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In my finance classes, I always learned that the a firm earning an "economic profit" is one for which its return on invested capital (ROIC) is greater than it's opportunity cost of capital (usually calculated using the Weighted Average Cost of Capital). But, in my economics classes, I learned that economic profit accrues to a firm that has the ability to price above marginal cost (the demand curve for its product is not infinitely elastic).

Are these two definitions compatible? Is there a way to connect the two? The reason for my question is that I have noticed situations in which the two don't concur. For example, oil companies have negligible market share (when considered globally; e.g. Exxon, the largest U.S. oil major, has about 3% market share - will try to find the reference for this, can't currently remember) and sell a commodity product, and so that's pretty close to the "competitive ideal" as depicted in any Intermediate Micro class. However, if you look at Exxon's ROIC, it has at times been in the 30% range, much higher than any reasonable estimate of WACC (usually around 7-12%). So there appears to be a discrepancy between two different measures of "economic profit".

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Both of them are consistent. The economic profit is the total revenue $TR$ minus total cost $TC$ but in economics costs must include also opportunity costs not just accounting ones.

However, for all standard market structures $TR>TC$ happens only if the marginal revenue or price $P$ is above marginal costs $MC$.

Also if there is positive economic profit then also return on the capital will be higher than opportunity cost of that capital, because by definition such profit must be higher than the minimum necessary to compensate for the opportunity cost.

So it’s not that the definitions are inconsistent they are just different results based on the same principle. However, if you would try to calculate the true economic profit by different estimation methods you could get different answers because some opportunity cost might be not easy to observe. For example, weighted average costs of capital (WACC) is a crude way how to estimate opportunity cost it’s not the definition of it. Also many inputs in WACC are only proxies not actually directly observable variables.

Now turning attention to your example it’s simply not true the demand for oil is elastic or that oil market is perfectly competitive market. Due to organizations as OPEC oil market was for long time almost monopolized and even though the strength of OPEC decreased in recent years I would still put it somewhere more close to oligopoly. It’s definitely not even close to perfectly competitive market which requires many sellers not just few key players. Also perfect competition requires (virtually) no barriers to entry and in oil industry the entry barriers can be high.

Moreover, demand for oil is also very inelastic. Unfortunately even now in 21st century our civilization crucially depends on fossil fuels to run. Oil is still virtually a necessity and demand for it is highly inelastic. In fact if you try to survey the literature on google scholar by checking for elasticity of oil demand you find that most mean estimates report elasticity less than 1 and many close to 0.1 which is very small. In such setting in most market structures you get a room for significant economic profit as market power varies inversely with elasticity of demand.

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  • $\begingroup$ "perfect competition requires (virtually) costless entry" I don't think this is true, or at least it depends on what you mean by entry costs. There should be no barriers to entry, costs are fine. In fact one of the results of perfect competition is that it minimizes average costs (AC). This itself assumes some fixed costs. $\endgroup$ – Giskard Dec 1 '19 at 11:05
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    $\begingroup$ @Giskard true, but I meant it in a way as you see in some IO models which make distinction between entry fixed costs that become sunk ex post and fixed costs that are incurred due to production but I changed it to entry barriers to make it less confusing $\endgroup$ – 1muflon1 Dec 1 '19 at 11:08
  • $\begingroup$ So I'm sympathetic to the idea that WACC is a very noisy measurement of true opportunity costs. How would you actually measure the opportunity cost of capital then? Additionally, I disagree partially with your characterization of oil markets. True there was a time when OPEC was a substantial fraction of market, but it's market share now is 30%. And yes, market demand for oil is inelastic, but market demand curve != firm demand curve, the latter of which is what's important for market power determination. $\endgroup$ – windfreedom22 Dec 6 '19 at 7:04
  • $\begingroup$ And from what I know about oil markets, despite the presence of barriers to entry, firms all take commodity prices as given, which is exactly how perfectly competitive firms behave. So although obviously not perfectly competitive, I still think my oil example stands as an example of when ROIC > WACC despite the presence of a flat firm-specific demand curve, which would imply that little market power exists. As you stated though, if WACC doesn't measure OC well, then ROIC>WACC does not imply that economic profit necessarily exists. $\endgroup$ – windfreedom22 Dec 6 '19 at 7:09
  • $\begingroup$ The reason for my question is that as an investor - which is what I am - I'm always taught that ROIC > WACC is a good thing to look for. But if ROIC > WACC implies the existence of economic profit (in the I/O sense of the word), then that seems troubling to me from a societal POV. Economic profit is usually seen as wasteful (deadweight loss). So are all investors looking for social waste? That conclusion strikes me as troubling and at odds with what I intuitively see in markets around me. $\endgroup$ – windfreedom22 Dec 6 '19 at 7:11

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