Cost of Capital in Pricing Monopoly in Communist Country

People are sometimes confused with the term of monopoly. Wherever it is conducted, monopoly is defined as a market set by only one provider of the product or service. For example, in most communist countries there is only one provider of telecommunication, transportation or electricity, which is normally in the form of state-owned enterprise (SOE), as this type known as a natural monopoly. Yet this monopoly market can also be applied in a liberal country like the United States, or other Western countries. The term used is softer, a quasi monopoly, and the example unsurprisingly are like Intel and Microsoft.

Monopoly is monopoly and the pricing decision of the product or service has to be influenced by public regulation in one country in order to get a fair price. In pricing a product, a company usually calculates the capital budget in a feasibility study of a project to finally find the suitable profit margin. In capital budgeting, the cost of capital is used as a comparative parameter with the rate of return. The rule is that the return rate must exceed the cost of capital. Once exceeded, an additional parameter like profit margin can then be considered with, of course, the role of public regulation set by the authority (Kiwicap, Roger Bowden).

In finance, the cost of capital can be calculated using the popular capital asset pricing model (CAPM) as the cost of capital (k) equals to risk-free rate (Rf) plus Beta times the market risk premium (MRP), which is the difference between the risk-free rate and the market return (Rm).

k = Rf + Beta x MRP, where MRP = Rm - Rf

To illustrate this calculation, I can use the example of People Republic of China market, picking up the China Telecom Corporation, which is 70% owned by the goverment and listed in Hong Kong and New York stock exhanges. China is a communist country who has a monopoly in telecomunication, however has 3 (three) considerable stock exchanges: Shanghai, Shenzhen and Hong Kong exchanges that can be referred to the market risk premium.

To define Rf, I will use the Chinese Government Bond rate. From the three exchanges, I will choose Hong Kong Stock Exchange (HSE) index for calculating the market return (Rm). For finding Beta, I will use the historical prices of China Telecom stock and HSE index. Then, calculate k, the cost of capital.

Whatever the result is, I have to say that even in a communist country, a cost of capital matters. Particularly, in pricing a monopoly product or service.

How about Intel and Microsoft, they are originated in a very sophisticated liberal country? The cost of capital, of course, matters. And also needs to be regulated, as can be seen from the 2004 news on Intel being investigated by the European Commission for quasi-monopoly.

THE European Commission said yesterday that it had re-opened a three-year-old investigation into Intel, the world’s biggest computer chip maker, just weeks after the company’s Japanese offices were raided by regulators on suspicion of anti-competitive practices.