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If everyone can do it, its difficult to


create and capture value from it.

If everyone can do it, its difficult to


create and capture value from it.
or, alternatively

In a perfectly
I
f tl competitive
titi market,
k t no
firm realizes economic profits (rents).

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)
$6,328

IBM

$2,541

$4,490
$4 490

Microsoft

$(5,525)

$3,776

$2,956

General Motors

All data in US $ millions from 1998.


Abstracted from S. Oster, Modern Competitive
Analysis. Oxford University Press. 1999.

Accounting Profits

Economic Profits

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)


g forward
Measures value of firm g
going
Discount rate reflects return to equity (i.e., opportunity cost)
Positive NPV indicates rents over and above returns to all inputs

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.

An Industry
S1

An Industry
S1
P1
D
Q1

An Industry

A Firm
S1

P1

MC

AC

P1
D
Q1

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An Industry

A Firm
S1

P1

MC

AC

P1
D
Q1

q1

11

Profits = Revenues Variable Costs Fixed Costs

= P1q1 - c(q1) cf
/ q1 = (P1q1 - c(q1) cf )/ q1 = 0
(q1) = 0
P1 cc(q
P1 = c(q1) = MC
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An Industry

A Firm
S1

P1

MC

AC

P1
D
Q1

13

An Industry

A Firm
S1

P1

MC

AC

P1
D
Q1

q1

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An Industry

A Firm
S1

P1

MC

AC

P1
D
q1

Q1

15

An Industry

A Firm
S1

P1

MC

AC

P1
D
Q1

q1

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An Industry

A Firm
S1
S2

P1

MC

AC

P1

P2
D
q1

Q1 Q2

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An Industry

A Firm
S1
S2

P1
P2

MC

AC

P1
P2

D
Q1 Q2

q2 q1

18

An Industry

A Firm
S1
S2

P1
P2

MC

AC

P1
P2

D
Q1 Q2

q2 q1

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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.

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Facts:
risk
Average industry returns vary even after controlling for risk.
Returns among companies within industries vary even more.

Density

Returns for individual companies vary over time.

Returns

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When you are presented with a project that appears to


have 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

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Schumpeterian Rents

Ricardian Rents

Monopoly Rents

((Dynamic
y
Capabilities
p
View))

(Resource Based View)

(Industrial Organization View)

S
MC 1MC 2

AC 2

AC 1

D
q1 q2

-Barriers to entry
-Industry structure matters

-Barriers to imitation
-Firm structure matters

-Markets are dynamic


-Innovation matters

Monopoly Rents

(Industrial Organization View)

S
S

D
Q

-Barriers to entry
-Industry structure matters

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Ricardian Rents

(Resource Based View)

MC 1MC 2
P

AC 2

AC 1
q1 q2

-Barriers to imitation
-Firm structure matters

Schumpeterian Rents
(Dynamic Capabilities View)

-Markets are dynamic


-Innovation matters

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The Fundamental Principle -- In perfectly competitive


k t no fi
li
i profits.
fit
markets,
firm realizes
economic
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
firms may capture
economic
B dl speaking,
ki
fi
t
i profits
fit
when there are either barriers to competition or
barriers to imitation.

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