Using NPV = 0 rule to infer excess profits in a competitive enviroment

Abstract

In this study we evaluate the methodology used by the New Zealand Commerce Commission in determining the socially 'optimal' price level for regulated industries. Focusing on the fact that the current methodology ignores the existence of costly market frictions and valuable real options, we identify possible weaknesses in the price setting process, which could result in regulated companies receiving an inadequate return on the cost of their invested capital. To test if these weaknesses invalidate the methodology we measured the effect of competition on the value of real options, with inconclusive results. However, evidence is found which indicates that some competitive industries may still have valuable real options or experience costly market frictions.