Measuring profits and market power

In situations where market power exists – one potential example being the levying of artificially high prices – authorities such as the Monopolies and Mergers Commission (MMC) and Office of Fair Trading (OFT) place significant weight on their analysis of whether profits are deemed “excessive”.

When investigating monopolies or oligopolies, the competition authorities are concerned with identifying:

whether and where market power exists; and

how it is used, including whether profits seem excessive.

In the UK, the MMC and OFT have generally analysed profitability using traditional accounting measures. At the European Union level, the competition directorate in Brussels (DGIV) is less developed in its analysis of profitability issues.

The OFT has recently shown considerable interest in supplementing accounting measures with approaches derived more from economic theory. These are essentially cash-based approaches to measuring returns and assessing profitability by reference to a firm’s cost of capital. Outside of regulated utility industries, however, the practical applications of such approaches have been limited. For guidance on how the UK authorities have assessed profitability, MMC reports are the best sources of detailed analysis and conclusions.

The preferred profit measures used by the MMC have for a long time been historic cost accounting returns on capital employed (ROCE) or on sales.

Of the two alternative measures, the MMC prefers ROCE but will use alternatives for industries in which capital employed is particularly difficult to measure – for example, where there are substantial intangible assets such as intellectual property rights. The MMC generally reaches conclusions on the basis of considering at least a five-year trend of ROCEs, which it calculates as profits before interest and tax as a proportion of mean annual capital employed.

The MMC then typically determines whether profits are excessive by comparison to the average levels of profit at the time in comparable industries and, sometimes, in the UK manufacturing sector as a whole. On the basis of such comparisons, profits have generally had to be very high before being deemed excessive. Throughout its monopoly reports over the last 20 years, the MMC has not tended to find profits “excessive” unless ROCEs have been at least 30-40% and hence at least twice the comparable average.

Furthermore, profitability is only one of the factors considered by the authorities in completing their economic assessment of a case. A lot of time is spent analysing the nature and extent of competition, the competitive or anti-competitive impact of specific company practices, and the potential for competition and new entry in the industry. Only when such analysis reveals concerns as to the effectiveness of competition, possibly allied to a finding of excessive profits, do they tend to reach adverse overall conclusions and impose remedies. This is highly appropriate – the authorities are acutely aware that they have to balance their policing of effective competition with the need for innovation and risk-taking to be rewarded.

The MMC, for example, may conclude that profits are very high but reach no adverse conclusion in a case due to finding that the market is actually or potentially competitive. This has happened in its investigations of markets such as those for instant coffee, electricity meters and ready mixed concrete.

Before turning to two recent examples, it is also important to realise that the authorities do not simply take their measures of profits from the accounts or submissions of the companies under investigation. The MMC, for example, commonly adjusts company data in various ways to arrive at “true” measures of the returns earned. It also frequently requires companies and their advisers to allocate revenues, costs and capital employed to those businesses or products in respect of which there may be market power.

Many of the above points are well illustrated in the two MMC reports on monopoly issues published in 1996. One concerned BT’s Yellow Pages business. The MMC calculated that Yellow Pages earned consistently high returns on both turnover and capital employed over the five years 1991 to 1995. The figures were 41% and 130% respectively in 1994, for example, although relatively little weight was placed in this case on ROCEs due to the limitations of such a measure in a publishing sector. The MMC concluded that the prices charged by Yellow Pages were higher than would have been the case if competition had been effective.

The MMC also calculated that Yellow Pages supplied about 84% of classified directory advertising services in the UK. It found that significant barriers to entry existed. On the basis of the evidence of both market structure and Yellow Pages’ pricing and profitability, it recommended that a price cap was required.

In another case involving a strong brand, namely Tampax sanitary products, the OFT asked the MMC to investigate the relevant markets. The MMC was to focus on the Tambrands practice of offering discounts to wholesalers and retailers who agreed to stock the whole range of its products rather than just part of the range. The MMC found high but falling ROCEs for the Tambrands UK business, as shown in the chart above. In calculating these profit levels, the MMC made very substantial adjustments to the ROCE figures submitted by Tambrands. In particular, it adjusted capital employed downwards by removing assets under construction and it revised allocations which the company had made between its UK and its export businesses.

The sometimes substantial impact of the adjustments is illustrated in the chart.

Alongside this profitability evidence, the MMC conducted its full review of competition in the sanitary products market. It concluded the market power held by Tambrands was weakening, the countervailing power of major retailers was significant and, in the light of all its detailed findings, that the Tambrands discounting policy was not anti-competitive.

This illustrates the case-by-case approach adopted to determine whether profits are excessive. It is highly appropriate given the difficulty of making both such determinations and the more general economic assessments required in competition cases. The need to analyse profitability as the authorities do might be enhanced, however, if the OFT attempts more pro-active, sector-by-sector monitoring and then launches investigations on the basis of apparently high, sustained levels of profitability.

Paul Rowe is a competition policy economist in Arthur Andersen’s Economic Consulting Group.