Thursday, March 8, 2007
Posted by D. Daniel Sokol
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.