Behavior of the Firm Subject to External Regulatory Constraint

by Harvey A. Averch, Leland Johnson

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An attempt to develop a theory of the monopoly firm seeking to maximize profit, but which is subject to a constraint on its rate of return. This model is then applied to the domestic telephone and telegraph industry. As the firm does not equate marginal rates of factor substitution to the ratio of factor costs, it operates inefficiently in the sense that (social) cost is not minimized at the output it selects. The firm has an incentive to expand into other regulated markets, even if it operates at a (long run) loss in these markets. Therefore, it may drive out other firms, or discourage their entry into these other markets, even though the competing firms may be lower cost producers. In applying the analysis to the telephone and telegraph industry, it is found that the model does contribute to understanding market behavior.

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