CFA Level 1 Study Notes – Econom ...
Study Session 4 Reading 8 – Topics in Demand and Supply Analysis LOS... Read More
Monopoly markets and situations where companies hold pricing power can result in inefficiencies. Nevertheless, government agencies and regulators face the difficult task of assessing market power and determining if a firm has a dominant position. This requires regulators to measure whether future events that have not yet occurred might lead to excessive market power.
To gauge market power, one can estimate the elasticity of demand and supply in the market. If demand is elastic, the market exhibits characteristics similar to perfect competition. On the contrary, if it is inelastic, companies may possess market power.
A challenge arises because the observed values of price and quantity may not accurately reflect the true values of supply and demand. To calculate elasticity, a model with two equations is necessary: one for the demanded quantity and another for the supplied quantity. This, in turn, requires a substantial number of observations, leading to the additional problem of potential changes in market structure over the extended data collection period.
Alternatively, a cross-sectional regression analysis can be employed, where sales from various companies in the market are observed within a single period. Nevertheless, implementing this approach demands a significant effort in data collection.
To address these issues, we employ more straightforward metrics such as:
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.
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.
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.
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:
$$ \text{Concentration ratio} = 35\% + 20\% + 10\% =65 $$
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 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.
Economists OC 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. The Herfindahl-Hirschman Index (HHI) for a monopoly firm should equal 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.
This measure was developed to try and overcome some issues associated with the concentration ratio.
Using the same example as above, the HHI for the top three companies can be calculated as:
$$ HHI = {0.35}^2 + {0.20}^2 + {0.10}^2 = 0.1725 $$
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.
HHI does not consider barriers to entry.
Question
Which of the following best describes a market structure with only one buyer?
- Monopoly.
- Monopsony.
- 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?
- Concentration ratio = 4%; HHI = 40.
- Concentration ratio = 40%; HHI = 0.08.
- 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 \({0.20}^2 \times 2 = 0.08\).