Optimal depreciation schedules for regulated utilities

This paper+ derives the combined effect of depreciation schedules and regulatory lag on a firm's choice of input mix. It shows that a schedule called the real constant (RC) schedule induces efficient capital-labor proportions. More (less) accelerated schedules cause undercapitalization (overcapitalization). Since most typically used schedules are accelerated relative to the RC schedule, they lead to undercapitalization. Testable predictions are derived by showing that these distortions become more severe as the inflation rate increases and as the lag length decreases.