Describe the 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 requires one to find the sum of the value of sales for the largest firms and divides them by the total market sales. Therefore, the resulting figure lies between zero (for perfect competition) and 100 (for monopolies).

Economists O.C. Herfindahl and A.O. Hirschman came up with an index which 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 (1/M). This is a very useful gauge for interpreting the HHI.

The main advantage of this concentration measure is the fact that it is simple to calculate. However, there are some limitations to using this method.

Limitations of the Concentration Ratio

First, this method cannot quantify the 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 as THE sugar company. However, the problem comes in when there exist large wholesalers in, say, the food sector. These wholesalers may decide to be importing sugar alongside their range of products. As a result, this will most likely convince the sugar company to set its prices like it’s in perfect competition.

Also, the concentration ratio tends not to be affected by mergers in 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 will not be accurately represented by the concentration ratio.

Question 1

The Herfindahl-Hirschman Index (HHI) is a method that first squares the market shares of the top N companies and then sums them up so as to find the concentration ratio. If a market has 5 suppliers and each supplier holds 20 percent of the market share, which of the following best represents the concentration ratio for the top 2 suppliers and their HHI?

A.  Concentration ratio = 4%; HHI = 40

B.  Concentration ratio = 40%; HHI = 0.04

C.  Concentration ratio = 40%; HHI = 0.4

Solution

The correct answer is B.

The concentration ratio is a 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 these is not a characteristic of the concentration ratio measure of market structure?

A. It is simple to compute.

B. It does not directly quantify market power.

C. It does not support the estimation of elasticity.

Solution

The correct answer is C.

As a matter of fact, analysts use the simpler measure of the concentration ratio to estimate elasticity.

Reading 15, LOS 15g:

Describe the use and limitations of concentration measures in identifying market structure

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