market concentration

Industry Concentration

How can you tell what market structure an industry is in?

(In other words, how do you know if a business in a monopolist, perfectly competitive, or something in between?)

Measuring an industry’s concentration

1. Concentration ratio

2. Herfindahl Index

If you watch “The Office” you’ve heard the about Herfindal index in Michael’s speech to the MBA class.

Questioner: What has happened to your Herfindahl index since the merger?

Michael: I don’t know. How is your “nerdsayswhat” index?

Questioner: What?

Michael: That is what I thought, Poindexter.

There are two ways to measure an industry’s

concentration. Interpreting that will allow you to see what market structure an industry

is in!

1. Concentration ratio

The concentration measures an industry’s concentration by examining the share of output controlled by the largest four firms in that industry

– This could be measured in terms of sales, value added, or other metric

– Data are published every 5 years by the Census Bureau in the Economic Census

Concentration Ratio

Hypothetical Examples: Concentration Ratios

Let’s assume this table describes the U.S. Dog Food Industry.Note that the largest firm had sales of $1 billion in 2006, which was 34% of the industry.

Note that the largest four firms added together had sales of $2.7 billion in 2006, which was 92.5% of the industry.

For this industry, the Concentration Ratio would be 92.5%. Production is heavily concentrated in the four largest firms.

Concentration Ratio

Hypothetical Examples: Concentration Ratios

Let’s assume this table describes the U.S. Retail Bakery Industry.Note that the largest firm had sales of $100,000 in 2006, which was 0.7% of the industry.

Note that the largest four firms added together had sales of $272,000 in 2006, which was 1.8% of the industry.

For this industry, the Concentration Ratio would be 1.8%. Production is NOT heavily concentrated in the four largest firms.

Concentration Ratio

Interpreting the Concentration Ratio0%

100%40%

Perfect Competition Monopolistic

CompetitionOligopolistic

Monopolistic

With a Concentration Ratio of 1.8%, the Hypothetical Retail

Bakery Industry is near Perfect Competition

With a Concentration Ratio of 92.5%, the

Hypothetical Dog Food Industry is near

Monopoly

Concentration Ratio

There is a problem with the Concentration Ratio

• If four firms share all output, their Concentration Ratio is equal to 100% but they are not a monopoly

• But if one firm is the sole producer, its Concentration Ratio is equal to 100% and it is a monopolist

Concentration Ratio

The Herfindahl Index solves this problem

The Herfindahl Index is calculated in three steps:

1. Determine the percent of output produced by each of the largest four firms

2. Square each of those share

3. Add all the squared numbers

Herfindahl Index

Hypothetical Example:Herfindahl Index

Herfindahl Index

Let’s assume this table describes the U.S. Dog Food Industry.Note that the largest firm had sales of $1 billion in 2006, which was 34% of the industry. That figure squared is 1,157 (34x34).

The same calculation was made for each of the four largest firms Those figures were then added.

For this industry, the Herfindahl Index is 2,415. We will interpret that figure soon.


Herfindahl Index

Let’s assume this table describes the U.S. Cat Food Industry.Note that the largest firm had sales of $1 million in 2006, which was 79.2% of the industry. That figure squared is 6,279 (79x79).The same calculation was made for each of the four largest firms

Those figures were then added.For this industry, the Herfindahl Index is 6,347. We will interpret

that figure soon.

Interpreting the Concentration Index0

10,000

1,000

Moderate Concentration

Acute Concentration

1,800

With a Herfindahl Index of 2,415, the hypothetical

Dog Food Industry is somewhat concentrated.

With a Herfindahl Index of 6,347, the hypothetical

Cat Food Industry is more heavily concentrated.

Herfindahl Index


Notice that the top four industries each comprise about 92%

of the industry…

But for cat food, the largest is really

dominant

The Concentration Ratio would look the same for these two industries, but the Herfindahl Index

really shows differences in

market concentration

Herfindahl Index

Why is this important?

• For self employed/ entrepreneurs: – It is a good idea to understand an

industry prior to entering competition within that industry

• For others:– It is a good idea to understand the

industry in which you are employed

How is this information used? Here is one real world application

• The US Anti-Trust Department uses the changes in the Herfindahl Index to decide if a merger between two companies is anti-competitive or not.

• An increase in Herfindahl Index value by 100 or level of over 1,000 is taken seriously.

Real World Data: What industries are heavily concentrated?

Moderate Concentration

Acute Concentration

I suspect seeing some of these

industries does not surprise you.

Industries that are concentrated have market power and are able to exploit

consumers.

In particular, you may feel it when you buy breakfast cereal or printer ink. These

goods seem quite expensive to me!

Think about industries that might be highly concentrated.

Can you guess some industries that appear on this list?

Click to see them.

Individual exercise

Please fill in the blank cells and answer the questions at the bottom.

About your business proposal

Please note that for your business proposal (and Mini Project #5), you are required to determine the type of market structure you will be competing in.

You may calculate either the Concentration Ratio or the Herfindahl Index (or both).

How do I determine industry concentration for my proposed business?!

Go to Google and type in the following:


Make sure you use data from 2007

Select “AFF” for the industry in which your

business will compete.*

*If you need help identifying your industry, please ask me.

Let’s assume I am proposing a business that will sell brick and stone

wholesale.


Once there, search for “concentration

ratios”. Look up your industry’s

concentration ratio based on its NAICS

code.

Look for the 4 largest firms.

Then find the Concentration ratio.

Here it is 24.4.

That means the 4 largest firms make up

24.4% of the industry.

Interpret the Concentration Index0%

100%40%

Perfect Competition

(0%-5%)

Monopolistic Competition (5%-40%)

Oligopolistic (40%-90%)

Monopolistic (95%+)

Brick Stone and related

merchandise wholesalers

(24.4%)

Once you have obtained the concentration ratio, use the spectrum below to interpret your business’ market structure

Note that these percentages are estimates and subject to interpretation.

Reflect on your market’s characteristics

You can then use the table to interpret the characteristics of the market you will be

competing in. Once complete, you’ll be able to answer key questions about your market!

Should I advertise a lot? And if so…do I product differentiate?

Do I have pricing power or am I a price taker?

Are my price changes dependent on other firms?

Can I expect tough barriers to entry?

market concentration

Education