market concentration
TRANSCRIPT
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.
Hypothetical Example:Herfindahl Index
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
Hypothetical Example: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:
How do I determine industry concentration for my proposed business?!
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.
How do I determine industry concentration for my proposed business?!
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?