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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
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    References listed on IDEAS

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    1. William P. Rogerson, 2008. "Intertemporal Cost Allocation and Investment Decisions," Journal of Political Economy, University of Chicago Press, vol. 116(5), pages 931-950, October.
    2. Rogerson, William P, 1992. "Optimal Depreciation Schedules for Regulated Utilities," Journal of Regulatory Economics, Springer, vol. 4(1), pages 5-33, March.
    3. Tardiff Timothy J., 2002. "Pricing Unbundled Network Elements and the FCC's TELRIC Rule: Economic and Modeling Issues," Review of Network Economics, De Gruyter, vol. 1(2), pages 1-15, September.
    4. Salinger, Michael A, 1998. "Regulating Prices to Equal Forward-Looking Costs: Cost-Based Prices or Price-Based Costs?," Journal of Regulatory Economics, Springer, vol. 14(2), pages 149-163, September.
    5. Gary Biglaiser & Michael Riordan, 2000. "Dynamics of Price Regulation," RAND Journal of Economics, The RAND Corporation, vol. 31(4), pages 744-767, Winter.
    6. William J. Baumol, 1971. "Optimal Depreciation Policy: Pricing the Products of Durable Assets," Bell Journal of Economics, The RAND Corporation, vol. 2(2), pages 638-656, Autumn.
    7. Ergas Henry, 2009. "Time Consistency in Regulatory Price Setting: An Australian Case Study," Review of Network Economics, De Gruyter, vol. 8(2), pages 1-11, June.
    8. Mandy, David M, 2002. "TELRIC Pricing with Vintage Capital," Journal of Regulatory Economics, Springer, vol. 22(3), pages 215-249, November.
    9. Falch Morten, 2002. "TELRIC - the Way Towards Competition? A European Point of View," Review of Network Economics, De Gruyter, vol. 1(2), pages 1-8, September.
    10. Mandy David M. & Sharkey William W., 2003. "Dynamic Pricing and Investment from Static Proxy Models," Review of Network Economics, De Gruyter, vol. 2(4), pages 1-37, December.
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    Citations

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    Cited by:

    1. 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.
    2. Stefan J. Reichelstein & Anshuman Sahoo, 2015. "Cost- and Price Dynamics of Solar PV Modules," CESifo Working Paper Series 5674, CESifo Group Munich.
    3. Stefan Reichelstein & Anna Rohlfing-Bastian, 2014. "Levelized Product Cost: Concept and Decision Relevance," CESifo Working Paper Series 4590, CESifo Group Munich.
    4. Christopher Decker, 2016. "Regulating networks in decline," Journal of Regulatory Economics, Springer, vol. 49(3), pages 344-370, June.
    5. 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.
    6. repec:now:fntacc:1400000054 is not listed on IDEAS
    7. 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.
    8. 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.
    9. 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.
    10. Alexander Nezlobin & Madhav V. Rajan & Stefan Reichelstein, 2012. "Dynamics of Rate-of-Return Regulation," Management Science, INFORMS, vol. 58(5), pages 980-995, May.
    11. 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.

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