Measuring Market Structure

1. Measuring Market Structure

2. Concentration ratios We have seen that the two polar extremes of market structure are monopoly, with one firm, and perfect competition, where there are many firms. Plus, we saw that the perfect competition situation was more efficient in the sense that total surplus for producers and consumers together was maximized. In the real world of business we see the number of firms varies from industry to industry. In an attempt to find a numerical measure to indicate which industries are more like monopoly and which are more like competition, concentration ratios were devised. Concentration ratios typically use sales as the concept used in the numerical measure.

3. Concentration ratios • CRn is the sales added across the n largest firms in an industry divided by the total industry sales(and then multiply the result by 100 to be in percentage terms). For example, CR4 is the sales of the 4 largest firms added together divided by total sales in the industry. • Examples • Monopoly industry –> CR4 = 100, • Industry with 4 firms of equal size (25% of sales for each) -> CR4 = 100. • Can you tell which of the examples above has only one firm by just looking at the CR4? Of course not!

4. More examples: • 10 firms, each with 10% of market -> CR4 = 40, • 4 firms, each with 10%, and 30 firms, each with 2% -> CR4 = 40. • Here we have two examples of industries where the CR4 is the same. But we see the remaining firms after the top 4 are very different in each example. You would see this by looking at the CR8, but not all the time. So, another measure has been added and the measure considers all the firms in an industry. The measure is the HHI

5. Herfindahl-Hirschman Index – HHI • To get the HHI we need the market share of each firm in percentage terms. Then we square the market share of each firm. After this, simply add the squared market share of each firm to get the final number. • Examples • Monopoly -> HHI = 1002 = 10,000. This is as big as you can get. • 4 firms with 25% each -> HHI = 252 + 252 + 252 + 252 = 2500 • 10 firms each with 10% -> HHI = 10 times 102 = 1000. • 4 firms with 10%, 30 firms with 2% -> HHI = 4 times 102 plus 30 times 22 = 400 + 120 = 520.

6. HHI The closer the HHI is to 10,000 the more the industry is like a monopoly. The closer to 0 the more the industry is like a competitive industry. Issues with CR4 or HHI How do we define a market? At issue is how narrow or broad do we define the industry. Is aluminum foil and waxed paper in the same market? What about that plastic wrap that gets all stuck together before you cover the food? Should that be included with the aluminum foil and waxed paper? The issue raised has to be settled before we can even calculate the CR4 or the HHI.

7. The Census Bureau looks at firms that have similar production processes and considers them to be in the same market. But, this method may not be useful if consumers do not consider different products with similar production processes to be substitutes for each other. The cross price elasticity of demand The cross price elasticity of demand is defined as the percentage change in the demand for good x given the percentage change in the price of good y. Example If the price of Pepsi (and only Pepsi in this example) goes up we would expect the demand for Coke to rise. So the cross price elasticity of demand is positive for substitutes and we would expect goods in the same market to have a high numerical value for the cross price elasticity.

8. Geography Most studies have considered concentration ratios for the country. Local ratios need to be considered. If you look at the services of real estate agents, then concentration ratios at the national level are probably small. But, in many towns there is only one agent. Local ratios could be large. Ratios at the national level do not include foreign firms that actually compete. This means that some industries will appear more concentrated toward monopoly when, in fact, if you include the foreign firms the ratios would be lower.

9. Vertical integration Goods and services are the end of a process of transforming inputs into those goods and services. Just think of a loaf of bread. The wheat needed to be grown. Then the wheat is sent on to millers. The miller sends on the “stuff” to the baker. From the baker the item might go to a distributor and then the retailer. The more that one firm is involved in all stages of the production process, the more vertically integrated the firm is said to be. With this in mind, there are some industries that are not vertically integrated and this would suggest low concentration. But this could be misleading because all the firms in the “stream” of production are tied to the main product.

10. The authors of our text use the example of Coke and Pepsi. There are many bottlers around the country and this leads to low concentration. But in the soft drink industry you and I know Coke and Pepsi are the dominant players. So, what have we done here? We listed numerical measures of concentration designed to show what type of market structure an industry might have. Plus, we indicated some ideas we need to be aware of as we look at these measures.

11. http://www.usdoj.gov/atr/public/guidelines/horiz_book/toc.htmlhttp://www.usdoj.gov/atr/public/guidelines/horiz_book/toc.html The link above is to a web site at the Department of Justice dealing with horizontal mergers – companies in the same line of business. Note section 1.5.