Concavity assumptions in regulatory models and the capital waste controversy

Sherman (1992, 197) concludes that the wasteful use of capital [by a rate-of-return constrained monopolist] is motivated to avoid an inelastic region of demand. Previous analyses of capital waste by regulated firms often employ models with concavity restrictions on the profit and production functions. Here we demonstrate that these conventional assumptions in Averch-Johnson type models require demand to be everywhere elastic, ruling out the avoidance motive emphasized by Sherman. Although these highly restrictive assumptions are suitable for studying inefficient input mix, they are inappropriate when considering investment in unproductive capital.This note is based on the appendix to my doctoral dissertation completed at The University of Tennessee, Knoxville, and supervised by John W. Mayo. Useful comments were also made by Ross Eriksson of The University of Tennessee, David Kaserman of Auburn University, David Mandy of the University of Missouri, and an anonymous referee. All conclusions and opinions expressed herein are mine and do not necessarily reflect the views or policies of the National Regulatory Research Institute (NRRI) or any organization associated with NRRI.