Question

Is it true that a merger between two firms that are already in the top four by size can affect both the four-firm concentration ratio and the Herfindahl- Hirshman Index? Explain briefly.

Short answer

Yes, it is true that a merger between two firms that are already in the top four by size can affect both the four-firm concentration ratio and the Herfindahl-Hirshman Index. When two top firms merge, their combined market share will generally be higher than their individual market shares, leading to an increase in the four-firm concentration ratio and a more concentrated industry. Moreover, the Herfindahl-Hirshman Index will also increase as the combined market share of the merged entity will result in a higher squared market share, indicating a more concentrated industry post-merger.

Step-by-step solution

The four-firm concentration ratio is an indicator used to measure the concentration of an industry. It is calculated by summing the market shares (usually in percentage terms) of the top four firms in the industry. A higher concentration ratio indicates a more concentrated industry, while a lower concentration ratio suggests a more competitive industry with many smaller firms. #Step 2: Understanding the Herfindahl-Hirshman Index (HHI)#

The Herfindahl-Hirshman Index (HHI) is another measure of market concentration, which is calculated by summing the squares of the market shares (in percentage terms) of all firms in the industry. HHI provides more weight to larger firms, as their squared market shares will be significantly larger than the smaller firms. The HHI can range from 0 (in the case of perfect competition with an infinite number of firms) to 10,000 (in the case of a monopoly where one firm has 100% market share). #Step 3: Impact of a Merger on the Four-Firm Concentration Ratio#

When two firms that are already in the top four by size merge, their combined market share will generally be higher than their individual market shares. Consequently, the four-firm concentration ratio, which is calculated by summing the market shares of the top four firms in the industry, will increase due to the merger. This implies that the industry will become more concentrated following the merger. #Step 4: Impact of a Merger on the Herfindahl-Hirshman Index#

A merger between two top firms will also affect the Herfindahl-Hirshman Index. As the HHI is calculated by summing the squares of the market shares of all firms in the industry, the combined market share of the merged entity will result in a higher squared market share for that entity. This will lead to an increase in the HHI, indicating a more concentrated industry post-merger. In conclusion, it is true that a merger between two firms that are already in the top four by size can affect both the four-firm concentration ratio and the Herfindahl-Hirshman Index, as the concentration of the industry will generally increase as a result of the merger.

Key concepts

Four-firm concentration ratio

Understanding the measure of industry concentration is crucial for analyzing market competition. The four-firm concentration ratio is a simple indicator of how much market power the top four largest firms hold in an industry. To calculate it, we add up the market shares of these top players. Suppose the largest four firms in an industry have market shares of 30%, 25%, 15%, and 10% respectively. When you sum these percentages, the four-firm concentration ratio is 80%. This ratio reveals that the industry is highly concentrated since the majority of the market is controlled by just a few firms. If the percentage is lower, it suggests a more competitive landscape with numerous participants vying for market share. It's vital to recognize that changes within these top firms, such as a merger, can significantly impact this ratio and thereby affect overall market concentration.

Herfindahl-Hirshman Index (HHI)

Delving deeper into market concentration measures, the Herfindahl-Hirshman Index (HHI) serves as a more sensitive tool compared to the four-firm concentration ratio. To compute the HHI, we square each firm's market share and then sum these squares across all firms in the industry. For example, if our industry has firms with market shares of 30%, 25%, 15%, and 10%, the HHI will be the sum of 900 (30% squared), 625 (25% squared), 225 (15% squared), and 100 (10% squared), resulting in an HHI of 1850. Representing the total of the squared market shares, the HHI reflects not only the size distribution among firms but also emphasizes the presence of very large companies. A higher HHI indicates a higher level of concentration, suggesting potential anticompetitive effects in the industry. Since squaring gives more weight to larger market shares, even small changes among top firms, such as a merger, can cause significant swings in the HHI value.

Market Share

At the core of these concentration ratios lies the concept of market share, which signifies the portion of sales within an industry that a particular company controls. Calculated as the company's sales divided by the total sales of the industry, it's often expressed as a percentage. For instance, if a company has sales of \(1 million in a market totaling \)10 million, its market share would be 10%. Market share is a direct indicator of a company's competitiveness and its clout in the marketplace. Significant shifts in market share can occur due to events like mergers, innovation, or changes in consumer preferences. These fluctuations have direct implications for the concentration of the industry, which in turn can influence market dynamics and competitive strategies.

Industry Concentration

The term 'industry concentration' encapsulates the overall distribution of market share among companies within a particular market. High industry concentration means that a few firms dominate the market, which could lessen competition and increase prices for consumers. Conversely, low industry concentration suggests a competitive market structure with many small players. Determining industry concentration is essential for policymakers and regulatory bodies when considering antitrust laws and competitive practices. The four-firm concentration ratio and the Herfindahl-Hirshman Index (HHI) are two of the primary tools used to assess industry concentration. Their calculation and interpretation help to gauge the level of competition and the potential for market abuse by dominant firms.