REGULATION AND CONSPIRACY.

Common sense as well as conventional marginal analysis tell us that a firm which is free to maximize profit and constrained only by its technology and the market it faces must experience a decline in profit if the price paid for any input is increased. For the regulated public utility, however, prices of inputs often help to determine how much profit the firm is permitted to earn. Regulation of electric utilities by State or local regulatory commissions usually involves some limitation on the rate of return on value of assets. Details vary widely. Allowable rates of return, however computed, are in excess of the rate of return associated with unregulated maximizing behavior. As for the unregulated monopoly firm, higher prices of inputs must reduce profit. On the other hand, in circumstances where the regulatory climate is less favorable and the restriction on the rate of return does take a bite, the increase in cost associated with the higher capital-goods prices may at least in part be counterbalanced by what amounts to a relaxation of the regulatory commission's restriction on profit, as the value of the capital base rises with capital-goods prices. If, in sharp contrast to token regulation, the utility is forced by the regulatory commission to operate on an inelastic portion of the demand curve for electricity, then the higher prices will surely allow the utility to more than compensate for higher costs by additional revenues, whether the commission's rate of return is based on capital valued at original cost or at replacement cost.