Rate Of Return Regulation

  

You probably know, as a knee-jerk fact, that monopolies are dangerous. But you probably don’t think much about why. (And it's not because all those hotels on Park Place will bankrupt you if you roll an 11).

The main danger posed by monopolies comes from the fact that customers don’t have any choice. By definition, a monopoly is the only provider of a particular good or service. Therefore, they can charge whatever they want. It makes gouging a distinct possibility.

You live out in the way, way boonies. There's only one gas station for hundreds of miles. That gas station can charge pretty much whatever it wants for gas. No competition. It has a local monopoly. $5...$6 a gallon...whatever it can get away charging before you decide you'd rather just ride a bike, or buy a mule.

But monopolies usually don't get a chance to take full advantage of this pricing power. Regulators step in to put a cap on the amount they can charge. These are known as rate of return regulations.

The rules involve the government setting prices for the thing provided by a monopoly. The regulations allow the company to earn a set rate of return, but don't permit them to take advantage of consumers.

Think about the electric company or the water works (two classic monopolies). The amounts they can charge are heavily regulated by the government.

Related or Semi-related Video

Finance: What are Return on Equity and R...145 Views

00:00

finance a la shmoop. what are return on equity and return on assets? all right

00:09

return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]

00:15

the outside of sushi. it's the kissing cousin of ROA if that helps. so what

00:20

is return then in this instance huh? well it's just profits. and there's a broader

00:24

frame here to think about. if your company just made five million dollars

00:27

in profits, was that good bad middlin? well if you were a little lemonade stand

00:32

that took 50 grand to start last year and you've made this massive five

00:37

million dollar haul well then yeah wow that's awesome. but if you're Google and

00:41

this year you only made five million bucks well you have tens of billions of

00:45

dollars of capital out there trying to earn lots more while making only five

00:50

million was a huge fail. so these concepts revolve around the balance

00:54

sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]

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asset side is enormous. say with the notional fifty billion dollars in assets

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if you made a ten percent return on your assets or raw ROA

01:09

return on assets well that would mean you netted five billion dollars right?

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ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]

01:17

there. so remember equity or shareholders equity or retained equity on the balance

01:22

sheet yeah this thing right here what equity is the retained profits after

01:26

you've started to build your company and after years and years of building your

01:29

company you would expect to have a lot of retained earnings. so what were the

01:33

returns on that equity or ROE only returns or profits number is the same as

01:39

it was in the ROA calculation only now in the denominator we have equity so if

01:44

your returns were say five billion and your retained equity was twenty billion [equations shown]

01:48

well you had a lovely twenty five percent return this year. twenty five

01:52

percent of twenty billion you know five billion. meaning that in just this one

01:56

year you grew your retained equity one massively. you've become a big harvester [man lifts weights]

02:01

of cash profits from whatever great business it is that you built. well why

02:06

do we care about ROA and ROE? well because capital efficiency

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matters. it's a reflection of how efficient you are, how well you're

02:14

investing your capital how will you're able to grow the business. that is in

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theory you could just sell your assets and go invest them elsewhere, like go

02:22

play an index fund in the stock market, and potentially return better profits

02:26

for your shareholders, and if you can do that well then you're probably going to

02:30

get fired. and there is precedent for this change .the airline industry there [airplane taking off]

02:37

was a time when American Airlines and United Airlines and crash Airlines owned

02:43

all their airplanes. they bought them at 50 million bucks a pop give or take but

02:47

the airline industry is a lousy business producing very low cash profits. every

02:52

time the economic cycle is good the economy is good people are buying

02:56

airline tickets up the wazoo, the Union strike and the airline's try to do

03:00

stupid things with pricing and a bunch of other things happen and all the

03:03

profits go away. anyway so one day a smart MBA employed by the airline said

03:09

hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]

03:14

them and we only need a fraction of our assets or equity or capital to produce

03:18

about the same investment returns for our shareholders. yeah and that's what

03:22

they did. so most airlines these days don't own

03:24

their own planes they lease them from the manufacturer or others and well

03:29

there haven't been any airline bankruptcies lately. and yes the airline

03:33

industry hard to find a better success story. [plane takes off]

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