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On the Relationship Between Historic Cost, Forward Looking Cost and Long Run Marginal Cost

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  • Rogerson William P

    (Northwestern University)

Abstract

This paper considers a simple model where a regulated firm must make sunk investments in long-lived assets in order to produce output, assets exhibit a known but arbitrary pattern of depreciation, there are constant returns to scale within each period, and the replacement cost of assets is weakly falling over time due to technological progress. It is shown that a simple formula can be used to calculate the long run marginal cost of production each period and that the firm breaks even if prices are set equal to long run marginal cost. Furthermore, the formula for calculating long run marginal cost can be interpreted as a formula for calculating forward looking cost (where the current cost of using assets is based on the current replacement cost of assets). However, through appropriate choice of the accounting depreciation rule, it can also be interpreted as a formula for calculating historic cost (where the current cost of using assets is based on the historic purchase cost of assets). In particular, the results derived in the simple benchmark model of this paper contradict the commonly expressed view that measures of forward looking cost are superior to measures of historic cost in environments with declining asset prices.

Suggested Citation

  • Rogerson William P, 2011. "On the Relationship Between Historic Cost, Forward Looking Cost and Long Run Marginal Cost," Review of Network Economics, De Gruyter, vol. 10(2), pages 1-31, June.
    • Handle: RePEc:bpj:rneart:v:10:y:2011:i:2:n:2
    DOI: 10.2202/1446-9022.1242
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    References listed on IDEAS

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    Cited by:

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    2. Schober, Dominik & Weber, Christoph, 2015. "Refinancing under yardstick regulation with investment cycles: The case of long-lived electricity network assets," ZEW Discussion Papers 15-065, ZEW - Leibniz Centre for European Economic Research.
    3. Stefan J. Reichelstein & Anshuman Sahoo, 2015. "Cost- and Price Dynamics of Solar PV Modules," CESifo Working Paper Series 5674, CESifo.
    4. Livdan, Dmitry & Nezlobin, Alexander, 2021. "Investment, capital stock, and replacement cost of assets when economic depreciation is non-geometric," Journal of Financial Economics, Elsevier, vol. 142(3), pages 1444-1469.
    5. Alexander Nezlobin & Madhav V. Rajan & Stefan Reichelstein, 2012. "Dynamics of Rate-of-Return Regulation," Management Science, INFORMS, vol. 58(5), pages 980-995, May.
    6. Nezlobin, Alexander, 2018. "Dynamic Investment Models in Accounting Research," Foundations and Trends(R) in Accounting, now publishers, vol. 12(3), pages 216-297, December.
    7. Livdan, Dmitry & Nezlobin, Alexander, 2022. "Incentivizing irreversible investment," LSE Research Online Documents on Economics 110531, London School of Economics and Political Science, LSE Library.
    8. Christopher Decker, 2016. "Regulating networks in decline," Journal of Regulatory Economics, Springer, vol. 49(3), pages 344-370, June.
    9. Alexander Nezlobin, 2012. "Accrual Accounting, Informational Sufficiency, and Equity Valuation," Journal of Accounting Research, Wiley Blackwell, vol. 50(1), pages 233-273, March.
    10. Alexander Nezlobin & Madhav V. Rajan & Stefan Reichelstein, 2016. "Structural properties of the price-to-earnings and price-to-book ratios," Review of Accounting Studies, Springer, vol. 21(2), pages 438-472, June.
    11. Dominik Schober, 2013. "Refinancing under Yardstick Regulation with Investment Cycles–The Case of Long-Lived Electricity Network Assets," EWL Working Papers 1321, University of Duisburg-Essen, Chair for Management Science and Energy Economics, revised Jun 2013.
    12. Christian Lohmann, 2015. "Managerial incentives for capacity investment decisions," Journal of Management Control: Zeitschrift für Planung und Unternehmenssteuerung, Springer, vol. 26(1), pages 27-49, April.
    13. Stefan Reichelstein & Anna Rohlfing-Bastian, 2014. "Levelized Product Cost: Concept and Decision Relevance," CESifo Working Paper Series 4590, CESifo.
    14. Sunil Dutta & Stefan J. Reichelstein, 2019. "Capacity Rights and Full Cost Transfer Pricing," CESifo Working Paper Series 7968, CESifo.
    15. Sunil Dutta & Stefan Reichelstein, 2021. "Capacity Rights and Full-Cost Transfer Pricing," Management Science, INFORMS, vol. 67(2), pages 1303-1325, February.
    16. Timothy Tardiff, 2015. "Prices based on current cost or historical cost: How different are they?," Journal of Regulatory Economics, Springer, vol. 47(2), pages 201-217, April.
    17. Guthrie, Graeme, 2020. "Regulation, welfare, and the risk of asset stranding," The Quarterly Review of Economics and Finance, Elsevier, vol. 78(C), pages 273-287.
    18. Küpper, Hans-Ulrich & Pedell, Burkhard, 2016. "Which asset valuation and depreciation method should be used for regulated utilities? An analytical and simulation-based comparison," Utilities Policy, Elsevier, vol. 40(C), pages 88-103.
    19. Maureen McNichols & Madhav V. Rajan & Stefan Reichelstein, 2014. "Conservatism Correction for the Market-To-Book Ratio and Tobin's q," CESifo Working Paper Series 4626, CESifo.

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