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Profitability Measures and Competition Law

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  • Paul A.Grout
  • Anna Zalewska

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Abstract

The paper outlines various measures of profitability and considers what role they can play in competition law. We argue that profitability measures can provide a good answer to the wrong question and a much less good answer to the question we really want to answer. Using appropriate definitions of asset value it is possible to identify whether a firm earns more than the absolute minimum needed to cover cost and compensate for risk, i.e., whether profitability measures such as the internal rate of return and the accounting rate of return are above the cost of capital. However, both the empirical evidence we present and theory indicates that this does not really help in most cases. Knowing that a firm is earning say, half a percent more than the cost of capital is not really much help in almost all competition law cases. But we show that once the rate of return deviates from the cost of capital it becomes hard to measure. Using simple examples we show that shifts in cash flows that preserve the net present value of a project can have dramatic effects on profitability measures. Hence, it is hard to assess the quantity of the “excessive” return. Furthermore, this problem is likely to be far more prevalent today than in the past given the growth in outsourcing (since outsourcing has exactly this type of effect on cash flows). Despite such problems, we argue that the measurement of profit has a role to play in competition law but that the analysis is far more of an art form and far less of a simple statistical procedure.

Suggested Citation

  • Paul A.Grout & Anna Zalewska, 2006. "Profitability Measures and Competition Law," The Centre for Market and Public Organisation 06/144, Department of Economics, University of Bristol, UK.
  • Handle: RePEc:bri:cmpowp:06/144
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    File URL: http://www.bris.ac.uk/Depts/CMPO/workingpapers/wp144.pdf
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    References listed on IDEAS

    as
    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    2. Robert S. Pindyck, 2005. "Sunk Costs and Real Options in Antitrust," NBER Working Papers 11430, National Bureau of Economic Research, Inc.
    3. van Breda, Michael F, 1984. "The Misuse of Accounting Rates of Return: Comment," American Economic Review, American Economic Association, vol. 74(3), pages 507-508, June.
    4. repec:reg:rpubli:237 is not listed on IDEAS
    5. Long, William F & Ravenscraft, David J, 1984. "The Misuse of Accounting Rates of Return: Comment," American Economic Review, American Economic Association, vol. 74(3), pages 494-500, June.
    6. Horowitz, Ira, 1984. "The Misuse of Accounting Rates of Return: Comment," American Economic Review, American Economic Association, vol. 74(3), pages 492-493, June.
    7. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
    8. Martin, Stephen, 1984. "The Misuse of Accounting Rates of Return: Comment," American Economic Review, American Economic Association, vol. 74(3), pages 501-506, June.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    profitability measures; excess return; competition;

    JEL classification:

    • K21 - Law and Economics - - Regulation and Business Law - - - Antitrust Law
    • L43 - Industrial Organization - - Antitrust Issues and Policies - - - Legal Monopolies and Regulation or Deregulation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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