Consider the Edison Electric Company with a production function Q=(K^0.5)(L^0.5), where Q is output, K is capital, and L is labor. The market rental rate of capital is $0.50 and the wage rate is $0.50 also. The utility commission has set the allowed rental rate at $0.80. (Rental rates of capital are in dollars per unit of capital per year. With zero depreciation they are related to percentage costs of capital in the following way. Suppose that the utility must invest in a generator at a cost of $5 per kilowatt of capacity, and 10 percent is its cost of capital; then the rental rate per year is 10 percent of the $5 per unit, or $0.50. Similarly, the percentage allowed rate of return would be 16 percent, since 16 percent of $5 is $0.80. Rental rates are therefore comparable to wage rates and other factor costs in applying standard static production theory.)
Edison were unregulated, it would produce efficiently at a constant average and marginal cost of $1. However, because of Averch-Johnson effects, it uses too much capital under regulation and produces at an average cost of $1.01. Edison charges a price of $1.35 and sells Q=0.42
1. Find the sum of consumer and producer surplus for the case where Edison is regulated and where it is not.