Operating Ratio Regulation: Control Theory Approach

This paper investigates the dynamic effects of operating ratio regulation. This form of regulation allows the regulated industry to have preselected markups on noncapital expenditures. In a two-factor model, noncapital expenditures are labor alone. When the firm earns more than a preselected ratio of revenue to labor expenditures, price changes will result and this constitutes the dynamic constraint over time. The industry will maximize the long-run constrained profit function (Hamiltonian) with its control variable, labor. The general conclusion we reach is that regulation of this type causes inefficient production and undercapitalization. Using specific functional forms, we are able to establish the existence and stability conditions for an equilibrium of the constrained profit function and make comparisons for given parameter values, between the dynamic, static and unregulated firms under operating ratio regulation.