Use and Limitations of Concentration Measures in Identifying Market Structure

Concentration Ratio

The concentration ratio is the sum of market shares covered by the largest N firms. It is determined by finding the sum of sales value for the largest firms and dividing it by the total market sales. Therefore, the resulting figure lies between zero (for perfect competition) and 100 (for monopolies).

The main advantage of this concentration measure is the simplicity of its calculation. However, there are some limitations to the usage of this method.

Example of Concentration Ratio

Suppose there are 10 producing companies in a market. The production percentages for the top three companies are 35%, 20%, and 10%. Calculate the concentration ratio for these three companies.

Solution

The concentration ratio is the sum of market shares covered by the largest N firms. So the concentration ratio for the first 3 companies are:

$$ \text{Concentration ratio} = \frac{35\%+20\%+10\%}{100%}=65%$$

Limitations of the Concentration Ratio

This method cannot quantify market power directly. The big question should be whether high concentration levels can be interpreted as an indication of monopoly power. An example is the case of only one sugar company in a country. This company enjoys monopoly power. However, the problem comes in when there exist large wholesalers in, say, the food sector. These wholesalers may decide to import sugar alongside their range of products. As a result, this will most likely compel the sugar company to adjust its prices as if it’s in perfect competition.

The concentration ratio tends not to be affected by mergers among the top market incumbents. If there exists a merger between the largest and second-largest companies, their combined pricing power is most likely to be larger than that of the two pre-existing companies, which the concentration ratio will not accurately represent.

The Herfindahl–Hirschman Index (HHI)

Economists O.C. Herfindahl and A.O. Hirschman came up with an index that first squares the market shares of top N companies. These squares are then summed up. For a monopoly firm, the Herfindahl-Hirschman Index (HHI) should be equal to 1.

Consequently, in the case of M firms with equal market shares, the HHI should be equal to \(\frac{1}{M}\). This is a very useful gauge for interpreting the HHI. This measure was developed to try and overcome some issues associated with the concentration ratio.

Example of the Herfindahl–Hirschman Index (HHI)

Using the same example as above, the HHI for the top three companies can be calculated as:

$$ \text{HHI} = 0.35^2+0.20^2+0.10^2=0.1725$$

Limitations of the HHI

The HHI does not consider the elasticity of demand, and thus it cannot approximate the potential profitability of a single company or a group of companies.

Question 1

If a market has 5 suppliers and each of the top two suppliers holds 20 percent of the market share, which of the following best represents the concentration ratio for the top 2 suppliers and their respective HHI?

A.  Concentration ratio = 4%; HHI = 40

B.  Concentration ratio = 40%; HHI = 0.08

C.  Concentration ratio = 40%; HHI = 0.4

Solution

The correct answer is B.

The concentration ratio is the sum of the two suppliers’ market share.

Therefore, 20% + 20% = 40%.

For the HHI, we take 0.20² × 2 = 0.04.

Question 2

Which one of the following is least likely a characteristic of the concentration ratio measure?

A. It is simple to compute

B. It does not directly quantify market power

C. It cannot be used to estimate elasticity

Solution

The correct answer is C.

As a matter of fact, analysts use the simpler concentration to estimate elasticity. On the other hand, the HHI does not consider the elasticity of demand and as such, cannot be used to approximate the potential profitability of a single company or a group of companies.