Introduction

We now turn our attention to the major institution of monopoly regulation in the United States, rate-of-return regulation. That institution was not designed specifically to achieve economic efficiency. It grew slowly out of a history of conflict, which was gradually resolved by the U.S. judicial system. The right of states to prescribe rates was affirmed little more than a century ago by the Supreme Court in the case of Munn v. Illinois, and the guidance that has come to be called rate-of-return regulation was essentially worked out over the half-century between Smyth v. Ames in 1898 and Hope Natural Gas Company in 1944. This history reminds us that once parties have had scope to entertain quite different positions, they may have difficulty bringing their dispute to an efficient outcome. Although legal issues have been settled, in the wake of their settlement economic issues today have become very complex, as observation of any modern rate case will confirm. Economic issues are complex in part because rate-of-return regulation evolved before some economic principles that might have affected its design were fully known. These principles would have made untenable some of the legal positions that partisans in past adversary proceedings created.

Our aim in this chapter is to show how rate-of-return regulation came into being and to describe its operational shortcomings. Its consequences for input inefficiency, output inefficiency, and incentives within the firm are explored in subsequent chapters.