Chapter 3

Tuesday, June 6, 2023 11:08 AM

Market Concentration
- A situation in which a few leading firms control a market (or industry).
- It measures the extent of domination of sales by one or more firms in a particular market.
- Two variables that determine such situations are: number and size distribution of firms
- Market concentration is an important element of the market structure which plays a dominating
role in determining the behavior of a firm in the market.
- Elements of market concentration: concentration in ownership of industry, in decision-making
power, of firms in a particular location.
○ All of these elements may have considerable impact on market performance (profitability,
growth, technological progress)
- Measurement of market concentration helps us empirically test the behavioral hypothesis about
firms and industries. These interrelate with measures for monopoly power and cannot be
separated in the measurement process.
○ Measures for monopoly power: appropriate at firm level, indicate actual monopoly power
○ Measures of concentration: potential monopoly power in the market or industry as a whole.
Therefore, market concentration is a necessary condition for the monopoly power
○ Some general conditions that should be satisfied by the indices: unambiguous ranking, a
function of the combined market share of firms (rather than absolute size of the market), If
no of firms increases, concentration should decrease (except in the case of a large new
entrant), concentration increase if there is a transfer of sales from a small firm to a large
one, proportionate decrease in the market share of all firms leads to reduction of
concentration by same proportion, mergers increase concentration
○ There is no perfect index for concentration or monopoly power, i.e., an index might not
satisfy each one of the conditions.
- Market concentration curves plot the cumulative market share. X-axis represents cumulative
number of firms from the largest to smallest, Y-axis shows cumulative percentage of market
supply
- Measures of concentration:
1. Concentration ratio: simples, most popular, defined as a proportion of market share
accounted for by r largest firms where usually, r=4.

C = = = + + +

Where is the percentage of market share of firm i. The higher the Cr, the greater the
market concentration/ monopoly power.
Limitations: arbitrary selection of r and that the Cr indicates only a single point on the
concentration curve. Basic problem is that it provides no info about the size distribution of
the r firms.
2. Hirschman-Herfindahl Index (HHI): Takes into account all points on the concentration curve.
Mathematically, =∑ where Si = qi/Q and qi is the output of the i'th firm, Q=
total output f all firms, n=total number of firms. 100 ≤ HHI ≤ 10,000.
As inequality in concentration increases, so does the HHI. The HHI is used as a guideline to
decide merger cases. Accordingly, unconcentrated markets are defined as those in which
HHI is 1000 or less. The pre-merger HHI is the same but the post merger HHI is given as:
∑ − − +( + ) =∑ +2 where the change in HHI = 2S1S2
Advantages: Squaring gives more weight to the shares of larger firms, and it uses info about
the market share of all relevant firms.
Disadvantages: Doesn't take into account the possibility of entering new companies,
challenging to collect market share data for the entire market, sensitive to market
 definitions, says nothing about differentiation.
3. Hannah and Key's Index (HKI): HKI is the general counterpart to HHI special case. They vary
in the weight given to large firms. In HKI, the market shares are raised to the power of
where the actual value of is decided by the investigator but should lie between 0.6 and 2.5
(and isn't =1). Mathematically, =∑ ( )
4. Entropy Index: recently introduced approach, market concentrations are weighed by the
logarithms of the market shares.
=∑ ∗ log where 0 < EI < log (n)
It in fact measures the degree of market uncertainty faced by a firm in relation to a given
customer. For a monopoly firm (n=1), the entropy coefficient =0 which means no
uncertainty and maximum concentration. Therefore, there is an inverse relationship
between the entropy coefficient and the degree of market concentration.
The HHI and EI are similar but the EI gives relatively more eight to smaller firms.
5. Gini Coefficient (GC): used to measure inequality, used to plot cumulative market share
against cumulative percentage of firms (from smallest to largest). The straight diagonal line
represents perfect equality and the farther the Lorenz curve is from it, the higher inequality.
We can find the Gini coefficient by dividing the area bounded between the Lorenz curve and
the diagonal line by area of the total triangle under the diagonal line. 0 < GC < 1
Limitations: doesn't regard the number of equal sized firms, sufficient data about the
market share of every firm in the market might not be available
6. Lerner Index (LI): the best known measure of monopoly power and is expressed as: LI=(P-
MC)/ P= 1/e where e is the price elasticity of demand.
The greater the deviation between P & MC, the higher the monopoly power and the greater
the market concentration.
- Concentration and market performance relate to one another. These theories try to reflect the
relationship between them.
i. Concentration and profit: market power -> increased profitability has long been
assumed. Bain was the first to argue for the strong linkage between the two hence
concluding that profit rate can be a measure of concentration. But there has been
difficulty establishing the correct relationship since: there are many measures of
concentration, and profit measurement is often based on accounting rate which
ignores certain opportunity cost elements
ii. Concentration and Price-Cost margins: Price margin is a short term view of
profitability based on current assets and cost figures. Some studies support the
positive relationship between concentration and price-cost margin but other studies
indicate insignificant relationships.
iii. Concentration and firm growth: Two differing views explaining the actual relationship
between concentration and profit.
First: Negative relationship between concentration and growth of the firm. It's
because its assumed that firm with market power prefers to maintain high profits by
restricting output and charging high prices; growth is unlikely to be in its interest but
static diseconomies of scale and other bottlenecks would also adversely affect the
growth of such a firm anyway.
Second: Positive relationship between concentration and growth. Its because its
assumed that firms may like to grow over time even under market concentration to
maximize long term profits by creating excess capacity to meet the future growing
demand and also to discourage new entry in the market
iv. Concentration and technological progress: Some research show that concentrated
market and innovative activities are positively correlated but there is no conclusive
evidence.
v. Concentration and other aspects of market performance: Stability in the business is
expected in higher performing firms i.e., in a firm within a concentrated market.
- Determinants of Concentration: Two approaches, the deterministic and stochastic approach.
A. Deterministic Approach: Concentrated markets could come from persistent scale
economies, which constitutes the relationship between the size of the firm and its costs of
production. This relationship may be expressed by the long-run average cost curve (LAC) and
we can identify various relationships between LAC and level of output.
1. Constant Cost Case: no cost advantages/ disadvantages associated with large-scale
production. Market structure is indeterminate
2. Rapid fall in unit production costs: Economies of size are not exhausted until a very
large level of output is attained. Such is the case of natural monopoly.
3. Rapid Rise in unit production costs: the economies of scale are negligible. Market
structure is competitive.
4. Constant range of minimum LAC curve: a small rate of output enables the firm to take
advantage of economies of scale, meaning diseconomies don't occur until the output
rate is quite large. Small and big firms both can co-exist.
B. Scholastic Approach: Assumes a certain factor (∑ ⬚) for all factors that are unmeasurable
but still affect market concentration. Unlike the deterministic approach which assumes all
factors that affect concentration are measurable.