On the Relationship Between Historic Cost, Forward Looking Cost and Long Run Marginal Cost

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.