Most public utilities (gas, electricity, water, and local telephone companies, for instance) are subject to rate of return regulation, under which a

Most public utilities (gas, electricity, water, and local telephone companies, for instance) are subject to rate of return regulation, under which a firm is allowed to choose its price, subject to its proving that it is not earning too much money. Typically, the firm is allowed to cover its expenditures for labor and material exactly and to earn a "fair" rate of return on its capital investment. Can you think of any problems with this sort of regulatory scheme? In particular, what do you think that this plan does to the firm's incentives to substitute capital for labor?