TY - JOUR

T1 - On the relationship between historic cost, forward looking cost and long run marginal cost

AU - Rogerson, William P.

N1 - Funding Information:
KEYWORDS: historic cost, forward looking cost, long run marginal cost, cost allocation, depreciation Author Notes: Research support from the Searle Fund for Policy Research is gratefully acknowledged. I would like to thank Debra Aron, Kathleen Hagerty, Michael Salinger, Stefan Reichelstein, Korok Ray, David Sappington, William Sharkey, Nancy Stokey, T. N. Srinivasan, Jean Tirole, Julian Wright and two anonymous referees for helpful discussions and comments.

PY - 2011/6/7

Y1 - 2011/6/7

N2 - 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.

AB - 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.

KW - Historic cost

KW - cost allocation

KW - depreciation

KW - forward looking cost

KW - long run marginal cost

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U2 - 10.2202/1446-9022.1242

DO - 10.2202/1446-9022.1242

M3 - Review article

AN - SCOPUS:79959927390

SN - 1446-9022

VL - 10

JO - Review of Network Economics

JF - Review of Network Economics

IS - 2

M1 - 2

ER -