A standard portrayal of traditional rate-of-return regulation holds that output price is set equal to long-run average cost.1 Under natural monopoly conditions, such regulation results in a price that exceeds long-run marginal cost and is, therefore, allocatively inefficient.2 Specifically, where the This article explores how the standard analysis of the regulated firm is influenced once the ability of such a firm to advertise is recognized. The results demonstrate that incorporating advertising into the traditional model negates the well-known conclusion regarding the allocative inefficiency of regulatory equilibrium. The attainment of allocative efficiency is obtained however, through the cost-increasing consequences of advertising. Consequently, an important question becomes whether the potential welfare gain from shifting output toward the point of minimum average cost outweighs the welfare loss of increasing that minimum cost. Accordingly, the article explores these welfare effects of such regulated firm advertising. * We express our appreciation to Andy Barnett, Bob Ekelund, David Mandy, and an anonymous reviewer for their helpful comments on an earlier draft. The usual caveat applies. 1. Such regulatory behavior can result from two alternative regimes. First, standard cost-plus regulation is consistent with this assumption where "cost" is average accounting cost and the "plus" is normal unit profit. Second, average cost pricing is also consistent with traditional rate-of-return regulation if the firm's allowed rate of return is set equal to the actual cost of capital (Bailey 1973). At the same time, however, it is well known that, if the allowed rate of return on capital exceeds the firm's actual cost of capital, an incentive to employ more than the cost-minimizing quantity of capital in the production process arises. See Averch and Johnson (1962) and the subsequent literature. We abstract from these considerations here by considering the base case where the allowed rate of return is set equal to the firm's cost of capital, so average cost pricing results. This assumption may be defended on two grounds. First, the empirical literature dealing with the Averch-Johnson hypothesis has been inconclusive. Courville (1974), Spann (1974), and Peterson (1975) tend to confirm this hypothesis, while Boyes (1976) and Smithson (1978) fail to confirm it. Second, incorporating such distortions here would complicate, but not materially affect, the basic results of our analysis.