2
If everyone can do it, its difficult to create and capture value
from it.
3
If everyone can do it, its difficult to create and capture value
from it.or, alternatively
In a perfectly competitive market, no firm realizes economic
profits (rents).
4
def. economic profits (rents) are returns in excess of what an
investor expects to earn from investments of similar risk (i.e., in
excess of the opportunity cost of capital)IBM $6,328 $2,541
Microsoft
$4,490 $3,776
$(5,525)
General Motors
$2,956All data in US $ millions from 1998. Abstracted from S.
Oster, Modern Competitive Analysis. Oxford University Press.
1999.
Accounting Profits
Economic Profits
5
Tobins Q Ratio of a firms market value to its asset replacement
value Directly measures rents above those to physical inputs
Difficult to calculate because it requires knowledge of assets
replacement value
Discounted Cash Flow (DCF) Measures value of firm going forward
Discount rate reflects return to equity (i.e., opportunity cost)
Positive NPV indicates rents over and above returns to all
inputs
6
In a perfectly competitive market, no firm realizes economic
profits (rents).
The existence of economic profits suggests some type of market
inefficiency. The strategists task is to identify ways in which
firms may capitalize on these market imperfections.
7
An Industry S1
D
8
An Industry S1 P1 D Q1
9
An Industry S1 P1 D Q1 P1
A Firm MC AC
10
An Industry S1 P1 D Q1 P1
A Firm MC AC
q1
11
Profits = Revenues Variable Costs Fixed Costs
= P1q1 - c(q1) cf /q1 = (P1q1 - c(q1) cf)/q1 = 0 P1 c(q1) = 0 P1
= c(q1) = MC12
An Industry S1 P1 D Q1 P1
A Firm MC AC
13
An Industry S1 P1 D Q1 P1
A Firm MC AC
q1
14
An Industry S1 P1 D Q1 P1
A Firm MC AC
q1
15
An Industry S1 P1 D Q1 P1
A Firm MC AC
q1
16
An Industry S1 P1 P2 D Q1 Q2 S2 P1
A Firm MC AC
q1
17
An Industry S1 P1 P2 D Q1 Q2 S2 P1 P2
A Firm MC AC
q2 q1
18
An Industry S1 P1 P2 D Q1 Q2ar s t i f o r c p i m o n y! o a Ec
w a d e compet e
A Firm MC P1 P2 q2 q1 AC
S2
19
In a perfectly competitive market, no firm realizes economic
profits (rents).
The existence of economic profits suggests some type of market
inefficiency. The strategists task is to identify ways in which
firms may capitalize on these market imperfections.
20
Facts: Average industry returns vary even after controlling for
risk. Returns among companies within industries vary even more.
Returns for individual companies vary over time.
Density
Returns
21
When you are presented with a project that appears tohave a
positive NPV, dont just accept the calculations at face value. They
may reflect simple estimation errors in forecasting cash flows.
Probe behind cash flow estimates and try to identify the source of
economic rents. A positive NPV for a new project is believable only
if you believe that the company has some special advantage.From the
chapter, Where Positive Net Value Comes From Brealey & Myers,
Principles of Corporate Finance
22
(Industrial Organization View)
Monopoly Rents
(Resource Based View)
Ricardian Rents
Schumpeterian Rents(Dynamic Capabilities View)
S MC 1MC 2 P S P AC 1 q1 q2 AC 2
D Q
-Barriers to entry -Industry structure matters
-Barriers to imitation -Firm structure matters
-Markets are dynamic -Innovation matters
(Industrial Organization View)
Monopoly Rents
S P S
D Q
-Barriers to entry -Industry structure matters
(Resource Based View)
Ricardian Rents MC 1MC 2
P
AC 2
AC 1 q1 q2
-Barriers to imitation -Firm structure matters
The Fundamental Principle -- In perfectly competitive markets,
no firm realizes economic profits. Economic profits are returns in
excess of the opportunity cost of capital. In the real world,
product markets are rarely perfect and firms often have competitive
advantage. Broadly speaking, firms may capture economic profits
when there are either barriers to competition or barriers to
imitation.
27
