Identifying the Type of Market Structures

Monopoly markets and situations where companies hold significant pricing power can result in market inefficiencies, as the monopolies tend to constrain output in order to sell at higher prices. Due to this, many countries have a competition law that regulates the degree of competition in many industries.

Econometric Approaches

To gauge market power, one can estimate the elasticity of demand and supply in the market. If demand is elastic, the market is close to perfect competition. On the contrary, if it is inelastic, companies may possess market power.

We can use a time series or cross-sectional regression analysis to calculate the elasticity of a market.  In a time series analysis, we observe the behavior of a parameter over an extended period, for instance, a company’s annual sales for the last 50 years. Since the market situation may have changed over the chosen period, the estimated elasticity may not reflect the current situation.

A cross-sectional analysis entails analyzing different parameters, probably from different companies, within a specific time period, such as sales from different companies within a year; This may be complicated as it requires a substantial effort to gather data from across all selected companies.

To address these issues, we employ more straightforward metrics, as discussed below.

Concentration Ratio

The concentration ratio is the sum of market shares covered by the largest N firms in a market. It is determined by finding the sales value for the largest firms and dividing it by the total market sales.

The ratio lies between zero (for perfect competition) and 100 (for monopolies).

The main advantage of this concentration measure is the simplicity of its calculation.

Limitations of the Concentration Ratio

1. It fails to quantify market power directly, i.e., a high concentration ratio may not necessarily mean that a firm is a monopoly. For instance, a monopoly operating in a market structure with low barriers to entry may be forced to behave (price its products) like a firm operating in perfect competition.
2. It is not affected by mergers among the top market incumbents. For instance, if the top two companies merge, their combined pricing power will be greater than that of each of the two pre-existing companies. However, the concentration ratio may not change much.

Example: 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:

Concentration ratio = 35% + 20% + 10% = 65%

The Herfindahl–Hirschman Index (HHI)

The HHI first squares the market shares of the top N companies, then sums them up. The HHI is 1 for a monopoly firm, and  for M firms with equal market share.

The HHI was developed to try to curb some of the limitations of the concentration ratio.

Example: Herfindahl–Hirschman Index (HHI)

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

HHI = 0.35² + 0.20² + 0.10² = 0.1725

Limitations of the HHI

1. The HHI does not consider the elasticity of demand; thus, it cannot approximate the potential profitability of a single company or a group of companies.
2. HHI does not take the possibility of entry into account.

Question

Which of the following best describes a market structure with only one buyer?

1. Monopoly.
2. Monopsony.
3. Monopolistic competitive market.

Solution

The correct answer is B.

A monopsony has only one buyer.

A is incorrect. A monopoly has one seller but many buyers.

C is incorrect. A monopolistic competitive market has many buyers and fairly many sellers.

Question

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?

1. Concentration ratio = 4%; HHI = 40.
2. Concentration ratio = 40%; HHI = 0.08.
3. 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 \({0.20}^2 \times 2 = 0.08\).