Question

Answer the following questions, which relate to measures of concentration: a. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are the shortcomings of concentration ratios as measures of monopoly power? b. Suppose that the five firms in industry A have annual sales of \(30,30,20,10,\) and 10 percent of total industry sales. For the five firms in industry \(\mathrm{B}\), the figures are \(60,25,5,5,\) and 5 percent. Calculate the Herfindahl index for each industry and compare their likely competitiveness.

Short answer

The four-firm concentration ratio indicates market control by the largest firms. Industry A (HHI 2400) is more competitive than Industry B (HHI 4300).

Step-by-step solution

Explain Four-Firm Concentration Ratio

The four-firm concentration ratio is a measure that sums the market shares (in percentage) of the four largest firms within an industry. A 60% concentration ratio indicates that the largest four firms control 60% of the market, suggesting a moderately concentrated industry. A 90% concentration ratio implies a highly concentrated market where the largest four firms hold a very competitive position, indicating less competitive and more oligopolistic behavior.

Identify Shortcomings of Concentration Ratios

Concentration ratios, like the four-firm concentration ratio, do not account for the distribution of market shares beyond the largest firms, making them less sensitive to changes among smaller firms. They also ignore the competitive dynamics like buyer power, and they do not consider international competition, which can significantly affect market conditions.

Understand Herfindahl Index Calculation

The Herfindahl index (HHI) is calculated by summing the squares of the market shares of all firms in an industry. It provides a more comprehensive view of market concentration than concentration ratios by accounting for the size distribution of all firms.

Calculate Herfindahl Index for Industry A

Calculate the Herfindahl index for Industry A: \( HHI_A = 30^2 + 30^2 + 20^2 + 10^2 + 10^2 = 900 + 900 + 400 + 100 + 100 = 2400. \)

Calculate Herfindahl Index for Industry B

Calculate the Herfindahl index for Industry B: \( HHI_B = 60^2 + 25^2 + 5^2 + 5^2 + 5^2 = 3600 + 625 + 25 + 25 + 25 = 4300. \)

Compare Competitiveness Using Herfindahl Index

Industry A, with an HHI of 2400, is more competitive and less concentrated than Industry B, which has an HHI of 4300. A higher HHI indicates less competition and greater market control by the leading entities.

Key concepts

Four-Firm Concentration Ratio

The Four-Firm Concentration Ratio is a popular metric used to gauge the concentration of power within an industry. This ratio focuses on the total market share held by the top four companies in the sector. If this ratio is 60%, it suggests that the four largest firms control 60% of the entire market. This indicates moderate concentration, meaning the market is somewhat competitive, but the large firms still have significant influence.
On the other hand, a 90% concentration ratio implies that the top four companies have a stranglehold on 90% of the market share, which points to a high level of concentration. Such a scenario can lead to oligopolistic tendencies, where the market behavior closely resembles monopoly characteristics.
However, the Four-Firm Concentration Ratio has some drawbacks. It doesn't consider the distribution of market shares outside the top four firms, which means smaller firms' performance gets overlooked. Moreover, it fails to address the competitive dynamics, such as the role of buyer power and international competitors, that could impact the market.

Herfindahl Index

The Herfindahl Index (HHI) is another valuable tool for evaluating market concentration. It provides a more detailed picture than simple concentration ratios by including all firms in the calculation. To determine the HHI, you square each firm's market share percentage, then sum all those squared figures. This approach sheds light on the impact of all competitors in the market, offering a fine-grained assessment of market structure.
For example, if an industry has five firms with market shares of 30%, 30%, 20%, 10%, and 10%, the Herfindahl Index would be calculated as follows:
\[ HHI = 30^2 + 30^2 + 20^2 + 10^2 + 10^2 = 2400. \]
A lower HHI indicates a more competitive environment, as is the case with Industry A, compared to a higher HHI, like that of Industry B, which suggests less competition and more concentrated market power. Therefore, the Herfindahl Index is an excellent indicator of overall industry competition and firm domination.

Monopoly Power

Monopoly Power refers to the extent of control a single firm or a small number of firms have over production and pricing in an industry. High monopoly power means that these firms can manipulate market prices without losing customers, primarily because alternatives are limited or nonexistent.
If the market shows a high Four-Firm Concentration Ratio or a high Herfindahl Index, it could indicate significant monopoly power within the industry. Such power often leads to higher prices and reduced innovation, as the dominant firms face limited pressure to improve or compete.
The drawbacks are profound as consumers face few choices and may endure lower-quality goods and services. Recognizing monopoly power is crucial for regulatory bodies aiming to maintain market fairness and competitiveness.

Market Shares

Understanding Market Shares is key to analyzing how much influence a company or a set of companies has in their industry. A market share refers to the percentage of total sales in the industry that a company earns. The larger a company's market share, the more concentration and control it likely has in that sector.
These shares are crucial for calculating both the Four-Firm Concentration Ratio and the Herfindahl Index. Analyzing market shares gives insight into who holds the majority of market power, which can suggest industry health and competitiveness.
For robust market analysis, one must recognize the relative sizes and influence of firms. An industry where a few firms hold the majority of market shares is typically less competitive than one where market shares are more evenly distributed. Therefore, monitoring market shares helps in identifying shifts in industry dynamics and potential monopoly power.