nent o f their rate levels, o n
the o ne hand, and the efficiency w ith whi ch they ma ke use of so ciety's
resour ceson the oth er. Th erefo re, interm s of their quantitativ e importance,
it wo uld be reaso nable to expect regulatory co mmi ssions to give these co sts
the majo r part o ftheir attention. But infactthey hav e not do ne so; they hav e
giventheir princi pal attention instead to the limi tat ion of profit s.
Th e reasons for this perverse distributio n o f effo rt illustrate onceagain the
inherent limit ations of regulation as an institution of effective so cial control
o f industry. Effective regulation of op erating expenses and capital outlays
Percent
ofStock
Outstanding Industrial
O-I 66
1-5 29
5-10 7
10-20 6
20-30 2
30-40
40-50 I
50plus 4
To tal 115
PubUc
Utility Railroad
33 21
3 I
2 I
38 23
supplier,WesternEl ectricCom pany, has thus
beena subjectof continuingregulator y concern.
lnoneo f the landma rkU nited States Suprem e
Cour t decisio nsinthe 1920sthe Cour t refused
to perm it the PublicServiceCo mmission o f
Missouri to disallow certain paym ents by the
local Bellcomp anyto AT& T fo r rentals and
services.Southuiestern BeU Telephone Company v.
Public Sennce Commission oj Missouri, 262 U .S.276,
288 -289(1923).Th e Co urt reversed itself o n
this m atter inSmith v. Illinois BeU Telephone Co.,
282 U .S.133,152-153(1930),andthe general
rule is that these charg es m ust be justified in
terms o f the costs to AT & T of perfo rm ing the
services.Similarl y,numerous state commissions
checkon the paym entsby their various Bell
comp aniesfor W esternElectricequipm ent and
supplies,and the Smith v. lllinois BeU decision
required tha t this scrutiny take into account
Western'sprofits from thesesales.Th e Mi chigan
Commi ssionhas in the past scal ed down the
paym entswh enit foundthat the rate ofr eturnon
W esternEl ectric'scapital exceeded the rate of
returnthat it permitt ed the Mi chiganBellCo mpany
to earn.C. Em ery Trox el, "T elephone
R egulatio n in Michigan," in Willi am G .
Shepherd and Thomas G . G ies, ed., Utility
Regulation: New Directions in Tkeory and Policy
(N ew York: Random House, 1966),168-169.
Butthe ov erwh elmingmajority of commissions
have fo undW estern's charges reasonable and
have permitt ed them to enter the ope rating
com panies'cost of servicewithout adjustment.
For a fullerdiscussion,seeChapter 6,Vol um e2.
21 Di stribution of 176large corporations, accordingto
the proportion of voting stockowned
?y m anagem ents, September 30, 1939,by
IUdustrialclasses:
Source.Rob ert Aaro nGo rdo n,Business Leadership in
the Large Corporation (W ashington: Th e Broo kings
Institutio n,1945),27.
A later study of the 200larg est nonfinancial
corporations found that in 196318% of the
industrial corpor ations w ere controll ed by
own ersof mor e than 10% of their sto ck;the
corr espondingfigures for public utility and
railroad corporations w ere 2.% and 4% respectively.At
the other extrem e,manag ementcontrolledcompaniesw
ere 78% of the industrial
and98% of the publicutility group. Inthe case
of railroads the percentage w as 83,but if one
adds inthe corporations found to be controlled
bya legal devicesuch as pyramiding or the use
of voting trusts,that figure risesto 97% ,whil e
the ratio for industrials rises only to 82% .
Rob ert J.Larner, "Ownership and Control in
the 200 Largest Nonfinancial Corporations,
1929and 1963,"Amer. Econ. Rev. (September
1966),LVI : 781.
22 See Barnes,Economics oj Public Utility Regulation,
618-619andthe casescited there.Following
up a findingbyGar y S.Beckerthat monopolistic
30 I I The Institutio n of Regulated Mo n
oPO l}'
would require a detailed, day-by-day, transaction-by-transactio n, al1
decision-by-decision review of every aspect of the company 's op eratiol1d
Commissions could do so only if they w ere prepared compl etely to duplicat'
the rol e of manag em ent itself. Thi s so ciety ha s never be~nwill ing to hav~
commissions fill the role of manag ement and doubtless with good reason ..
. .II
is difficult to see how any company could functio n under two separate
coequal managements, each with an equally pervasive role inits operatio n '
s.
Therefore, when the controlling decisions are mad e, they are mad e inthe
first instancebyprivate manag em ent itself.R egulation cando little more than
review the major decisionsafter the fact,permitting here and disallowing
there. Inthese circumstancesthey have beenunableas a general practiceto
substitute their judgments for those of management; and often wh en they
have tried, the courts have denied them the authority to do so, except in
casesof obvious and gross mismanagement.23 Profits, incontrast,are merely
a markup, something added to the sum total of expenses.This do es not mean
that profit control isnoncontroversial-quite the contrary.But their regulation
do esnot involve the same type of detailed and pervasive supervision as woul d
a comparable control of the decisions that determine a company's efficiency.
enterprises discriminate against blacksmore
frequently than competitive ones, Armen A.
Alchian and Reuben A. K essel developed the
more general hypothesis that the manag em ents
of companies whose pecuniaryprofits are limit ed
by regulation (or similar pressures)will beunder
strong temptation to take out any possibilities of
monopoly profit that remain unexploited in the
form of "nonpecuniarygains,"one category of
which is "the indulgenceof one's tastes in the
kindofpeople with whom one prefers to asso ciat e.
Specifically,this may take the form of pretty
secretaries, pleasant, well-dressed congenial
people who never say anything annoying, of
lavish offices, of large expense accounts, of
shorter working hours, ('f costly administrative
procedures that reduce the wear and tear on
executives... having secretaries available on a
momenťs notice ... and of many oth ers."
"Competition, Monopoly, and the Pursuit of
Pecuniary Gain," in Universities-National
Bureau Committee for Economic Research,
Aspects oj Labor Economics (Princeton University
Press: Princeton,1962),163. Th e likelihood of
this managerial behavior may not be significantly
greater for regulated public utility companies
than in the caseof unregulated companies with
market power. See Oliver E. Williamson,
"Managerial Discretion and Business Behavior,"
Amer. Econ. Rev. (December 1963), LIlI:
1032-1057,and William G. Shepherd, "Market
Power and Racial Discrimination in Whit eCollar
Employment," Antitrust Bulletin (Spring
1969),XIV: 141-161 and, with particular
referenceto regulated companies, 155-157.
23See,for example, William K .Jones,Cases and
Materials on Regulated lndustries (Brooklyn: The
Foundation Press,1967),175-186.
"Good faith is to be presumed on the part of
the manag ers of a business.... Inthe absenceof
a showing of inefficiencyor improviden ce, a Court
will not substitute its judgment for theirs as to
the m easure of a prudent outl ay." West Ohio
Gas Co. v. Public Utilities Commission 294U.S. 63,
72 (1935). See the exhaustive summar y o f the
case law in Priest, PrinciPles oj Public Utility
Regulation, I, Chapt er 3.
On the oth er hand :
"Th e Alaska commiss ion upheld disallow ance
of $50,000of expenses to comp ensate fo r inefficiencies
in an electric company's operation .
Comparison of the company's expense with that
of automat ed companies ... showed the cost to
be one and one-half to seven tim es that of the
othe r companies designated as comparab1e ....
"[Accordingto the hearing officer:] It was
not out of place for the commission to disallow
expensesdaim ed to be excessive becauseavailable
advances in technology had been ignored
and the capacity and efficiencyof the plant had
beenerod ed through years of inadequate ma in­
tenance....
"It was not so much a matter of how the
company stacked up inrelation to the efficiency
of oth er companies, but a m easurem ent of how
it operated at present compar ed to how it would
ha ve op erated if suggested recommendations
had beenput into effect....
"The company had adequate notice and
opportunity to institute procedures recom mended
by engineers ir had hired as consultants,
which it had neglected to do ."
"Expense Reduction to Compensat e for
Inefficiencies U pheld," Public Utilities Fortnightly,
March 27, 1969,60-61.
31I 1
T he Tra ditionallssues inthe Pricing of Public U tility Services
h as fo cused prim arily on profit s, also , because these are
Th e process II • d d
.. the most visible-excessive profits the m os t obvio us .~nger an
po htlcally 1it ť inthe absenceo f effective com peution, regu.
of consumer exp Ol a IOn, 1 1 .
slgn b . d comf o rting evidencethat regu ation can
lated profits the m o st o vio us an
" ffective."24 .' .
be e . tho ugh compar ati vely um m po rtant m stancesm
A d m those num erous, . f
n .' d infact decide wh ether or no t to disallo w som e Item o
w hich comm lsswns o .' b h t lic w ould
ď the gover ning consideration turnso ut to e w a po y
expen ltU ,~~'." to stockho lders on the one hand and consumers on the
beh ~os: co~~:antlyrecurring them e inthe regulator y pr?cess.25 Iti: certain~y
o t e ested here that considerations such as these are lr:ele:ant m what is,
~o t sug:bl a o litical determination-that is,a determmatwn of who gets
m escap y, p h ( d th " ho" ma y includenot just stockholders,
h t and ho w mu c an e w . .
w a ers and customers but,for exampl e, the colleges,churches,o ~minority
m a~a~ th~t mi ght benefit from contributions or ot her such expen~ltures.th~!
gro p . be unable to justify on a purely econo mlC basis).
the corpo ratwn ma y . . h or ma not
B .' ímportant to recognize that cntena such as t esema y y
c;~~~~: lwith the type of results compe tition w ould produce, or with what
. II . 127
would be economlca y optima.
1 o us situation prevails with respect
24 The ana O;cquisition by the D epartm ent o f
to w eapons
D efense:
"a work able definitio n of efficiency requires
'd' all of the costsgenerated m a wea po ns
conSIenng .' . IC'
'fit bemg Just one speCla .o rmprogram , pro .. ,
f t H ercin lies the second reason fo r the
o cos. fi' ď a tor o f
hasis on m inim um pro ts as an m IC
:~pons acquisition efficiency. Itis usuall~ much
easierfo r gove rnment negotiato rs or audlto rs to
say that pro fits are to o high than. to dalm that
the cost of develo ping som e techmcally compl ex
item of equipm ent is excessive. ~o ver.nment
personnel recognize tha t if any Item m the
we apons bili can be att acked and perhaps
reduced, it is the pro fit item . How ever, thls
Ma chiavellian realism ignores the 90% or .mo re
of the bili inw hich a mu ch greater pote ntlal for
efficiencyimpr ove m ents typically exists.,.M erton
J.Peckand Frederic M . Scherer, The ~eapons
Acquisition Process,' An Economic Analysu, DlvlSlOn
of R esearch G raduate School of Business
Adm inistrati~n (Bos ton: Har vard U niversity,
1962),509.
25 lt frequently recurs ou tside the regulato: y
area as w ell. A strikingexample is to be :ound m
the field of antitrust policy, wh ere preClsely the
sam e issuesarise about the compatibility of "fair
comp etition" and economi c efficiency. See, for
examp le, Joe! B. Dirlam and Alfred E. Kahn,
Fair Competition, The Law and Economlcs oj
Antitrust Policy (ltha ca: Co rnell UniverSity Press,
1954),wh ich is addressed to this issue. ,
26 T his means that the pro cess,being essentlally
politi cal, is capa ble of generating viol ent
emo tions o r at least rhetori c, on the part both of
the industry, in its efforts to reduce the ~oad of
regulation, to justify its manag em ents comPensatio
n and its own performance agamst t~e
. . d of ltSthreat o f go vernment competltlOn , an
critics,who see regulation as ineffecti~e and the
consum er subjected to m erClless gougmg. For a
fine exampl e of the latt er, see Lee Metcalf ar:d
Vic R einem er, Overcharge (New York : .Da v,d
M cKa y Comp any, 1967),passim, and, sp~Clfi~ally
on cost items such as charitable .c?ntnbutlOr:s,
manag erial comp ensation, and pohtlcal adver~,s.
Ch ters 6 8 and 9.lt is no condescenslOn
Ing, ap " . I'
to point out that the book:s e~onomlc ana Y Sl~
and appraisals are neither obJe.ctlvenor thorough,
but its argum ent cannot be Ignored. .'
27 See fo r exampl e, the survey of the pohCl es of
regul~tor y commi ssions w ith respect to the
allow ance or disallowan ce of pron:otlOn~l,
public relation s, or charitable expend'tures m
C. F. Phillips, op. cit., 186-188. Or see ~he very
interesting confiicting m ajority, concurnng, .and
dissenting opinions on the subJectof contnbu.
'Pacihc Telehhone and Telegraph Co. v.
tlOns ln ~'r C l;.(. ,
Public Utilities Commission oj the State oj a tJorma
et al., 401P. 2d 353, 374-375, 379-3~2 (1965).
It is very difficult to detect any conslstent co~sideration,
let alo ne application, of. economlC
criteria, of the kindto be develop ed m Part. II.
lnstead there is a mush y mixtur e of questlOn~
suchas: Do these outlays benefit the company.
Or the communit y at large? Or the stockhol~e.rs,
m ainly? Are they prop erly part of the utlhty
b · ? What would be fair? Th ese observa-usm ess. h
tions are by no m eans intended to s~,ggest,t ~t
I,' f "strictly economl c cntenaapp IcatlOn o
would provid e any simpl e answers to these
problem s either.
32 I I
The Institution of Regulated Monopoly
Therefore, although efficientoperation and continuous improvement
therein are, quantitatively, the most important aspectsof industrial perform _
ance,the principal reliancefor securingthese results cannot,in the nature
ofthe case,beplaced on the regulatory processitself.The major contribution
that regulation canmake, and it is a modest one, canonly be the providing
of incentives-or takingcare not to remove incentives-for private manage_
ments to exert themselves continuously in this direction. Whether such
incentivescan ever be sufficient,once the spur of competition has been
drastically attenuated, is the fundamental question with which we deal in
Volume 2.
The allowance for deprecíation expensesis of quite a different character.
Operating expensesinvolve actual money outlays, which canbeautomatic _
ally recorded incompany accountsand transferred into the computed cost of
service. Depreciation, too, goes into cost of serviceand price; but it is not a
money outlay in the year it is charged. It is an imputed cost,introduced to
take accountof the fact that the economic life of capital assetsis limited; to
distribute the declineintheir value-which is a genuinecost ofproduction_
over their economic life, in order to assure its recoupment from customers.
So the portion oftotal revenuesit permits the company to earn does not, as is
the case with normal operating expenses,go out in payments to outside
parties-suppliers of raw materials, workers and so on. It belongs to the
owners; it is part of the gross return they are permitted to earn on their
investment.
The return to capital, in other words, has two parts: the return of the
money capital invested over the estimated economic life of the investment
and the return (interest and net profit) on the portion of investment that
remains outstanding. The two are arithmetically linked,sinceaccording to
the usual (but not universal)regulatory practicethe sizeof the netinvestment,
on which a return is permitted, dependsat any given time on the aggregate
amount of depreciation expenseallowed in the previous yeal's-that is,the
amount of investment that remains depends on how much of it has been
recouped by annual depreciation charges previously. And the two are linked
economically, sincethe rate at which owners are permitted to get their
capital out helps determine the true rate of return that they earn on their
original investment.To the extent-as happens insome jurisdictions-that
accrueddepreciation is not fully deducted from the rate base,the regulated
companies ineffectare beingpermitted a higher rate ofprofit; and the same
result could be achieved by allowing a higher nominal rate on original
investment cost lessfull depreciation.
Any economic discussionof depreciation should realIy consider it along
with the return on investment. Inmany contexts it must take into account
also the changingprovisions of the corporation income tax law concerning
allowable rates of depreciation for tax purposes. Consider, for instance,the
three-fold effecton tne cost of service,henceon allowable rates of return,of
provisions for accelerated depreciation in the income tax laws, suchas were
enactedin 1964,via (I)what it may do to the appropriate level of annual
depreciation expenseallowed by the regulatory commission, (2) the effectof
different rates of annual depreciation on the net remaining investment,on
which the net return is permitted, and (3)the amount of income taxes that
ought to beincIudedinthe cost of service.That requires some explanation.
The effectof accelerated tax depreciation is not to reduce total taxes paid
33 I I
The Traditional Issuesinthe Pricingof PublicUtility Services
over the life of any particular pieceof capital equipment, but only to change
its timing. Only the original cost of the equipment canbe charged o ff, in
to tal, over its life. When a company charges a disproportionateIy large part
of the total in the earlier years for tax purposes-which has the effect of
reducingtaxable income, hencetaxes-this means it will beable to charge off
correspondingly less,hencewill be forced to pay equivalently higher taxes,
inlater years. Assuming no changeintax rates inthe interim, the taxes saved
in the early years have to be paid backin full in the later years. But the
postponement is beneficialto the taxpayer ; ineffect,accelerated depreciation
means the Treasury Department is giving him an interest-free loan, during
the period of the postponement. It increasesthe real rate (after tax) of return
on investment,if one is permitted to keepmore of his profits for a while,
before having to hand them over to the government.
So regulatory commissions have had to decide whether the taxes to be
incorporated inpriceshould beonly those actually paid-in which eventthe
benefitsof accelerated depreciation are passed on entirely to customers inthe
years of tax saving-or "normalized" over the life ofthe investment (higher
than actual taxes in the early years, lower in the later)-in which event
the interest-freeloan is retained by the company. If the latter is chosen,
.commissions have had to decide also what treatment should begiven to the
revenuesrecouped from consumers inexcessof the taxes actually paid inthe
earlier years. These "phantom taxes" are typically segregated in a special
reserve for deferred taxes, in recognition of the fact that taxes will in later
years exceed these "normalized" recoupments from customers. But the
controversial question is whether the amount of that reserve should be
deducted from the company's net investment or rate base,on the ground
that, as with depreciation, these monies have beenretrieved from customers
and that it would bedouble recoupment to permit the company also to earn
a return on that portion ofits undepreciated investment; or whether it should
be left in the rate base, because Congress intended the tax savings to
benefitinvestors and by so doing to encourage additional investment.The
more frequent practice is to permit the company no return on the assets
represented by the tax reserve; but many commissions permit a small return
(for example, 1.5%, in contrast with 6.5% on the normal rate base),and
some allow the full return-that is,they do not reduce the rate base by the
accumulations of deferred taxes at alI.28
Advocates of includingin the cost of serviceonly the taxes actually paid,
which involves "flowing through" the benefitsof accelerated depreciation to
the custorners,argue that the benefitsare likely to be permanent-that is,
that the amount of taxes saved is not really postponed but is, in effect,
forgiven. And they are more right than wrong, provided the company's total
investmentsgrow over time at a sufficientlyrapid rate. Inthat event,the tax
postponements on its newer (and ever larger) investmentswill always exceed
the higher taxes continually coming due on the older (and smaller) investments.
Indeed,as long as to tal company assetsgrow at all, taxes will always
be lower under accelerated amortization than they would be otherwise.
Opponents of flow-through, assuming instead that the tax is merely postponed,
maintain that this method confersa windfall of rate reductions on
28 See Eugene F. Brigham, "Public UtiIity
Depreciation Practicesand Po licies,"National
Tax J. (June1966),XIX: 149.
34/ I The Institution of Regulated Mono
Pol)'
currentcustomers at the expense of future custo m ers. And,indeed, und
. ~almost any assumption about future gro w th of the compan y, rates unde
Row-through will hav e to beincreased at some tim e inthe future-alth o ughr
as long as growth is positiv e, not to the levels that would hav e to bechargect
all the way along by a company that failed to take advantage o f this tal{
privilege.
Rate-payers benefit from normalization also , as lo ng as the accumulated
tax reserve is deducted inwhol e or inpart from the rate base,sincethey no
longer have to pay a return on that part of the company's to tal aSSets
represented by tho se accumulated tax-savings. Flow-through gives them the
greatest immediate benefit.Whether inthe long runrates endup low er under
Row-through than normalization depends,for the reasons already indicated
on how rapidly the company'g total assetsgrow. 29 '
Not surprisingly, there has beencontinuous controversy and litiga tio n
over which of these methods, if either, utility commissions ought to adopt;
and, if they adopt Row-through , whether regulated companies can be
required to avail themselves of the tax privileges, although they retain none
of the benefitsand run the riskof having to askfor rate increasesin the
future.š? These are really questions ofth e appropriate return to bepermitted
on capital investment. When company spokesmen argue against Rowing_
through or deducting the deferred-tax reserves from their allowable rate
base,they are in effect arguing for a larger return on investm ent. When
consumer representatives argue on the oth er side, their contention, at least
impli citly, is that regulation must in any casepro vide a sufficient rate or
return-in which event these additional incentivesare unnecessary and
ought to bepassed on inlower rates.
Another issueassociated with the determination of depreciation expense is
wh ether the number of dollars that investors are permitted in this fashion
to recoup from customers sl?ould be the amounts originally invested,or
whether that total should be adjusted ov er tim e to reRect the changing
purchasingpower of those dollar s. H ere, again, the question is really one of
what type of return investors ought to bepermitted; ineconomic essence,it is
the same issue in anoth er form as whether the rate base, on which the
29 For a generalsurveyof the issues,seeGarfield
and Lovejoy ,Public Utility Economics, 109-114.
For a very lucidaccountand analysisof the
pattern of rates over time under the various
possiblesystemsandunderdifferentgrowth rate
assumptions, see Eugene F. Brigham, "Th e
Effectsof AlternativeTax D epreciationPolicies
on PublicUtility Rate Structures," National
Tax J. Oune1967),XX: 204-218.
30A surveyat the outset of 1970showed that
commissions in 20 states required normalization,in17Howing-through,
andin12had taken
no action at aH .Both the Federal Power Commission
and the Interstate Commerc e Commission
have ordered How-through; the Civil
Aeronautics Board, normalization; and the
Federal Communications Commission has taken
no stand,exceptto declarethat the failure of a
regulated company to take advantage of accelerateddepreciationfor
tax purposes would be
takeninto accountinfixingthe rate of return.
"States Split on Accelerated Depreciation,"
Electrical World, January20,1969,73,and ibid.,
January 12,1970,12.FPC decisionsrequiring
Row-through and computing company costsof
service as though the companies had avail ed
thems elv~sof the tax privileges even though
they had ceased to do so, have beensustained
in the courts. See Alabama- Tennessee Natural
Gas Co. v. Federal Power Commission, 359F.
2d 318(1966), cert. denied,385 U.S. 847
(1967); Natural Gas PiPeline Co. of America v.
Federal Power Commission, 385F. 2d 629 (1967);
and Midwestern Gas Transmission et al. v. Federal
Power Commission, 388F. 2d 444(1968),cert.
denied392U .S. 928 (1968).But the ability of
commissions to require Rowing-through was
severely curtailed by the 1969income tax law
revision.PublicLaw 91-172, 91stCongress,
December 30,1969,83Stat .487,625-628.
The Trad itional lssues inthe Pricingof Public Uti lity Services
35/ I .
allowab le return is to be comp uted, sho uld be sim ilarly adjusted-to w hich
we turn short l y. I I .
of depreciation expense under public uti ity regu atio nT he treatment h " h d ts
'des an early illustration of the respectsin w hic pncmg ere. ~par
prov\he norms ofmicroeconom ic theory. It is an elementary propos ltlOn?f
from del and one aspect of its central rule, as we shall see m~re fully in
~~: :~ 3 that priceideally shou ld beset at marg inal cost-that IS~at sh_or~ p
.' 1 st But that marg inal cost is a measure of changesinuariab e
run margma co . . . t f the net
I .it does not include (most ofl depreciation, or any par o
costs a o ne ~ tme nt as such. Nor do mo no po lists, who are suppo sed to
return on mv es , .. . t nt
mar inal cost to ma rginal revenue, take depreciation .I~ o acco u
:~~:~ein th;ir pricing decisio ns-again according to the trad~tl~nal. theo {y
f the firm w hich assumes continuo us, short -run profit maxlm l~at lO~. n
o 'h' ghly that the businessmanmust cover his vanableboth casest ISmeans, rou , t o n
t if he is to continue to o perate at all; and so far as gross re urn h
~~~e~tment is concerned, he takes as m uch as he canget, over handabokvet\~
. h ť l'ttle-whatever t e ma r e wriable costs=-sometim es mu c ,some imes I .
bear It is only inthe long run, ove r the life of investme nts, that pnces, thus
. cted to be high enough o n the average to cover fixed cos.ts.
set, are expe . I d fi d ts such as depreciaT
herefo re wh enregulatory com m issions mc u e xe cos. d h
. d eturn o ninvestm ent intheir cost ofse rvice comp utatlO~s, an ence
tio nan r . . t gmal cost but
in the permi ssible rates, they are in effectrequmng no ~a~ - I t d
average-cost or full-cost pricing-a practice widely fo llo:ve inu~r:gu ~ ~n
industries as we ll. Ho w serio us this departure fro m opt im um pncmg IS I
practice is a m ajo r to pic of Part II.
Determination of the "Rate Base" .
S'ncethe pro ductio n of public utility servicestypically isunusually capI~al~
inte~sive 31the element of cost represented by the return on i.nvested cat~tad
necessarily bulks larger in their final selling price than m unregu a e
A clearer impression of the u.nusuallyheavy
utilizationof capitalinthepublicut1htyllldustneslS
'd d b the fo llow ingskeletal finanClaldata
prOV 1e y bl' tT t a
takenfrom the Annual R epo rtsof a pu 1CU ll y,
steel,anda groceryretailingcompa ny.No tethew 1de
rangeinthe ratios of their cap1talto sales,w hether
the fo rme ris measu redbyto tal assets,fixedass~ts
-land plant andequipment-or, Onthe hab1hty
" ,I h t' longterm debts'de byto tal investedcap1ta-t a lS, - ,
1, , 't Or to describethesame relatlOn-and OW nerseqUly. , , h
ship by its reciprocal,note ,~hediffere?,cesIII t e
numberof times theircap1tal turnsove r eachyear
inthefor m o fsales.
Source.Op. cit., 23~. ~::~:::- __
31G arfield and Love joy o ffer as typical the
follo w ingcapital turnover ratios (gro ssrevenues
dividedby capital investm ent).
Electricutilities
N aturalgasutilities
N aturalgaspipelines
Bel!Telep honeSystem
W aterutilities
T o talmanufacturing
0.30
0.60
0.40
0.40
0.20
2.00
PacificGas The Great
United States Atlantic & Pacificand Electric
Tea Co .(A&P)Co. Steel Corp.
236 2,091 558CUl Tentassets
Land,plant,and equipment,
3,551 3,446 326net
28 854Otherassets
6,391 884T ota l assets 3,815
36 / I The Institution of Regulated Monopoly
industriesgenerally.š"And sinceit is this element inthe cost of servicethat
determines the size of the company's profit, it is not surprising that its
determination has beenbyfar the most hotly contestedaspectof'regulation.ea
consuming by far the greatest amount of time of both commissions and
courts.
The number of dollars of investment return are, of course,a product of
the aggregate investment,on which some return is to be allowed, and the
percentage rate permitted . Arithmetically, the two factors are of equal
importance; the result canbechangedby increasingor decreasingone justas
well as the other. But, largely for constitutional reasons, the traditional
emphasis and focus of most of the litigation in the American regulatory
. h b h r th " t b "expenenceas eenon t e rormer , e ra e ase.
It was not always so. Inits historie Munn v. lllinois decision,the Supreme
Court addressed itself to the contention of the appellants that it was up to
the courts to determine whether the rates prescribed-in this caseby the
legislature itself-were reasonable or unreasonable. It specificallydeclined
to do so:
"It is insisted,however, that the owner of property is entitled to a reasonLongterm
debt
Ownersequity
Paeifie Gas The Great
and Eleetrie United States Atlantie & Pacific
CQ. Steel Corp. Tea Co. (A&P)
1,830
1,625 3,344 627
3,456 3,344 627
1,005 4,609 5,459
Total investedcapital
Sales
Ratios to sales:
Total assets 3.8 1.4 0.16
Fixedassets 3.5 0.7 0.06
Investedcapital 3.4 0.7 0.11
Souree. The P.G.&E.andU.S.Steelfiguresare for 1968,the A&P for the fiscalyear 1967-
68; balancesheetitemsare for the endofthose years.From their Annual Reports.
32Capital costsas a percentageof sales,1965.
Net Ineome After
Taxes PlusInterest
Paid %a
Depreeiation Plus
Ineome Taxes %b
Transportation 5.9 9.7
Communications 13.4 18.6
Electric,gas,andsanitaryservices 15.4 19.3
Total manufacturing 5.1 6.3
Souree. Computed from U.S.Treasury Department, InternalRevenueService,Statistics oj
Income, 1965,Corporation Income Tax Returns, Washington,1969,17,20.
b These are shown additionalIy inconsideration
of the fact,already noted, that they are also
part of the gross costsof capital.The percentages
inthe two columnsshould therefore beadded to
obtain a fulIerindicationof the relative import anceof
alIcapital costsinthesevarious industries.
a This columnpresentsnetreturnon investment
(equity plus borrowed capital)as a percentage
of total businessreceipts.lnterest alone representedthe
folIowing portions of the to tal
returninthe four industrygroups: 41,21,38
and 14%, respectively.
33This generalization,along with the generalization
that commissions have devoted their major
attention to the generallevel of rates,does not
apply to transportation, where, for more than
four decades,profits (at least of railroads) have
typicalIy beenbelow levels that regulatorY
commissions would have regarded as reasonable,
and primary attention has gone insteadto r~te
structuresand the conditionsof inter-carner
competition. Seep. 170,below.
37 / I The Traditional Issuesinthe Pricingof PublicUtility Services
able compensation for its use,eventhough it beclothed with a publicinterest
and that what is reasonable is a judicialand not a legislative question. '
"... the practicehas beenotherwise. Incountrieswhere the common law
prevails, it has beencustomary from tim e immemorial for the legislature to
declare what shall be a reasonable compensation under suchcircumstances,
or, perhaps more properly speaking,to fix a maximum beyond which any
charge made would beunreasonable....
"We know that this is a power which may be abused: but that is no
argument against its existence.For protection against abusesby legislatures
the people must resort to the polls, not to the courts."34
Thirteen years later, however, the Court took the opposite position:
"The question of the reasonablenessof a rate of charge for transportation
by a railroad com pany, involving as it does the element of reasonableness
both as regards the company and as regards the public,is eminently a
question for judicial investigation, requiring due process of law for its
determination."35
Finally, inSmytk V. Ames, in 1898,the Court not only strongly reaffirmed
its responsibility under the Fourteenth Amendmenťs due process clause to
review the reasonablenessof rates set by state commissions, but it proceeded
to specifyits criteria of reasonableness:
"We hold ... that the basisof all calculations as to the reasonablenessof
rates to becharged bya corporation maintaining a highway under legislative
sanction[the casein question involved a railroad] must be the fair value of
the proper ty beingused by it for the convenienceofthe public.Andinorder
to ascertainthat value, the original cost of construction,the amount expended
inpermanent improvements, the amount and market value of its bonds and
stock,the present as compared witk the original cost of construction, the probable
earningcapacity ofthe proper ty underparticular rates prescribedbystatute,
and the sum required to meet operating expenses,are aU matters for consideration,
and are to begivensuchweight as may bejustand right ineach
case.We do not say that there may not be other matters to be regarded in
estimating the value ofthe property. What the company is entitled to askis a
fair return upon the value of that which it employs for the public con­
venience."36
The "specification"was hardly precise;several of the listed "matters for
consideration" were distressinglyvague, and the Court was also vague about
how it wanted all of them, along with the "other matters," combined into
a composite "fair value" figure. Nor were regulatory commissions thereafter
much clearer about how they were foUowing those instructions,as BenW ~
Lewis has causticaUyobserved:
"A word should be said at this point with referenceto the hybrid 'fair
value' ('trance')method .... The 'fair value' method consistsof an examination
bythe commission of evidencerelating to reproduction cost and prudcnt
investment, together with evidence of intangible values and observed
condition of the property, the application of judgment whose processesdefy
::c94hU .S.113,133-134(1877).
lea ssuv M' go, I waukee & St. Paul Railway Company
c~ znnesota, 134U.S. 418,458 (1890). For a
mpendlum of the leadingcasesconcerningthe
judicialreview of utility regulation, seeBarnes,
Cases on Public Utility Regulation, Chapter 3.
36Stresssupplied.169U.S.466,546-547(1898).
38 / I The Institution of Regulated Monopoly
analysis or description, and the selectionof a final value figure which bears
no derivative relation to any figures inevidenceand no ascertainable relatio n
to any functional purpose of rate making. The determination is typically
accompanied by explicit denials that a formula was employed or that ~he
result isa compromise, together with a statement that the commission isquite
incapable of retracing and setting forth the processes by which the value
figure was reached."37
ltwas not only its lackof precision that made Smyth v. Ames the bane of
publicutility regulation for the next 50 years, embroiling commissions and
courts inendlesscontroversies about the definition and measurement of fair
value. lt was also its specificinsistencethat stockholders were entitled to a
return not on the dollars they had actually invested-a quantity easily
recorded in the com pany accounts, hence readily ascertainable-or
"prudently invested,"but on the currentvalue of their investment.The first
thing wrong with sucha standard is its possible circularity.As the Supreme
Court pointed out 46 years later, inoverturning Smyth v. Ames, "fair value"
cannot serve as the basis for rate regulation if it is takento mean market
value, sincethe market value of any enterprise or of its common stock
dependson its earningsor anticipated earnings,which inturn depend on the
rates that are allowed it: "'fair value' is the end product of the process of
rate-making not the starting point ...." 38This objectionis sound, however,
only if "fair value" is to be measured in terms of the market value of the
enterprise. It is incorrect if applied to the customary interpretation that
measured fair value (at least inpart) with referenceto the cost ofreproducing
the company's assets,as Smyth v. Ames likewise instructedcommissions to do.
Whatever the problems of applying the reproduction cost standard, and they
were great, circularity was not one of them. The currentcost of duplicating
the existing facilities or others capable of giving the same servicedoes not
move up or down so as to validate whatever levels of rates and earningsare
perrnitted.š?
37 ln Leverett S. Lyon and Victor Abrarrison,
Government and Economic Lije: Deoelopment and
Current Issues oj American Public Policy (Washington:
The Brookings Institution, 1940),2:692.
38 "The heart of the matter is that rates cannot
be made to depend upon 'fair value' when the
value ofthe going enterprise dependson earnings
under whatever rates may be anticipated."
Federal Power Commission v. Hope Natural Gas Co.,
320U.S. 591,601(1944).
The "market value of its bonds and stock"
was one of the considerations that the Supreme
Court said had to go into the determination of
"fair value" inSmyth v. Ames.
39There is some causa1 connection between
rates and reproduction costs. Higher or lower
rates will mean a greater or lesser volume of
sales,hencea need for greater or lesser production
capacity. To the extent that capacity is
supplied under conditions of increasing or
decreasingcost, its reproduction cost will vary
dependingon whether a greater or lesservol ume
is demanded, hence on the level of rates. In
principle,this relationship does not precÍude a
singledeterminate solution, with a level of rates
set in order to permit the desired return on the
currentcost of producing the capacity required
to satisfy the demand elicited by that rate level
(and structure). In contrast, there are any
number of possible rate levels compatible with
earning that return on the market value of investment,
since-if demand issufficientlyinelastic
-higher rates will mean a correspondingly
higher market value, low rates a lower market
value. Indeed,in perfectly functioningcapital
markets the market value of the company will
move up and down, whatever the level of rates
set,sufficientlyto keepthe rate of return earned
on that market value at a constant leve!.(If
investors are satisfied with a 10% return on
investment, the market value of any com pany
or of its securitieswill be ten times its permitted
earnings,no matter what the rates it is permitted
to charge; so its earningswill always be equal to
10% on its "fair value," thus defined,no matter
what their absolute leve!.)
39/ I The Traditional Issuesinthe Pricingof PublicUtility Services
As we shall see,a strong economic casecanbemade for basingrate levels
on "the present as compared with the original cost of construction,"as
Smyth v. Ames suggested.But as it developed inpractice it had a fatal flaw: it
invited endlesscontroversy over the proper valuation ofsunkcapital, indirect
contradiction of the economic principle that sunkinvestment costs are
prominent among the "bygones"that ought to beignored in pricemaking.s?
"ltis not too much to say that interms of cost,delay, uncertainty,and the
arousing of animosity and contention,the performance of the reproduction
cost method falls little short of a publicscandal; byfar the greater part of the
grotesque and costly ponderosity which characterizes modern rate regulation
is to be attributed directly and solely to the reproduction cost approach.
There is no occasion here to recite details of the maneuvering ina typical
rate proceeding. The months and years spent by contending parties,
commissions, and courts over suchhypothetical factors as pricing,conditions
of construction,labor performance, overheads, intangibles; the huge sums
paid to engineersand accountantsand other professional experts, directed in
their claims and counter-claimsby high-priced attorneys skilledinthe art of
rate casestrategy; the highly charged, politico-legal-mystic character of the
whole performance-this is all acceptedpracticeunder the reproduction cost
method, yet it seems far removed from the essential businessof setting the
price of a singleservicein a singlecommunity under conditions of simple
monopoly."41
It is ironie that when the Supreme Court insisted on the relevance of
currentor reproduction cost, in Smyth v. Ames, it did so in the interest of
effective regulation, and specificallyin order to preserve "the right of the
public to be exempt from unreasonable exactions."42For obvious reasons,
the respectiveenthusiasms for original and reproduction cost on the part of
regulatory commissions and regulated companies has varied dep~ndingon
the trend ofprices and constructioncosts.Smyth v. Ames came at a Hrne when
the general price level had fallen to its secular low point as a result of the
deflations following the Civil War and the extended Depressions ofthe l870s
and the 1890s.ltwas the state ofNebraska that argued for the use ofpresent
value, as measured by (the lower) reproduction cost,and the railroads that
argued for book or historical cost. Insupporting the position of the former,
the Court had in mind not only the long-term declineof constructioncosts,
henceof fair value relative to original investment, but also the common
complaint that railroad capital structures,on the liability side,and prope~ty
valuations, on the asset side, were vastly inflated because of excessive
payments to contractors and promoters and inadequate accounting for
depreciation.v'
40 This does not mean that the returns permitted
on past investments are irrelevant to the
optimal pricing of public utility services.It
means that endlesscontroversies over the proper
valuation and continual revaluation of capital
'nvestments made in the past are a deplorably
inefficient and indirectway of approaching the
task of devising economically efficient rates.
(See the discussionon pp. 109-117,Chapter 4).
41Lyon and Abramson, op. cit., 2: 691.For a
more recentappraisal, seeLewis' "Emphasis and
Mis emphasis inRegulatory Policy," inShepherd
and Gies, op. cit., 229-236.A place of high honor
in these evaluations must be accorded also to
JusticeLouis D. Brandeis,who made many oft~e
same observations as long ago as 1923;see his
famous dissentingopinion inthe Southioestern BeU
Telephone case,262 U.S. 276, 289-312(1923).
42 169 U .S. 466,544(1898).
43See ibid., 544-545,and Justice Brandeis, in
Southwestern BeU Telephone, op. cit., 298.
40 I I The Institution of Regulated MonOpoly
During and after World Wars I and II,the positions of the contendi
agencies were reversed: inflation and the introduction of more effecttg
~on~rols o ver book (historical) prop erty valuation s and company capit~~
izations converted regulated companies into enthusiasts for reproductio
cost,and most commi ssions and advocates of effective regulation the otl, n
. f er
way -mto proponents o a rate or earningsbase measured by" ·:,rude
investment"-the number of dollars originally, prudently investedin t~
prop er ty used and usable inpublicservice,lessaccumulated depreciatio n 44
It was not until 1944,in the Hope Natural Gas case,45that the Supre~e
Court at last decided, in the immortal words of Lord Mountararat, to
"withhold its legislative hand,"when it explicitly declinedto tie the Federal
Power Commission to any particular prescribedformula for the fixingof
reasonable publicutility rates. Rejectingfair value on grounds of circularity,
the Court asserted that it would no longer insiston commissions taking
reproduction cost into accountinfixingpermissible rates, either.
"Under the statutory standard of 'just and reasonable' it is the resuh
reached not the method employed which is controlling."46
What "endresults"w ere relevant? The testswould henceforth beeconomic
and pragmatic:
"Rates which enable the company to operate successfully,to maintain its
financialintegrity,to attract capital, and to comp ensate its investors for the
risksassumed certainlycannotbe condemned as invalid, eventhough they
might produ ce only a m eager returnon the so-called 'fair value' rate base."47
As long as regulation treats investors sufficientlywell, by the acid test o f the
competitive capital-market place, to enablethe regulated companies to raise
whatev er fundsthey needto provide acceptableservice,the Court seemed to
say,it would pose no additional testsor obstacles.sf
The Court has beentrue to its promis e. Outside ofth e novel area ofnatural
gas production, it has entertained no public-utilityrate-level case of the
traditional kindsince Hope.49 State regulatory commissions have responded,
44 See,among oth ers,John Bauer and Nathaniel
Gold , Public Utility Valuation for Purposes of Rate
Control (New York: The Macmillan Co., 1934),
Chapter 3; Barnes, The Economics of Public
Utility Regulation, Chapters 11-17,an especially
thorough analysis; Troxel, Economics of Public
Utilities, Chapter 13;Eli Winston Clemens,
Economicsand Public Utilities (New York: Appleton
Century-Crofts, 1950),157-158;Wilcox, Public
Policies Toward Business, 311-314; James C.
Bonbright, Principles qf Public Utility Rates (N ew
York: Columbia University Press, 1961),Chapters
11-12;C. F. Phillips, op. cit., 231-240.
45 Federal Power Commission v. Hope Natural Gas
Co., 320U.S. 591(1944).
46 lbid., 602.
47 lbid., 605.
48 Even in applying that prirnary test, it indicated
it would give heavy weight to the "expert
judgment" of the regulatory commission:
"Moreover, the Commission's order .... is the
product of expert judgment which carries a
presumption ofvalidity." lbid., 602.
49 Information by courtesy ofEdward M . Barrett.
ln the natural gas cases, the Federal Power
Commission was attempting to evolve some
system for fixing the field prices of a commodity
produced at widely varying costs by a large
number of producers. The Supreme Court had
to decidea number of issues,the most important
of which was wheth er the Commission had to
make the traditional type of cost of service
determinations, company by company, or might
instead shift, as it wished to do, to setting areawide
rates applicable to all companies regardless
of their individual costs. Ingeneral, following
the philosophy of Hope, the Court sustained the
Commission 's exercise of its own "expertise."
See Wisconsin v. Federal Power Commission, 373
U .S. 294 (1962) and Permian Basin Area Rate
Cases, 390U.S. 747(1968).For a similar decision
in a case involving the ICC's use of multicompany
costsindetermining the proper division
41I I T he T raditio nal Issues inthe Pricing of Public U tility Services
invarying degree, by shifting their attentio n fro m a preo ccupat io n w ith the
rate baseto the m ore manageable questio n of the appro priate rate of return.š?
Ina sense,the changeis com pletely insubstantial: the substantive question of
how mu ch return o ninvestme nt should beincorpora ted inthe total cost of
serviceis the sam e w hether it focuseson one or the oth er o f the tw o factors
by w hich it is determined. And,as fo r admi nistrative practicability, sinceit
is the aggregat e of dollar profits that concerns the parties to regulato ry
proceedings,it wou ld seem there w ould be just as m uch o pport unity for
controv ersy ov er the percentage rate as there w as in the past ov er the
principal sum to whi ch that rate wa s to be appli ed. Th e battle has not
abated but m erely shifted ground. As regulatory att ention ha s turned from
the rate base to the rate of return,and the latt er ha s become lessand lessan
essentially conventional 6 % or so, the litigants hav e become increasingly
skilled and assiduou s in developing prolong ed, compl ex, and inconclusive
testimon y about its proper m easurem ent.š!
N evertheless the transforma tion of the rat e base bymo st state commi ssions
from a hypoth etical or imaginary to an actual book figure,52 representing
actual mon ey outlay s, introduced a strong elem ent of stability and predictability
into the regulatory process. Whil e the question of what constitutes a
"fair" rate ofr eturn, as anethical or poli tical matt er, would seem to bejust as
pot entially productive of controversy as the question of what constitutes
"fair value," the economi c question, thou gh ina sense unchangedand no
easier to solv e than befor e,is at least subject to the pragmatic test suggested
by the Suprem e Cou rt itself-are the regulated compani es succeeding in
attracting the capital they require ?53
of revenues for mul ti-line freight service,see
Chicago & North Western Railway Co. et al. v.
Atchison, Topeka & Santa Fe Railway Co. et al.,
387U .S.326 (1966).
50 This do es not m ean that they ha ve been
perm itted to ignore the rat e base. On the
contrary, as long as the courts continue to review
commi ssion rate ord ers at all, it is diffi.cult to see
how they can avoid insisting on som e evaluation
of the prop erty on whi ch a reasonable return
mu st be permitt ed. Thi s ha s been the continuing
practice of such courts as hav e spoken since
Hope. See Francis X .W elch, "Th e Rat e Base is
H ere to Stay!" Public Utilities Fortnightly
(October 22, 1953),LIl: 635-641.
51 See,for example , the possibly jaundiced view
of BenLewis:
"aswe begin insheer disgust to mo ve aw ay from
the debacIe o f valuation , w e w ill pro bably
substitute a new 'form of Rom an holid ay-Iongdrawn
-out , co stly, confusing, expert-contrived
presentat ions, in which the simpl e directions of
the Hope and Bluefield cases are turned into
veritable wit ches' brew s of statistical elaboration
and manipulation .... W e do not need to do this
sort o f thing to regulat ion; we do no t need to do
it to our selves.T he behavio r of investor s w ill tell
us, day by day, all w e need to kno w abo ut
'compar ability.'" InShepherd and G ies,op. cit.,
242-243. Co pyright, 1966,by Random Ho use,
Inc.
52 On the ima ginary chara cter of the reprod uctio
n cost calculation, see Wilcox , op. cit., 317.
53Contro versy o ver the rate base has by no
m eans disappeared. W ith price levels increasing
secularly since the Hope decision,it has paid
regulated comp anies to argue for som e incorpora tio
nof reprodu ction co st intheir rate bases.T he
stat e co m mi ssions have to som e extent acceded:
as of 1967, 31of them (incIudingthe D istrict
of Columbi a) used original cost (or "prudent
investm ent") in regulating electric and gas
utilities, 12 used fair value-a compro m ise
betw een original and reproduction cost-one
call ed its m ethod "average net investment," and
one used reprodu ction co st specifically. Of the
remaining six states, four had no state commissions
to regulate gas and electric utilities (see
note 36,chapt er I)and two commissions had no
established pro cedures. U.S. Senate, Committ ee
o n G ov ernment Operations, Subcommitt ee on
Inter-go vernmental R elations, State Utility Commissions,
op. cit., 37-40.See also Federal Pow er
Co mmi ssion, Federal and State Commission Jurisdiction
and Regulation : Electric, Gas, and Telephone
Utilities, op. cit., 11-12, whi ch gives a slightl y
different tabulat ion; and Joseph R. R ose on
"Confusion in Valu ation for Public U tility
R ate M aking," Minnesota Law Review (1962),
42 I I The Institution of Regulat ed Monopoly
Selection of the Permitted Rate of Return
ln essence, every part of the regulator y price making exerciseinvolves
determining the prop er level of earnings to be permitt ed the regulated
compani es. This is obviously true of the explicit determination o f return,
whether concentrating, as it traditionall y ha s, on the valuation of the
prop er ty on which a m or e or lessconventional rate o freturn is to be allow ed,
or, as has become the practice inthe majority of jurisdictions, on the rate of
return to be perm itted o nthe do llars actually invested inthe enterprise. Itis
also the consequence o f a commi ssion's deóding wh ether or not to include
items suchas publicrelations expenditures in the co st of service, or how to
measur e depreciation, or how to treat income tax costs wh en accelerated
depreciation is available. The process has inevitably reftected a compl ex
mixture ofpolitical and economic considerations. Gov ernmental price-fixing
is an act of political economy. And,it bears repeating, this means that it
necessarilyand quite properly involves the strikingof a balance betw een
conftictingeconomic interests, inftuencedby political considerations inboth
the crassestand the broad est possible senses,and informed by community
standards of fairness. Therefore , from tim e to time, the courts and commissions
have characterized the entire task of setting "justand reasonable
rates," and particularly that portion representing return to shareho lders, in
terms of reaching an acceptable compromise between the interests of
investors on the one hand and consumers on the other. 54Th e conceptionis
that there is no single, scientifically correct rate of return, but a "zone of
reasonableness," within whi ch judgment must be exercised.
What are the limits of th is zone? Th e bottom limit is an economic one, set
by the necessity of continuing to attract capital; but, as we shall see,even
that limit is an elastic one, dependingon how much capital is required and
how well one wish es to treat the company's existingstockholders.55Th e upper
XL VII: I,whose analysis demonstrat es that the
for egoing simple designations conceal considerable
differencesin application. In a few instances,
for exampl e, "original cost" states ha ve
applied the permissible rate of return to an
undepreciated rate base. For a thorough survey of
actual valuation practices and rates of return
allowed , see Return Allowed in Public Utility Rate
Cases, 1915-54and 1955-61,2 vols., Arthur
Andersen & Co. (place and date of publication
not indicated); also A.J. G. Priest, "Th e Public
Utility Rate Base," lowa Law Review (W inter
1966),LI: 283-303,yielding a count of 31
original cost, and 19fair value jurisdictions.
This continued emphasis on the rate base
might seem irrational : inflation can be taken
into account just as effectively by varying the
permissible rate of return as by continuingto
fight the old valuation controversies. To som e
extent this is what has happened. State com m
issions continuingto emplo y or iginal cost hav e
tended to compensate by allowing higher rates
of return than the states that hav e either continued
to use or hav e turned to fair value. But
the comp ensation has beenonly partia!. Ther e
continuesto be a strong element of convention
and tradition in the allowable rates of return;
confinedto som ething likea 5.5 to 8% interval,
their variation has not beena complet e substitute
for alt erations inthe rate base as wel!. See C.F.
Phillips, Jr., op. cit., 268-271, Garfield and
Lov ejoy, op. cit., 133-134,and the sources cited
by both .
54 See,for example , the words ofJustice Douglas,
speakingfor the Supreme Court major ity in the
Hope case, 320U .S. 591,603(1944).
55 A firm can continue to attract outsid e capital,
within limits, even though its overall rate of
return is held w ell below the rate that new
investors will require if they are to make funds
available to it. If it does so , it will be at the
expense of its present stockholders. See note 64,
p. 46. Its manag ers will therefor e be reluctant
to do so in thos e circumstances, to the extent
that they are interested in the welfar e of thei.r
stockholders. Th e bot tom limit canbe low er if
it is defined as how mu ch the firm must be
permitt ed to earn on its total investm ent in
ord er for it to be able to pay new investors
enough to hav e them wiIlingly supply the firm
with additional fundsthan if it is defined as the
rate that will make a company willing, without
Th e T raditional Issues inthe Pricing of Public Utility Services
limit ha s been either w hat it w as estimate d capital w as obtaining in investm
ents of simila r riskelsew here or , even higher, at what ever it wa s deem ed
the trafficw ould bear. AsJustice H o lm es o ncecomm ented, rate regulation
"... ha s to steer betw een Scylla and Cha rybdis. On the one side, if the
franchise is taken to m ean that the m os t profitabl e return that could be go t,
free from comp etition, is prote cted by the Fourt eenth Am endment, then the
pow er to regulate is nul!.On the o ther hand, if the power to regulate
withdra w s the pro tectio n of the Am endment alto gether, then the prop erty
IS nought. .Thzs IS not a matter oj economic theory, but ojfair interpretation oj a
bargazn. Ne lther extrem e can ha ve been m eant. A midway betwe en them
mu st be hit."56
43 I I
Such a view of regulation, as a sort of collective bargaining process, with
the commi ssion m ediating betwe en investor s and consum ers, may be justified
on two quite distinctbases.Th e first is that there really is sucha thing as the
correct rate of return, but that it is impo ssible to measure it precisely. Th e
econom ist,. taking as his mod el the equating o f price and rnarginal cost,
wou ld ordmari ly begin57 by identifyingas the "correct" return the one that
cov ers the costs of (increm ental) capita!.58 But as w e shall see there is no
obje:tive, unequivo cal m ethod of ascertaining the cost of capital, even for a
partl .cular regulated com pany at a particular tim e and place; the process
requires the exercise of a good deal ofjudgm ent, andjudgments will inevitably
differ as to the result.
coercio n by the regulator y authoritie s, to seek
outsid e capita!. And it canbe lo we r, stilI, if the
comp any do es not need outside capita!. Th e
point in either case is that, by virtue of their
pow er to contro l the distribution of dividends
and both to prohib it the discontinuance and to
require extensions of servi ce,commi ssions can
comp el public utility compani es to reinvest
internally generated funds or to seek ou tside
fundsdespite the fact that allow ed returns are
lessthan sufficient to induce such investm ent on
a voluntary basis. If the supply of capital thus
obtained sufficed to pro vide the desired quantity
and.quality of service, it would not be necessary
to glve shareholders a return as high as would be
demanded by suppliers of new capita!. Thi s is
mer ely a recognition of the fact that capital
Irretnevably sunkin an enterprise has a low er
oppo rtunity cost than increm ental capita!. See
pp. 70-73, 118.
T~is was one consideration underlying the
decIslon of the Federal Po we r Commis sion in
1965to introduce a two-pri ce system for natural
gas,with a low er price for gas discovered in the
past and already committ ed under existing
contr~cts,and a higher price for new, additiona l
sU pplJes of gas committed in new interstate
Contracts.Th e differentiation in this case took
th fOrm not of allow ing different nominal rates
~Ireturn but of using different cost computa :Ionsfor
old and new gas, with the price for the
att er beingset at the estimated full currentcost
of new, additional supplies. The justification,
proff ered by this writer and accepted by the
Commi ssion, wa s that it w as both undesirable
and unnecessary to extend tha t high er price to
the o ld gas-undesirable because to do so would
confer windfalls o n the own ers of reserves discovered
and develop ed at lower co sts in the past
(a noneconomic argum ent), and unnecessary
because the investm ents in the old gas had
already been mad e (an economi c consideration).
Area Rate Proceeding, Claude E. Aikman, et al.,
34 FPC 159, 185-192 and passim (1965),
sustained in Permian Basin Area Rate Cases, 390
U .S. 747 (1968).
56 Stress supplied. Cedar Rapids Gas Light CO. V.
Cedar RaPids, 223U .S. 655,669 (1912).
57 On the reasons wh y he w ill not necessarily
stop there, see pp. 44and 69-70.
58 Thi s w as one of the criteria listed by the
Suprem e Court in its leading decision in the
Bluifield case, backin 1923:
"Th e return sho uld be reasonably sufficient
to assure confidence inthe financialsoundness of
the utility and should beadequate, under efficient
and economical manag em ent, to maintain and
support its credit and enable it to raise the mon ey
necessary for the proper discharge of its public
duties." Bluefield Water Works & lmprov. CO. V.
Public Service Commission rif West Virginia, 262 U .S.
679,693(1923).
It was also one of the standards set forth by
the Suprem e Co urt majority in the Hope decision.
See p. 40.
44 / I The Institution of Regulated Monopoly
The other view would be that the proper return that the regulatory
processseeksand should seekto ascertainis not itself an objectivephenolll_
enon:what is a "just"or "fair and reasonable" return is a poli tical, not a
scientificquestion.This view is certainlynot incorrect,either as a description
of the rate making process or as prescription.A model of the pricesystem in
the modern, impurely competitive economy constructedin terms of the
interplay of various organized groups, each with some degree of market
power, with the results determined by the equilibrium of power relations,
on the one hand, and inftuencedby considerations of "justprice,"on the
other, is in some ways more relevant than one in which the transacting
parties are conceivedof as individuals, each a pecuniaryprofit-maximizer
whose actions are entirely dictated by the objectiveconstraints of the
impersonal market. Inany event,the economist cannot claim that sucha
vision of regulation as an essentialIypolitical proeess is "wrong;" alI he can
do is point out the costs to society of departing from purely economic
standards.
Economists could make suchan argument with better grace and greater
forcefulnessif they could themselves declare unequivocalIy what rate of
return those purely economic standards dictate. The problem is that evenif
we confineourselves to economic criteria we find that the very idea of the
"correct"rate is elusive.The cost of capital is only the beginningpoint, for
two reasons, both of which we will be explaining and exploring at a later
point. (l) If perfect competition does not prevail in the real world, nonregulated
industriesgeneralIymay earn more (or less)than that minimum
return.Ifso, it would produce misalIocation to hold the pricesofregulate d
servicesdown (or up) to that level: this is the problem of the so-calIed
"secondbest."59(2) The microeconomic model that calIsfor equating all
pricesto (marginal) cost and profits to the (marginal) cost of capital, which
we describein Chapter 3,is a static one. It tells us how to make the most
satisfactory useof our limited resourceswith giventastes and a giventechnology.
But it does not necessarilytell ushow bestto promote economic progress.
The provision of incentivesand the wherewithal for dynamic improvements
in efficiencyand innovations in servicemay require allowing returns to
exceedthat level: this was the essenceof Joseph A. Schumpeter's classic
defenseof monopoly.v? Thus, the rate of return must fulfill what we may
term an institutional function:it somehow must provide the incentivesto
private management that competition and profit -maximization are supposed
to provide inthe nonregulated private economy generally.We have already
identifiedthis as a centralproblem of regulation. 61There isas yet no sdentific
way evenof definingthe rate of return arrangements that would achieve this
more complex definition of economic optimality, not to mention measuring
them.
Inkeepingwith the purpose of this entire chapter, the ťollowing survey of
59 Seepp.69-70,Chapter 3and p. 195,Chapter
7.
60 See his Capitalism, Socialism and Democracy
(New York: Harper & Brothers,1942),Chapters
7-9.
61This lsnot to suggestthat it isonly through the
rate of returnthat the necessaryincentivesare
best provided . Given the divorce between
ownership and management,the reward smight
better be offered to, and penalties assessed
against,the managers themselves,for example,
inthe form of variable bonusesprop o rtio nedto .
some measure of performance.See the section
on "IncentivePlans,"Chapter 2,Volu m e2.
45 / I The Traditional Issuesinthe Pricingof PublicUtility Services
the major problems and issuesindetermining the proper rate of return (we
assume, for simplicity, that the investment to which it is to be applied is
valued at original cost lessdepreciation)is intendedprincipalIyto illust~ate
the foregoing observations. While summarizing the major traditional issues
in price regulation, as backgroundfor our own, alternative approach in
Part II,it should demonstrate also (I) the problems in measuring the
minimum cost to which priceswould beheld byeffectivecompetition, which
regulation issupposed to emulate; (2)the important inftuenceofnoneconomic
considerations,and especially of. conceptionsof what is "fair;" and (3)the
elusivenessof the proper economic standards, for the reasonsjustidentifiedthe
problem of "secondbest"and the institutional functionof the rate of
return.
Problems in Measuringthe Cost of CapitaI.The public utility
company competes with alI other companies inthe economy for the various
inputs of its production process-for labor, materials, and capital. To the
extentthat these are supplied inopen markets (insteadof, for example, under
negotiated bids),in principlethere ought to be readily available objective
measures of the pricesof these inputsthat have to beincorporated inthe cost
of service.This is clearly true of the capital input: sincethe regulated
company must go to the open capital market and selIits securitiesincompetition
with every other would-be issuer,there clearly is a market price (a
rate ofinterest on borrowed funds,an expectedreturn on equity)that it must
be permitted and enabled to pay for the capital it requires.Of course,the
costs that go into its price(or rate levels)are a functionnot only of the unit
pricesof its inputs (for examp le, the priceof a ton of coal, delivered to the
generatingplant, or the interestrate on its bonds)but also of the efficiency
with which they are employed (for example, the number of tons of coal or
the number of dolIars of capital investmentrequired to generate a kilowatt
hour of electricity);and we have already alIuded to the problem of assuring
maximum efficiencyunder regulation and to the important role that the
alIowable rate of return may play inproviding an incentivefor managers to
run their companies as efficientlyas possible.But the proper starting point
is clearly the competitive price-inthis case,the so-called"cost of capital."
1.But whose cost of capital ? Should it bethe cost to the individual company
under consideration? Or of a representative group of companies? If the
latter, what constitutesa representative group? The conceptof regulation
as seekingto keeppricesat the 100'I'estpossible level consistentwith the
company's supplyingthe amount and quality ofservice demanded at that
price-which is surely the competitive ideal, also-would argue for
measuring the actual cost of capital to that company alone. But suppose
one company isso well run(or promis esto become so much more so) that
investors,having particularly great confidenceinit (or inthe stability or
growth of its future earnings)are willing to .make capital available to it
at a price (for example, at currentor promised rates of return)lessthan
the average for other regulated companies? If the unusually efficient
company's resultant lower cost cfcapital is automatically translated into
lower permitted profits per dollar of investedcapital-something that
would not automatically happen underpure competition-will it not have
beendeprived of the incentiveto beefficient,or to become more so: Its
owners, and therefore conceivablyits managers, would have beendepnved
46 / I The Institution of Regulated MonOpOly
ofthe supernormal rewards (quasi-rents) that constitute innonregulated
markets a prime spur to efficiency.vš
2. Should it be the cost of capital at a particular mom ent in tim e, or an
average over some period inthe past? Ifthe fo rmer, what moment? Ir the
latt er, how long a period? Is what is sought the historical cost of capital, as
of the time when it wa s raised? Or the current cost? The reader will
recognizethe relatednessof these questionsto the question of wh ether the
rate base and depreciation should likewis e be m easured 'at or iginal or ar
currentcost.63The usual practiceis to combine the actual or historical
interestcost,as far as debt capital and preferred stockare concerned, with
the (estimated) currentcost of raising money by sale of common stock.
Does this make economic sense?Is it fair? How do these various po ssible
approach es compar e with the results that would be produced by COm_
petition? And,in sucha comparison, what "competition" is relevanr;
"ideal" pure or perfectcompetition? Or the highly imperfect mixtur es of
competition and monopoly that actualIy prevail inunregulated ma rkets?
3. The usual starting point for m easuring the cost of equity capital is the
ratio of earningsto market pricesof the common stocksof the com pany
or companies selected. Th e logic ofthis procedure-and it ispersuasiv-c.,
isthat the priceinvestors are willing to pay inthe open securitiesmarkets
for shares of stockwith known levels of earningsprovid es an objective
measure of the terms on which they are willing to make their m oney
available to the companies in question. If, for example, the common
stockselIsat 10tim es annual earnings, the earnings/price ratio is 10%
and that ma y (subjectto the very serious qualifications to be noted) be
taken as the cost of capital-the rate of return that the compani es must
be able to earn on any additional dolIars investedin them if they are
going to bewilIing and able to raise thos e dolIars inthe capital ma rkets.š+
However, the principaldifficultyis that what investors are capitalizing
inthe purchase priceof the securities they buy is not currentbut antici-
62 Of course, som e diminution of the incentive to
efficiencyis inherentinany system of regulation
that hold s rates of return to some prescribed
level, regardless of ho w o r w here that level is
set. Stili, if the more efficient and progr essive
company is permitt ed some sort of high er,
industry-average rate of return, instead of its
own, low cost of capital, it is on this account
rewarded for its own, deserved, abov e-average
attractiveness to investors, and retains an incentive
to improve its efficiencyin hope of
increasingthat reward.
63 He is rerninded, too , that w e consider the
economics of these interrelat ed choi ces in the
following chapters-in particular, Chapt er 4.
64 As w e have already suggested, a com pany can
raise capital evenif it is allow ed a rate of return
Assets
N et plant
And suppose its permitt ed rate of return (r) and
cost of equity capital (k) w ere,asabov e, 7!% and
below the cost of capital, but only at the expense
of its existing stockholders. Th e commo n sense
of this should be appar ent: if a company sells
its new stocko n terms that give the new stockhold
ers, for instance, a 10% return on their
investment-the cost of capital being10% , they
will pay only ten tim es the prosp ective earnings
for each share-and investsthe fundsinassets on
which it isperrnittedto earn only 7 1/2% , clearly
the oth er 2 1/2% must be coming out of earnirigs
previously availabl e to its existingsto ckholders.
This is what is known as dilution-dilution of
the share in equity (that is,in the claim on net
assets of the firm ) of existing sto ckholders.
Suppos e, for example, the firm had the fo llow ing
skeleton balance sheet befor e the new stbek
lssue:
LiabUities
$100 Net worth
Common stock(10shares)
Surplus
10% , respectively. Inthis event, its perrnltted
earnings would be $0.75per share, and investo rs
$50
50
47 / I
T he Tra ditional Issuesinthe Pricing of Public U tility Services
pated earnings ;65and there is no objective m easure of w hat their anticipa~
ions .w er.e or are. T hus, com puted contemp ora neo us earnings/price
ratios ",:111either underestimate or ove restima te the actual cost of capital,
d.ependmg o n the extent to w hich investors were expectingearnings to
nse or falIfro m current levels wh en they paid those prices. From the lat e
1940so n, for exam ple, security pricesinthe United States soare d relativ e
to earnings; this sharp dro p inearnings/price ratio s continued alI throu gh
the 1950s,leveling off during 1960-1965 at the 5 to 6% level, whi ch was
we ll below the average o fthe preceding half-century.66 Th ere canbe little
do u~t that these trends partly reftected the anticipation of increasing
earnmgs and future appreciation of security values; thos e anticipatio ns
we re an imp or tant consideration in the high and rising pricesinvestors
w ere wiBing to pay for each dollar of current earnings.ě? If so , the
contempor aneo us earnings/price ratios mu st hav e understated the true
cost of equity capital :investo rs thought they we re getting a better return
would pay only $7.50 for a share. (Th e ma rket
value would thus be below the book value of $IO
per share, precisely because r is less than k; see
note 69.)N ow suppo se the comp any sough t to
raise ano ther $100to invest inplant.It would be
permit ted to earn an additional $7.50 o n this
investm ent,or a to tal of $ I5. Ho w m any shares
would it have to selI and at wh at price would
they seli? Let x be the required additional
number of shares. T hen earnings per share will
endat $15/(10+x). Th ese earnings would be
eapitalized at 10%- that is,investor s would pay
JO tim es those earnings for each new share o f
sto ek,assum ing they expected per share earnings
to remain thencefor th at tha t leve!.So the price
of each share would be (10) ($15)f(1O+x) and
x shares wo uld ha ve to be sold at that price to
raisethe required $100;
(10)($15)
x= $100
lO+x
x = 20
Th erefore 20 additional shares would have to be
sold to raise the added $100, at a price of $5.
Th e price per share would thus ha ve dropp ed
[rom $7.50 to $5; the to tal permitt ed earnings
of $15 would now be distributed among 30
shar es,yielding $0.50 per share capitalized at
10°/ '
/0' Assuming they predicted accurat ely the
trend in earnings per share, the new investor s
would be ina pos ition to dem and the 10% kthey
w o uld pay o nly $5 for a share promi sing
e~rnlllgsof $0.50. But sale of the sto ckin these
clrcum stanceswould dilute the shar e inown ership
o~ t.hehold ers of the 10original shares of stock:
t elr share in book equity would decIinefrom
.e ?riginal $10per share to $6.67, the new total
~O\lity of $200 being distributed now among
f shares.Th e 33t% decline inthe market value
,.~il their sto ck.would reftect this corr esponding
uhon o f thelr equity.
A comp any can, thus, raise mor e capital when
r is below k (wi thin limits -try to work out the
abo ve exampl e if r is only 5%) but only at the
expense of its existing stockholders. This is
som ething its m anagem ent would ordinarily be
unwilling to do.
65 It is uncertain to wha t extent and in what
direction investors' appraisal of earnings is
altered by variat ions of the propo rtions respectively
distributed individends and reinvested in
the business. Th e we ight of inform ed opinion
since the early 1950sseems to be that it is total
earningsinstead of dividends alone that investors
value inpurchasing securities; that pay-out ratio s
ha ve little if any effect-that is, that investors
are essentially indifferent to what percentage o f
earnings is distributed individends. See Fred P.
Morris ey, "Current Aspects of the Cost of
Capital to U tilities," Public Utilities Fortnightly
(August 14, 1958), LXII: 217-227; M erton H.
Mill er and Franco Modigliani, "Som e Estimat es
of the Cost of Capital to the Electric U tility
Industry," Amer. Econ. Reu. (June 1966),
LVI : 368-370; Irwin Friend and Marshall
Puckett, "Di vidends and Stock Prices," ibid.
(September 1964), LIV: 656-682; cf. E. W.
Clem ens, "Som e Aspects of the Rat e-of-Return
Problem ," Land Econ. (February 1954),XXX:
32-43.
66 Di vidend/price ratios show ed a similar trend,
and betw een 1955and 1965w ere low er relative
to levels of the preceding half-century than w ere
earningsfprice ratios. Board of G o vernors of the
Federal R eserve System , Historical Chart Book,
1967,Wa shington, 37.
67 It can be demonstrat ed that, under not unreasonable
assumptions, the market price of a
share of stock (P) will be equal to current
dividends (D) divided by (the cost of capital, k,
minus the anticipated annual percentagegrowth
in dividends, g): P= D/(k- g). Or, in other
words, that the cost of capital is equal to the
48 / I The Institution of Regulated MonOpoly
than would be indicated by that ratio. 68 Any sueeessfuleffort by utility
eommissions to hold earningson the eompanies' rate basesthereafter to
the low rates suggested by tho se ratios w o uld surely have resulted in a
deftation of seeurity priees,and, by thus inereasingearnings/price ratio s
have demonstrat ed that the true eost of eapital was high er than they had
originally inferred.šf But how much higher, it is impossible to say with
any precisio n.ř"
4. ls there need for eonsisteney betwe en the basison whieh the eost of equity
eapital is determined and the rate base to whieh it is then applied? Ifthe
current dividend/priceratio plus that anticipated
percentage growth : k = DI P + g. For a fuller
explanation, see the Appendix to this chapter,
whi ch reprodu ces a very lucid account by
H erman G. Roseman.
To some extent, g results merely from the
reinvestmentof earnings.Ifa company earns9%
on book equity,distributes 2/3 and reinvests1/3
(that is,6% and 3% ofbook equity, respectively),
the book value of each share of sto ckwill grow
3% a year and dividends may therefor e be expected
to do the same on this account, ceteris
paribus. If 9% is also the cost of capital, the
market value of the stockwill be equal to book
(see footnot e 69, below) and (DIP) + g (in this
case 6% + 3% ) will, as far as this source of
growth isconcerned, bethe same as the earnings/
priceratio , EIP (9%) . The problem arises wh en
g is expected to be greater or less than what
would result merel y from the reinvestment of
earnings.See for exampl e the estimat es referred
to innote 70.
68 That certainly had been their experience
during the preceding years. An investment of
equal amounts inevery stocktraded on the New
York StockExchange in D ecember 1950would
have yielded an investor 15.0% compounded
annually,individendsand capital appreciation,
by D ecember 1960;a sim ilar investment in
December 1955would have yielded ILl % by
Net plant
And suppose the true cost of capital is 10%. If
the regulatory commission permits the company
to earn 10% on its net plant, valued at original
cost, the profits will be $1 a share, and, ceteris
paribus, investors will buy thos e shares for $10:
market value and book value will coincide. But
the market value will exceed boo kvalue if the
commission permits a return inexcessof the cost
of capital: if, for examp le, it allows 15% , this
will yield $1.50a share, for which investors will
bid $15.
But suppose, to illustrate the point inthe text,
the commission had beenallowing only the true
cost of capital, 10% or $1 a share, but investors
had bid share pricesup to $15,yieldingcurrently
the later dat e. See L. Fisher and J. H. Lorie
"Rat es of R eturn on Investmentsin Commo~
Stocks,"Jour. oj Bus. (January 1964),XXXVII :
5. During the first period E/P ratios dropped
continuously from over 15 to less than 5%,
during the secondits range was from about 8 to
5% . Board of Governors, op. cit., note 66.
Obviously what dropped E/P ratios was investor
expectations that they would continueto seethis
kindof growth inearningsand market value of
their investm ents.
69 On the other hand, the sharp appreciation in
the pricesof publicutility stocks,to one and a
half and then two tim es their book value during
this period , reftected also a growing recognition
that the companies inquestion were infact being
permitted to earn considerably more than their
cost of capital. Perhaps, indeed, the discrepancy
was growing over time: as the data in note 76
demonstrate, the return on equity among the
public utilities increased markedly relative to
manufacturing in the two decades after World
War II. See Miller and Modigliani, op. cit.,
Amer. Econ. Reu. (June1966),LVI: 386;David
A.Kosh , "R ecent Tr endsinthe Cost ofCapital ,"
Public Utilities Fortnightly (September 26, 1963),
LXXII: 19-26.Suppose, for .example, the
following skeletal balancesheet of a regulated
company:
100 Equity
Common stock(10shares) 50
Surplus 50
only 6t% , becausethey expected to get the other
3t% from future increases in earnings and
appreciation of the securities'prices.If in this
event the commission took the 6t% earnings/
price ratio to represent the cost of capital, it
would permit earningsof ony $0.67 per share,
and the market price of the securitieswould
collapse either to the book value of $10, if
investor confidencein future trends continued
unshaken,or down to $6.67, if those favorable
anticipations were now destroyed.
70Sincethe true cost of capital (k) may betaken
as equal to (DIP) + g (see note 67), sorne
company witnesses in regulatory proceedings
have attempted invarious ways to make plausiblc
49 / I T'he Traditiona l Issuesinthe Pricing o f Public U tility Services
eos t o f equity capital is determi ned o nthe basis o f the ratio o f earnings to
the market price o f the eo m pany's eommon sto ek, is there not so me
ineonsistencyin applying tha t rate of return to a rate base as valued in
the eomp any's books-that is, at o riginal or histo rie eost -w hen, as has
been true for we ll ov er a decade, the market value o f most public utility
shares has far exceeded their boo k value? H , for exam ple, earnings per
share w ere $5, the market price $100, and the boo kvalue $50, the EIP
ratio wo uld suggest a 5% cost o f capital; if that 5% were applied to the
book value of (the equity po rtio n o f) the rate base, this w o uld produ ce a
return of only $2.50-thus eliminating the justifieation fo r the $100
market price.
Th e answer is tha t there w ould be an inconsistency in this case,but
only because it involves inconsistent assumpti o ns abo ut regulato ry po licy.
estimat es of the g investors had in mi nd in '
purchasingthecompan y sto ,ck,ino rder to com e
up with an estim ate of k (since D and P are of
course known).See,for instance, the testim ony
oflrwin Friend,Ma y 26, 1966,inFederal Communications
Commission , In the Matter oj
American Telephone and Telegrapb Company, Docket
16258, and of Ros eman befo re the Pennsylvania
Public U tility Commi ssion, R e: The
Peoples Natural Gas Company, Do cket No .
18527,Exhibit N o . 16, 1968.Ros eman's basic
approa ch, for exampl e, is to determine
statistically which m easure of growth (average
annual grow th inearnings, individends,inboo k
equity, in revenue, o r in net plant, all ov er
various tim e periods up to the present) correlat es
most dos ely with the current evaluation placed
by the m arket on dividends-that is, with the
DIP ratios -of 21 gas distribution companies.
The correlation is negative: the high er the
anticipated g, the higher the price investo rs will
pay for a dollar of current dividends, so the
low er is the DIP ratio. Then, having inthis way
identified the m easure of actual past grow th wi th
the highest negative correlation with DIP, he
propos esthat for his m easure of the (anticipated)
g compon ent of k. Applying this m ethod for each
of the 20 companies (inaddition to the one for
which he was testifying),he obtained anaverage
estimat e for k of 9.8%, compar ed with an
earningslprice ratio of 7.6% . Ros em an describes
this m ethod also in "M easuring the Cos t of
Equity Capital for Public U tilities," ABA,
Annual Report, Section oj Public Utility Law, 1969,
54-67.
Two oth er writ ers ha ve suggested an alt ernative
solution that would permit the use of EIP
ratios alone as the m easure of k. Th eir reasoning
is that w henever regulated comp anies purcha se
their inputs in comp etitive markets, regulato ry
commi ssio ns correctly accept the prices thus
determined for incorpor at ion in the cost o f
service. Capital m arkets are highly comp etitive;
they, 100, therefor e, should be able to pro vide
commi ssions with a very accurate m easure of the
comp etitive, mi nimum necessarycost o f capita l.
Th e problem at present is that commi ssions have
no wa y o ftelling w hat are the terms of the equity
share contract. Th at is, wh en investo rs pay
x dollar s fo r a shar e of sto ck, they are buying not
just current earnings but som e unmeasurable
am o unt o f growth o ver and above the growth
that o ccurs because of the m ere reinvestm ent of
earnings. (As w e ha ve alr eady seen, if dividends
are expected to grow only because o f reinvestm
ent of earnings, (DIP) + g is the sam e as EjP,
and che lat ter is a co rrect m easure of k. See
note 67,above . It is the expectatio n o f greateror
lesser=growth than this tha t renders EIP an
inaccurate m easure of k.) Th e first key to a
solution to this problem is to be found in the
fact that wh en earnings are expected to grow
o ver tim e m erely because o f reinvestm ent of
earnings, the m arket and book values of a share
of com pany sto ckw ill gro w tog ether; there is no
reason fo r such growth to produ ce any discrepancy
betw een them. It is the expectation of
a capital gainresulting fro m a discrepancybetw een
m arket and boo k values, thus, tha t makes EIP
an inaccurate m easure of k, and so makes the
latter so difficult to m easure. Th e second key to
the solution is that if the allow ed rate of return
(r) is held at the co st of capital (k), m arket value
will tend to equal book value (see no te 69),and
the pos sibility of a discrepancy betw een them is
greatl y diminished.
Th erefor e, the autho rs suggest, if regulator y
commi ssions w ere to put investor s on notice that
henceforth they would allo w a return equal only
to wh atever earnings/price ratio the securities
m arkets set wh en the m arket value of the common
stockequaled its boo kvalue (at which po int
presum ably r equals k), they could greatl y
diminish, if no t eradicate, the expectation of
capital gains or lo ssesarising from divergencies
of m arket and book value and thereby cause the
current earningsjprice ratio s to give them a
mu ch mor e accurate reftection of the true cost of
50 / I The Inatitution of Regulat ed Monopol y
That is,it assumes at one and the sam e tim e that the commi ssion all ow,
returns on equity (r) inexcess of and equal to the co st o f capital (k). The
source of the discrepancy betw een market and book value has been that
commissions have beenallowing r's inexcess o f k; if instead they had Set
r equal to k, or proceeded at some point to do so, both the discrepancy
between market and book value and the inconsistency would have
disappeared, or would never have arisen."!The fact that market value
ha s remained abov e book value indicates that inmo st jurisdictions r has
beenhigh enough, relative to k, so that its application to the lower book
value, indetermining allowable earnings, has not destroy ed the willing_
nessof investors to continue to pay above book value for publicutility
company shares.72
5. To what extent does the cost of capital, which is a w eighted averag e of
the separate costsof obtaining fundsbysale ofbonds, preferred stock,and
common stock,depend on the particular mix ture of sourcesof financing
selected?There is general agreem ent that up to a point the composite
cost will be reduced by resorting to borrowing , becausethe interestcosts
of borrowed capital may be deducted from taxable income, wherea s the
return on equity capital-which is no less a genuineeconomic cost of
production-is subjectto the corporation income tax.73 But some
commentators have maintained that, apart from this tax aspect, the
capital structure has no effecton the composite cost of capital; that the
more a company resorts to borrowing, typically at lower contractual
interest rates than the rates of return it has to promi se to common
stockholders, the correspondingly high er is its true cost of equity capital,
in reflection of the greater risks to stockho lders of having a larger and
larger share of aggregate earningssubject to the prior , contractual claim
ofthe bond hold ers.ř+ The more traditional view is that up to som e po int
capital. Thereaf ter, when investors purchased
the stockthey would be buyingonly current
earningsplus suchanticipatedgrowth as would
resultfrom reinvestmentof profits, which would
raise book and market value per share simultaneously.Th
ey would no longer bepayingalso
for the expectation that the market value per
share might rise relative to the number of
stockholder dollars actually investedin the
enterprise. Regulatory commissions could presumably
obtain successiveapproximations to the
true cost of capital by reducingpermitted rates
of return (r) sufficientlyto bringmarket prices
down to book value per share,andthenadjusting
r to the earnings/priceratios that em erged on
announcementof the policy that destroy ed
anticipationsof market price diverging from
book.
lnbrief,what the commissionswould be doing
inthis way would be specifyingthe terms of the
equity share contract.If they succeeded in
doing so ,the capital m arket would thenprovid e
them with an accurate measur e of thi: true
comp etitivecost of capital.SeeRob ertJ. G elhaus
and Gary D. W ilson, "An Earnings-Price
Approach to Fair Rate of R eturn inR egulated
Industries,"StanJord Law Rev. (January 1968),
XX : 287-317.
71ln the for egoing exampl e,oncemarket value
per share was reducedto book value-tha t is,
to $50-because r was set at k, here assumed to
be 5%, there would no longer be any inconsistency,provided,
of course,the commission
had correctly estimat ed k at 5% . R eturn per
share would be $2.50,and this would be 5% of
both market and book value.
72 See note 69.
73If the costof debtcapital to a company is5%
and the cost of equity capital is 10% , andit
raises$100by borrowing, this will add $5 a year
to its costs; if it raisesit byissuingnew sto ck,it
will add not $10 but, with the corpor atio n
incometax rate at 48%, $19.23a year to w hat it
must recover'in rates-$9.23 fo r the Interna!
R evenue Service,$10for the new sto ckholders.
74 Actually the cost of debt capital woul d likewis
erise,reflectinggrowing riskto bondhold ers
asw ell,as a larger and larger share of com pany
income w as pledged to them . Th e Gr and Inquisitor
's observation inThe Gondoliers,
"Wh enevery one issom ebodee,
Th enno one'sanybody!"
clearly applies to bondhold ers: wh eneveryone
51 / I
The Trad itional Issuesinthe Pricingof Public Ut ility Services
trading on equity has the effectof reducingthe average cost of capital,
evenapart from the tax advantage. Some comm issions,inconsequence,
have based their allowances for rate of return not on the actual capital
structu.re oft he regulated company but on their conceptionof a preferable
o ne,w ith a lower inferred composite cost.řš
Should the Rate Be Adjusted for Changes in Prices? W hat allowance
if any,sho uld bemade for changes inthe purchasing power of the investor'~
do llar, measúred in terms of its changingability either to buy consume r
goods and servicesor to replace capital equipment? Inparticular, sho uld
the owners of the business beoffere d some sort of protection aga instinflatio n
w het~er by introducing so m e reflection of (presumably rising)replacem en~
c~stsm the rate base and/or in allo w ahle depreciation expenses,or in a
higher rate o f return? On gro unds of fairness? Of econom ic efficiency?
Ought or need the sam e protections be o ffered to existingshareho lders as to
future suppliers o f capital? Ifto stockho lders, w hy not also to creditors? We
consider these questions at length in Chapter 4.
The Standard of Comparable Earnings. Du ring the early 1960s,w hen
pric~/earnings ratios ran aro und 5 to 6 %, m anufacturing corpo ratio ns were
earnm g lOto 13% o n their book equity.řf Ought or need public utility
wh o suppliescapital isat the head of the linein
hisclaim on ineome,no o ne isat the head of the
line-there isno line.Seethe considerably more
co mplex argument of Mod igliani and M iller,
"The Cost o f Capita l, Corporat ion Financeand
the Theory of Investment," Amer. Econ. Rev.
(June 1958),XLV III: 261-297, and "Some
Estimates of the Cost o f Capita l," Amer. Econ.
Rev. (June1966),LVI: 338-343,364-367;the
com mentson the for m er article by Josep h R.
R ose and David D urand and the Mo diglianiMill
er reply, ibid. (September 1959),XLIX:
638-669; Ha im Ben-Sha har, "The Capital
Struetureand the Cost of Capital: A Suggested
Exposit ion,"Jour. oj Finance (Septem ber 1968),
X X III:639-653.
75 See C. F. Phillips,Jr., op. cit., 169-171,
280-283;Tro xel,inShepherd and Gies,op. cit.
166-168. '
"On o ral argum ent,R espondents' counsel
stated:
'... Ithinkthe Commiss ion'sfunction here is
to examinea debt po licythat we fo llow ... but
unlessyou findthat we have abused our discretiono
r have beenimp rudent,Idon't believe
you should disturbit....'
"We agree that this Com mi ssion is not the
m anagerof R espondents'business.It is neither
Our br .
lio iganon o r duty to dictate the business
po IClesandpracticesto be fo llo we dby m anager:~nt.O~
the ot her hand,w~ have the statutory
ponslblhty fo r the estabhshment and ma intenanceof
just and reaso nable rates.... If we
~r,eto dischargethisresponsibility... we mu stbe
ree to exam ine fully all m atters affectingthe
future levelof rates.... We are no t limited to
actinginsituations inw hich we have firstfo und
abuse;impru denceo r indiseretio no nthe part of
management inthe past....
"At the IO-percentreturn on equity so ught
by respondentsherein,each do llar of equity
financingrequires nearly five times as m uch
gross revenue as a do llar of debt financing.Th us,
the rate payer is penalized if m ore of the
financingisby equity tha nisrequired....
"We find,therefore, that a continuation by
respondentsof their past po liciesw ith respect
to capital structure wi ll not beconducive to the
raisingof future required capital ina reaso nably
economicalfashion....
"Accordingly,infixingthe rate of returnto be
allo we d, we shall take into account this
'additional' and extrao rdinary amo unt of risk
insurance respo ndents have given its [sie]
sto ckho ldersby its lo w debt ratio po licy.. . .
respondentsare ina posit ion to im pro ve equity
earnings by inereasingtheir debt ratio .... "
FCC, In the Maiter oj American Telephone and
TelegraPh Company, Do cket No. 16258,Interim
Decision andOrder, 9FCC 2d. 30 (1967),sec.
86,89,216,220,222.
76 See not e 66, Chapter 2. During thesesam e
years (1960-1964,inclusive),the returns o nbo ok
equity of the "electricpower, gas, etc."companies
surveyed by the First Natio nal City
Banko f Ne w York ranged betwee n 10.0and
11.0% ,of telepho neand telegraph com panies
betwee n9.7and 10.3% and o f transport ation
co mpanies between 2.3and 5.5%, as the
fo l!owing table show s.Al!returnsare after tax.
52 / I The Institution ofRegulated MonOpOly
companies bepermitted earningscomparable to those receivedby compa .
. Id' d . nles
m nonregu ate m ustnes,under conditions of comparable risk?77 l'h'
. . I b f i IS
question mvo ves a num er o issues,conceptual and factual.
1.ls the comparable earningsstandard merely another measure of the c
of capital, reflectingwhat public utility companies themselves or pOSt
chasersof their stockscould obtain on their dolla rs elsewh ere? Or ma u~_
b h ·h . . d . Y It
e 19 er: may not returns m m ustry generally contam some monopoly
com~one~~, for ex~mpl e? Inpoint of fact, the own ers o r purchasers of
pubhc utility and mdustnal common stocksmight well not be able
obtain that typ: .of rate of return if they were to go into the market a:~
buy those secunties.78Th e cost of capital, which iswhat a utility compan
must match if it is to attract funds,is what investors could obtain bv
buyingthe securities of other companies inthe open market-not what the
companies themselves earn on a dollar of additional investment.rs e
2. If "comparable earnings" exceed the cost of capital, then, would an
attempt to hold public utility earnings to the lower, competitiv e level
reduce the prices of their servicesexcessively, relative to the prices of
other goods and services?80
Net Returns on Net Assets
Total ElectricPower, Telephone and Total
Year Mfg Gas, etc. Telegraph Transportatioll
1947-54 15.4 9.3 7.8
1959 II.7 10.1 9.9 3.9
1960 10.6 10.0 9.9 2.91961 9.9 10.0 9.9 2.31962 10.9 10.4 9.5 3.91963 11.6 10.6 9.7 4.6
1964 12.6 11.0 10.3 5.51965 13.9 11.3 9.9 6.9
1966 14.2 11.5 10.4 7.4
1967 12.6 11.6 10.2 5.41968 13.1 11.2 9.7 4.9
No. of Companies
1968 2,250 237 19 176
Sour~e.~irst National City Bankof N ew York, Monthly Economic Letter, April issues. 1947-54
compilation from Shepherd and Gi es,op. cit., 103.
77The Supreme Court specifiedsuch a com- that they would have beenwilling to take to
parable earningsstandard in both its Bluefield make their fundsavailabl e-is highly uncertain.
and Hope decisions.262 U.S. 679,692 (1923); 79 Ifthe cost of capital islower, any attempt of a
320U.S. 591,603(1944). regulatory commission , persuaded by the com-
78 See for example, Calvin B.Hoover, "On the parable earningsargument, to permit investors
Inequality of the Rate of Profit and the Rate the higher return would only be self-defeating.
of Interese," The South. Econ. Jour. (July 1961), lnvestors would respond to the higher earnings
XXVIII : 1-12; James Tobin, "Economic per share by bidding up the prices of the
Growth as an Objective ofGovernment Policy," securities to the point at which new purchasers
Amer. Econ. Reu., Papers and Proceedings (May would earn only the old cost of capital on their
1964), LIV: 13-14.This discrepancy is sug- investments.The only beneficiarieswould be
gested by the far lower earnings to market thos e who happened to own the stockat the
priccratios of both industrial and publicutility time the policy change was announced ar
common stocksthan those companies earn on anticipated. There is no way of giving new
book equity.Howev er, as we have seen,investors purchasersof stockmore than the cost of capital,
have beenearningmore than the contemporane- except by changingthe rules after they have
ous earnings/price ratios . (See note 68.)Whether made their purchases.See the same argument in
what they have in fact earned in this way was another context, p. 116,Chapter 4.
the same as the cost of capital-that is,the rates 80 This is the "problem -of the second best,"
53/ I The Tradit io nal Issues inthe Pricing of Public U tility Services
3.Inapplying this standard, how does one select nonregulated industries
of com parable risk? How do risks in public utilities comp are w ith tho se
of o ther industries, and to the extent they do differ ho w w ould this
differencebe allowe d fo r in translating com para ble earningselsew here
into perm issible rates of return here ?81
The Problem of Rewards and Incentives. How, if at all, canrates o f
return be varied in o rder to rewa rd, and hence to prov ide an incentive fo r
efficiencyand innovation? What standards of performa nce are available
that wi ll separa te results attributable to goo d o r bad ma nagem ent fro m
those attributable to oth er factors? H ow can such rew ards be related to
perfo rmance, and how m uch inthe w ay of rew ards isrequired? Inparticular,
is there any wa y of punishing poo rly mana ged companies with a reduced
rate of return without jeopardi zing their ability to attract the very capital
they m ay need to do a better job?
It ha s been urged by defenders of the co mpara ble earnings standard and
by ot hers that public utilities be allow ed returns m arkedly abo ve the bare
cost o f capital , in ord er to provid e them w ith bo th the financial m eans and
the incentive to engage in risky innovation, bo th technolo gical and comm
ercial. Tha t regulator y commi ssions hav e in fact allow ed earnings we ll in
excesso f k is suggested not just by the beha vior of the m arket priceso f public
utility securities but also by the apparent ease with w hich such co m panies
ha ve been able, since W o rld W ar II, to raise the huge amount s o f capital
required to m eet growi ng dem ands. Itissuggested also by their aggressiveness
inseeking such capital and expanding capacity, so m ething that they w o uld
obviou sly hav e been reluctant to do if all ow able returns w ere lessthan k.82
But this doe s not necessarily prove that these companies ha ve beeno ffered
the optimum amount o f incentive for undertaking risky investrnents.e" Th e
defining characteristic of such investm ents is tha t they o ffer a w ide range o f
possible out com es; tho se that are nevertheless economi call y w o rthw hile are
so because the po ssibilities o f very large pay-o ffs balance the possibilities of
failure. Any restriction o n aggregate earnings, by threatening to cut off the
opportun ities fo r the great successes,w ill therefor e hav e som e irnmeasurable
effect o f discouraging riskyinvestm ents that ot herwise would be mad e. How
im por tant this effect may be in public utility regulation is very difficult to
determine, but it is pro bably slight. Fo r o ne thing, there are miti gating or
countervailing considerations, am o ng them the slown ess of regulation in
to w hich we have already referred. As Shepherd
ha s observed, the problem of the second best is
the co re o f economi c validit y inthe comp ara ble
earningsstandard. "R egulato ry Constraints and
PublicUt ility Investm ent," Land Econ. (August
1966),XL II: 353.See pp. 195-198, Chapter 7.
81 See,for exarnple, Shepherd, "Utility Growth
a~d Profi ts U nder R egulation," inShepherd and
G ,es,op. cit., 35-45."ifutility sto cksare compared
w ith thos e of non-utility co rporations o f
comp ara ble size, utilities whi ch are prot ected
rro m many form s of comp etition will be com;
ared wi th the winners in oth er areas with no
~uch . . . prot ection. . . . Somehow , in strict
OgIC, the shadow losses of lo ng defunct automobil
e companies would have to be subtracted
[rom the profits of G eneral Mo tor s, aft er these
in turn had been adjusted down w ard for the
hypo thetical comp etitio n-and then, fo llowing
this trip throu gh the lo o king-glass, the result
would be comp arable earnings .... "
James R . Ne lson, "R eassessm ent of Econo m ic
Standards for the R ate of R eturn U nder
R egulation," in Ha rry M . T rebing and R.
H ayden How ard, Rate oj Return under Regulation:
New Directions and Perspectiues (Institute of
Public Utiliti es, Mi chigan State U niversity:
East Lansing, 1969),16.
82 See Troxel and Lew is, inShepherd and Gi es,
op. cit., 170-175 and 237-239and note 64,abo ve
83See Thom as G. G ies, "Th e Nee d for New
Concepts in Public U tility R egulation," ibid.,
105-107.
54 / I Th e Institution of Regul ated M:
ono po 1
reducingearnings that prov e ex post to be "excessive"-this is the f ' }'
:'regulatory lag"-and the ability of regulated companie s to seeka~rnlliat
mcreases that may be required to keep their ov era11rates of Y rate
, r. I retur
sanstactory evels,and henceto comp ensate for som e of their fail n at, , I; I ures 1\1
important ISthe fact that the regulatory restriction is on total ea " ore
the t fl 'd' id I rlllngs nre urns rom m lVI ua investrnents. It would only be ifth I .' o t
h I
' I e att er VY
so overw e mmgly large as to threaten to push the total b ' ere
I I hl' , , a ove permlssibl
eve s t at regu ation rnight discou rage it.To the extent a11th a: e
lificati , , eseOusets
qua I cations are insufřicient,there is no easy solution to th' and
probl MI" e mcentiv
em . ere y perrmttmg a11regulated companies as a matter f e
t ' o cour
o earn rates m excessof the cost of capital do es not supply the answer .th Se
has to be some means of seeing to it that those supernormal ret ' ere
earn d I" urnsare
e ,some m eans,ror example, ofidentifying the companies that ha b
unu II t ' , ffi ve een
,sua y ~nerpnsmg or e cientand offe ring the higher profits to the
while denymg them to others, We return to these institutional proble ~
Chapter 2 ofVolume 2, rnsln
REGULATING RATE STRUCTURES
With res?ectto the secondmajor aspectof publicutili ty priceregulation_
~h: reg~latl,on of rate patterns or structures-the typical statutory or judicial
mjunctionISthat rates be not "unduly discriminatory " that diff 'h ' I erences In
t e rates charged various customers or classesof servicebe likewise cc' t d
bl "A h' , JUS an
reasona, e. ,t t ISpomt we need make only two general observations about
t~e way m,whlch most regulatory commissions have carried out this mandate
FI~St,o~tslde of the transportation field, they have givenfar lessatt entio n t~
this subjectthan to determining general rate levels and especia11ythe rate
base and rate of return, 84Th e height of particular rates and the differences
~etw eenthem, ha ve be:n from the very out set a very important consideration
m the regulatlOn of rallroads: the feelingof differentcustomers and localities
that they w ere beingsubjected to unfair discrimination played a vital role
84 The managementsof publicutility compani es
have beenat least equally delinquent, See the
following acidcomments bythe PublicUtilities
CO,mmissionof California on the apparent lack
of mter ~stof ~he,P,acificTelephon e Company in
the vanous mdlvldual components of its aggregate
cost of serviceand unwillingnessto
supply information about them :
"Pacificadhe:es to a conceptof settingbasic
tel~phone,rates m relation to the availability of
m~m statlOnsa~d on a,statewid epatt ern, ,,,By
~hlsschemePaClfk,as m all prior rate proposals ,
Ignoresthe costsof providing serviceand from
~hepresentrecordit isapparent that it isn'teven
I~tereste~i? knowingwhat its costsare for any
glVen eXIstmgservice,It is contentto rely on
broad and loose~y-made estimates first put
together at the hrne an initial or innovative
serviceofferingispropos ed,no matter how long
ago suchestimates may hav e beenmade, . , ,
That the executivesof Pacifichave developed
no means by which the actual costsof any of
Pacific',sexistingbasictariff off eringsma y be
detern.llnedor m easured seems incomprehensible
butthlsrecord clearly establishesthat suchisthe
fact. Equally incomprehensibleis the fact that
Pacific,does not evenknow,nor canit readily
determme , what revenuesits individual tariff
off eringsproduct',. , , [F]or example, Pacific
cannoteventell the Commission what revenues
it actually receivesfrom its charges for color ed
telephoneswithout makinga special 'study' of
the situation."
"[I]t has been repeatedly pointed out that
Pacifichas not suppliedactual revenue,cost or
plant data in support of its tariffs. Wh en
specificallyrequested to do so , , , its Counsel
argued inopposition to the request,,,,
"Th e argum entsof Pacific'scounseland the
comments of its witnessesmake it abundantly
clear that the whole subjectis distasteful to
Pa~ific,It desires,apparently,to forever rely on ..
eshmates made prior to the settingof rates on
55 / I
The T raditional Issues inthe Pricing o f Public Uti lity Services
inthe passage andenforcement o fthe Interstate Comm erceAct,from the very
beginning,85 In the oth er utilities, the ma jo r issue ha s usua11y revo lved
aro und the adequacy of to tal or net revenues;and the so lutio n ha s usua11y
beena mo re or less across-the-boar d increase or decrease o f the cntire
structure,86 Second, to the extent regulatory laws and com mi ssio ns ha ve
considered the pattern of pricesset,they have been guided by the sam e sor t
o f mixtur e of essentia11yeconomi c and po litical-so cial consideratio ns as have
influenced their determ inations of the pro per returnson investrnent.
Th e relative neglect o f individual prices m ost clearly epito mi zes the
differencebetwee n the traditional approa ch to public utility price regulation
and the one the economi st would recomrnend. Inthis area, the commi ssions
typicall y pro ceed only in response to specific co m plaints: businessm en in
locality A compl ain that the freight rates char ged them are higher than tho se
char ged their comp etitor s; railroad s point out that they are los ingparticular
classesof business to trucks o r barges and ask permi ssion to reduce the
relevant rates to m eet comp etition; the affected trucking and navigation
compani es intervene to prevent the propo sed reductions, Comm ercial
custom ers assert tha t they are paying a higher pricethan residential users for
electricity; lo cal utility commi ssions complain that high rates fo r local service
are subsidizing unduly lo w rates o nlong-distanceca11s;oil jobbers argue that
gas distribution compani es are offer ing uneconomi ca11y low promotional
rates o nhom e heating; the latt er m aintain that to o large a pro portion of the
capa city co sts of the interstate pipelines that supply them are incorpora ted in
the demand charges that they pay and too little isim pose d on the lines'direct
industrial custom ers; and representat ives o f the bituminous coal industry
jo in inthese prot estati o ns, because the lo w-priced gas so ld fo r use as boiler
fuel for electricity generati o n takes business awa y fro m thern.And a11to o
o ften, fro m the econo mi st's standpo int, the com m issions resol ve such contro versies
o nbases other than economi c efficiency,seeking to prot ect off ended
comp etitor s from excessive lo sses of business,to preserve a "fair shar e" of the
,'
new servicesas justification for continuingrate
form sand relativerate levelsw hether or no t the
servicesare in reality tod ay prop erly priced.
Oneo f itswi tnessesis'hop eful' that the ori ginal
estim ateswill so pricenew servicestha t they wi ll
not be a burden on basicservice,Whil e this
Commi ssionma y share or evenapplaud such
'ho pes,'it has the duty to seeto it that ratesare
fair and reasonable,,,," In the Matler oJ. , , the
Pacific Telephone and Telegraph Company et al.,
D ecisio nN o .74917,N o vember 6,1968, m im eo "
30-31,60-61.
85 lndescribingwhat w as to becom e the Act to
R egulate Comm erce,in1887,the Cullom Co m mi
tteesaid:"the provi sionsof the biliare based
U pon the theor y that the para moun t evil
chargeable aga instthe op eration of the transport
atio nsystem of the U nited Stat es as now
conducted is unjust discrimination between
persons,places, commoditi es, Ol' particular
descriptio ns o f traffic."U .S. Senate, Select
Co lllmi tteeon lnterstate Co mm erce,49th Co ng.,
1stSess.,Sen.R eport 46, Part I, W ashington,
1886,215.Cor respondingly,"it would be possible
to writ e an extensive histor y of railroad
regulation with o ut m entioningcost of capital Ol'
rate o f return."James R . Ne lson,"Pricingand
R esour ceAllo cation:T he PublicU tility Sector,"
inShepherd and Gi es,op. cit., 83.Since1922,
the Interstate Comm erceCommi ssion"has no t
found it necessaryto specifya fair rate o f return
for the ro ads."Phillips,op. cit., 271.
86 See,fo r exampl e,Tr o xel, in Shepherd and
G ies,op. cit., 150-151, 175-176. R egulatory
commi ssio nsand courts alike have tended to
leave the designing of rate structures to the
discretion of m anagem ents.Evenintransport atio
n, both comp any m anagem ents and the
Interstate Comm erceCommi ssionfor m uch too
lo ng neglected the mu ch-needed reconsideration
of common- carrier rate structuresinthe light of
the intensified comp etitio no f newe r transport
m edia and o f private and contract carriers.See
the section on "Tr anspor tation," Chapter I,
Vo lum e 2.
56 / I The Institution o f Regulated ~
OIl°Po
market for each,to strike som e equitable or po litically acceptable dist.b Ir
fl ut"of common costsamong the variou s classesof patrons. We will seenu l()1l
illustrations of this kindof behavior inChapters I and 2 of V o lume ~er()1ls
M icroeconomics, incontrast, is interested first and for emos t inthe d
mination of individual prices. lts normative models also include c eter.
. b h . I· b . d' ertail\notions a out t e appropnat e re ation etwe enan Inustry s average .
ha.nri anrl i I Ptlcesor total revenueson the one and and ItSaverage or to ta costs on the Oth
but tha t optimum is conceived to be the result or endproduct of a co mpe r :r;
h di lv and i h first i . . di ·d Itlveprocess t at op erat es irect y an Int e rst Instance InInlVI ua] m ark
. h fixi f idivid I . 87 etsInt e XIngo InlVI ua pnces. ,
With respectto those individual markets, the rules of microe conomics
in principlesimp le and grounded in objectivefacts:subjectto impor t:re
qualifications that we shall elaborate at a later point, pricesshou ld bequated
to marginal costs.Inthis scheme, there is no room for separat~
considerationsof"fairness." Or, to put it another way, fairnessis defined in
strictlyeconomic terms: those pricesare fair that are equal to marginal costs
those unfair that are not equal. '
"As in so many other policy areas, the lawyers and engineers (and
increasinglythe accountants)-not the economists-have largely domin ated
regulatory policy."88This do es not mean that economists hav e not wri tten
at length and incisivelyabout publicutility regulation. But until recently,
their analyses have beendirected mainly toward the traditional issues,and
organized within the frarnework formulated by administrative commiss ions
and courts and bySmyth v. Ames inparticular. Our nextchapters,followin g
87 Th ese comments may seem arbitrarily to
suggestthat short-runequilibrium is somehow
more important than long-run,and inso doing
to reftect the essentially static character of
traditional economic theory, or its tendency
simply to assumemobility of resourcessufficient
to ensure the achievem entof long-runequilibrium.Ina
dynam icworld andinthe presence
of resourceimmobil ities,comp etitionsufficiently
pure to hold pricesconstantlyat short -run
marginal cost may prov e destructive and
violeml y unstable; and much of the pricingin
impur ely comp etitiv~ o r oligopolisti cmarkets
canoftenbeunders[Qodasseekingto achievethe
long-runcompetit iveresult-which ina perfectly
comp etitive market could safely be left to instantaneousinftows
and outftows of labor and
capital-at the possibleexpenseof the constant
equation of pricewith short -runmarginal cost.
The student of industrialorganization may be
as mu ch concerned with the processthat holds
an industry'stotal profits, averaged over som e
period of tim e,at the comp etitivelevelas that
its individualpricesbe instantaneouslyequated
with short-term marg inal cost.
Th e fact remains that the w elfare ideal is
constructedon the basisof the equation of price
to marginal cost inindividualma rkets and in
the short -run.That iswher e the processstarts.
De partures from that standard must be individual!yjustified.The
m ere control of overal!
rates of returndoes not initselfensure that the
pattern of individual pricesis economically
efficient:
"Agreat many different patterns,efficientand
inefficient,within the firm may be perfectly
consistentw ith a given ov er-al!rate of return.So,
what ever the rates of returnmay actual!yhave
been,they cannotby themselvesdemon strate
wh ether resourceal!ocation (to and within the
utilities) has been efficient."Shepherd, in
Shepherd andGi es,op. cit., 20.Seealso Nel son,
ibid., 66.
Moreov er-and this is a point critically
important with respectto the publicutility
industries-even long-runequilibrium price is
not the sam ethingas a price that coverscurrent
operating expensesplussome acceptableaverage
rat e of returnon investment,which iswhat has
principal!y concerned regulat or y commissions.
Onthe contrary,it involvesthe equationof price
with long-runmarginal cost.Correspondingly,
the investmentpolicy that produceslong-run
equilibrium inthe comp etitiveideal isone that
equateswith the costof capital the rate of return
on incremental investm ent,not the average rate
of returnon historical investment,however the
latt er isvalued.We shal!explor ethesesim ilarities
anddifferencesinthe ensuingchapters.
88 Shepherd, "Conclusion,"in Shepherd and
Gi es,op. cit., 266.
T be T raditio nal Issues inthe Prieing o f Publie U tility Serviees
57 / I icliterature'" andaccepting the impl iedf the recent econo m l . .. I
the leaclofsome O atural Gas clecisio n,returnsto the econormc ~nnclp es
invitatio no f the Hope ~hem to the problem s o fpublic utility.regulat lOn.In~o
clattempts to apply h diti onal regulato ry issues set fo rth Inan . t neglecttetra II .
cloingwe W Illtry n~t ~ d anal ze them in economi c term s, w hile conthis
chapter, but W Ill Insht~a t cl Y to assessthé limi ta tio ns as we ll as the
. thro ughou t t IS s U y, . 90
tinutng,as . . f econo mi csto their resolut io n.
ible contnbutlOns opOSSI
89 Seefor examp le the works citedibid., 267and
, , d h that follow.throug ho ut this chapter an t os e h
90T here is no intentionhere to exaggeratet.he
. h compar ed Wl tnovelty of thl s approa c, as . O h
h ·k· d practlce nt ecurrent regulator y t m mg an .
d·· 1 pproa ches that w econtrary the tra ItlOnaa h
have b~en describingin this chapter ave
certainly been modifi ed m recent years.
. and commi ssionsalikeR egulated compam es. . t the
a in increasmg attentlOn o
ha,,:ebeefnp y ?all y efficientrate structures;
deSigno economl c hav e
and in this taskand in oth ers,as w e. II
' d th ha ve m ade dramatlca yalr eady observe, ey t" es of
useof the too ls and·perspecIVincreasing
.t This book isina sensea survey,the economls . t.ce
d .. of thisem ergentpracI .summary, an cntlque