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On the Conceptual Inadequacy of the Original Cost Regulatory System

16 Pages Posted: 19 Oct 2005  

Michael C. Jensen

SSRN; Harvard Business School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

Fischer Black

Sloan School of Management, MIT (Deceased)

Clifford G. Holderness

Boston College - Department of Finance

Date Written: 1980

Abstract

The original cost regulatory system, as currently used in the regulation of utilities and natural gas pipelines, cannot emulate the response of a competitive firm to high and varying inflation. Although there can be many problems introduced by regulatory lag and by high administrative and hearing costs for all parties, these do not cause the difficulties we are concerned about here. The response of the original cost system to inflation, even when it is applied with no errors or lag, will be non-competitive, socially wasteful, and politically unsatisfactory. The system is conceptually flawed in a fundamental fashion that causes it to breakdown in times of high and varying inflation. It is possible to design a version of original cost regulation that responds appropriately to changes in expected inflation by using changes in interest rates, but such a system still won't deal properly with actual inflation when it differs from expected inflation. To emulate the response of a competitive return to actual inflation, we must use a version of original cost regulation that makes use of changes in a price index rather than changes in market interest rates.

Keywords: regulatory systems, inflation, interest rates, price index, market rate

JEL Classification: A00, H00

Suggested Citation

Jensen, Michael C. and Black, Fischer and Holderness, Clifford G., On the Conceptual Inadequacy of the Original Cost Regulatory System (1980). Harvard NOM Working Paper. Available at SSRN: https://ssrn.com/abstract=658102 or http://dx.doi.org/10.2139/ssrn.658102

Michael C. Jensen (Contact Author)

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Harvard Business School ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Harvard University - Accounting & Control Unit ( email )

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United States

Fischer Black

Sloan School of Management, MIT (Deceased)

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Clifford G. Holderness

Boston College - Department of Finance ( email )

Carroll School of Management
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Chestnut Hill, MA 02467-3808
United States
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617-277-8071 (Fax)

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