OPTIMAL DEPRECIATION, PAYMENTS TO CAPITAL, AND NATURAL MONOPOLY REGULATION

This paper examines optimal recovery of capital costs by the profit-maximizing firm operating under a rate-of-return constraint and for the regulator's problems of welfare maximization such that revenues are sufficient to cover economic costs. In this regard, we examine optimal depreciation schedules and time horizons for recovery, as well as the effects of stationary and nonstationary demand and cost conditions and a profit tax on the recovery paths. For the regulated firm seeking profits, once recovery begins, it continues at the most rapid rate until full recovery of costs occurs. In terms of the welfare objective, the regulator is required to commit to full recovery over a finite time period. For both the profit and welfare objectives, the optimal recovery requires "backloading" under a broad set of conditions (recovery increases through time, a practice that is contrary to extant rules).