Determining Market Structure

Measuring Market Concentration | CFA Level I Economics

Welcome back as we wrap up this topic on market structures by learning how market concentration can be determined: based on econometric approaches, the N-firm concentration ratio, and the Herfindahl-Hirschman Index. Let’s get started.

Econometric Approaches

We have learnt that market power can be abused when one or more dominant firms choose to price and produce at levels that maximise firm profits but result in market inefficiencies. Such inefficiencies come in the form of deadweight loss, reduced consumer surplus while producer surplus is maximised. Regulators are in the business of measuring the market power of large firms and ensure that their activities do not violate any anti-competition laws.

Econometric approaches aim to estimate the elasticity of demand and supply in a market. If demand is very elastic, the market must be very close to perfect competition. If demand is inelastic, companies may have significant market power.

Regression analysis is useful in computing elasticity but requires a large number of observations. The data points can be based on average past sales data of the entire market, or sales of individual firms in a single period.

The difficulty of econometric approaches is that a large quantity of data is required, and that demand and supply are dependent on each other, so it is very difficult to analyse the supply and demand of a market separately.

N-firm Concentration Ratio

Simpler measures that require much less data are more often used to obtain a quick estimate of market power. The N-firm concentration ratio is calculated as the sum of the percentage market shares of the largest N firms in a market.

For example, if the market shares of a particular industry is as such, the 5-firm concentration ratio will be the sum of the market shares of the top 5 firms, which is 70%.

While this measure is simple to calculate and understand, it does not directly quantify market power or elasticity of demand. High market share may not necessarily mean high market power. If the barriers to entry are low, existing firms with high market share cannot raise prices without attracting more competition.

Another disadvantage of the N-firm concentration ratio is that it tends to be insensitive to mergers among dominant firms. For example, if firms A and firms C were to merge, the 5-firm concentration ratio would merely rise by 3 percentage points. This is a mere 4.3% increase in the ratio.

Herfindahl-Hirschman Index (HHI)

This problem is reduced by using an alternative measure of market concentration, the Herfindahl-Hirschman Index. The HHI is calculated as the sum of the squares of the market shares of the largest N firms in the market.

So before the merger, the 5-firm HHI is 0.1176. After the merger, the 5-firm HHI increases to 0.1835. This is a 56% increase in the index, suggesting that the potential merger has a significant impact on the market power of the top 5 firms. For this reason, the HHI is widely used by competition regulators in granting approvals to potential mergers.

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