Measuring Market Power

Supplementary Notes

1
 STRUCTURAL APPROACH
n What are structural characteristics?
n The number of sellers
n Degree of product differentiation
n The cost structure
n The degree of vertical intergration with
suppliers

Industrial Organization - Matilde Machado Introduction 2

 STRUCTURAL APPROACH
n What is conduct?
n Price
n Research and development
n Investment advertising
n What is performance?
n Efficiency,
n Ratio of price to marginal cost
n Product variety, innovation rate and
n Profits and distribution
Industrial Organization - Matilde Machado Introduction 3
 n

Industrial Organization - Matilde Machado Introduction 4

 1.1. Concentration Measures
In the majority of markets, the level of competition lies between
the two extremes of Perfect Competition (minimum
concentration) and Monopoly (maximum concentration).
***Concentration measures offer a simple way to measure
the proximity of the competition level of a given market
to these two extremes.

2 reasons why concentration measures are useful:

Ø To compare different markets (inside and outside the

country)
Ø To help in market regulation. The regulator needs to
assess the level of competition of markets in order to
safeguard the consumer’s welfare.

Industrial Organization - Matilde Machado Introduction 5

 1.1. Concentration Measures
Concentration Indices should be:
Ø Easy to compute
Ø Independent of the market size
Ø Easy to interpret for example if the range
is an interval:
Î [ 0,1]

Perfect Monopoly
Competition

Industrial Organization - Matilde Machado Introduction 6

 1.1. Concentration Measures
q Concentration measures are related to
concentration curves
q A concentration curve describes the relation
between:
v the accumulated percentage of the total
production/sales in the market and the
accumulated number of firms in the
market ordered according to the firms’
size.
Industrial Organization - Matilde Machado Introduction 7
 1.1. Concentration Measures
The inequality in firms’ sizes is expressed by the concavity of the
concentration curve

% A B Cº D
production 100

Straight lines = equal

size firms (lowest
concentration)

0
5 10 20
Nº of firms
Market A is the more concentrated; Market D is the least concentrated; The
curves B and C lead to an ambiguous classification (market B has less firms
but less size inequality).
Industrial Organization - Matilde Machado Introduction 8
 1.1. Concentration Measures
Hannah and Kay (1977) listed the characteristics
that a concentration index should have (notice
that the concentration index is a summary of the
information contained in the curve):

A. Classification according to the concentration

curve: For example, the index should classify
market A as more concentrated than market B.

B. Principle of Transfer of Sales: A transfer of

sales from a small firm to a large one should
increase the concentration index
Industrial Organization - Matilde Machado Introduction 9
 1.1. Concentration Measures
C. Entry condition – The entry of a small firm (keeping constant the
relative shares of the existing firms) should decrease the
concentration index. The opposite in the case of an exit of a small
firm.

Note: The entry of a sufficient large firm may increase concentration. E.g.,
Trade Kings entry into the Maheu and water business

D. Merger Condition – The merger of 2 or more firms should increase

the concentration index since the merger may be decomposed as ≈

Transfer of sales + exit of the smallest firm

↑ concentration ↑ concentration

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 1.1. Concentration Measures
Examples of Concentration Indices:
1
1. The inverse of the number of firms = n
q Ideal when all firms in the market are of the same size
§ Which Zambian industry can we consider for this index?
q Only uses information about one point on the concentration
curve, the point where the concentration curve crosses the line of
100% accumulated production.
q Does not satisfy the Hannah and Kay criteria of “transfer of
sales” since a transfer of sales (keeping the number of firms
constant) does not affect the index.
§ Why is this the case?
§ Because they are all SMALL firms
Industrial Organization - Matilde Machado Introduction 11
 1.1. Concentration Measures
2. The Concentration Ratio = Cr - is the sum of the market shares
of the largest ‘r’ firms in the market
r
qi
Cr = å si where si =
i =1 Q
• It is easy to compute since we only need information on the r
largest firms
ér ù
• It is easy to interpret since: Î ê ,1ú
ën û
Minimum
concentration Maximum
– n equal size concentration
firms, si=1/n

Industrial Organization - Matilde Machado Introduction 12

 1.1. Concentration Measures
Critics to the Concentration Ratio = Cr :
1. r is arbitrarily chosen
2. Only takes information from 1 point of the concentration curve. For example
industries B and C have different ranking depending on the value of r
100 B C
r=5 Cr(B)=Cr(C)
r<5 Cr(C)>Cr(B)
r>5 Cr(B)>Cr(C)

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 1.1. Concentration Measures
3. A transfer of sales may not affect the index.
- The index may take the same value for two industries
when in fact one of them is much more concentrated
than the other. For example, in the next table, the two
industries have the same C4 but industry 1 is more
concentrated than 2.

Table 1 s1 s2 s3 s4 s5 C4
Industry 1 0.6 0.1 0.05 0.05 0.05 0.8
Industry 2 0.2 0.2 0.2 0.2 0.2 0.8

Industrial Organization - Matilde Machado Introduction 14

 1.1. Concentration Measures
3. Hirschman-Herfindahl index
2
n n
æ qi ö
H = å s = åç ÷
2
i
i =1 i =1 è Q ø

1. Takes into account all points of the concentration

curve (it is, therefore, harder to compute since one
needs information on all firms in the market)

1. Satisfies all the criteria of Hannah and Kay

2. H=1 (monopoly) y H=1/n → 0 (for the case of many

firms of equal size –
perfect competition) Introduction
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 1.1. Concentration Measures
1
4. n =
*
= Equivalent Number (n*), represents the
H
number of equal size firms that would give rise to the
same value of the concentration index (H). n* facilitates
the interpretation of the concentration index. For
example H= 0.385 Þ n*=2.59 (this means the market is
as concentrated as a market with n* firms of equal size)

5. Gives more weight to larger firms ( in the formula the

weight to each market share is the market share).

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 1.1. Concentration Measures

Table 2 s1 s2 s3 s4 s5 s6 s7 s8 H
Industry 1 0.6 0.1 0.05 0.05 0.05 0.05 0.05 0.05 0.385

Industry 2 0.2 0.2 0.2 0.2 0.2 0 0 0 0.2

Contrary to the result obtained using C4, H shows that industry 1 is more
concentrated than industry 2

Industrial Organization - Matilde Machado Introduction 17

 1.1. Concentration Measures

Maximum Minimum
concentration concentration
Industrial Organization - Matilde Machado Introduction 18
 1.1. Concentration Measures
n To assess whether price is above marginal cost,
one has to be able to measure or estimate
marginal cost. This is usually hard.
n Alternatively estimate the price-elasticity of the
residual- demand. This summarizes the ability of
the firm to raise prices and still keep some of
its demand in other words its market power.
n If the elasticity is high, little market power, if
low then a lot of market power.

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 1.1. Concentration Measures
Let’s do an experiment…

Suppose you are a monopolist facing an unknown

demand curve.
How should you set the optimal quantity?…and
let’s also see how much market power you
have.
 1.1. Concentration Measures
n Most empirical studies find residual-demand
elasticities of no more than 5 or 10, which implies
using this formula that price is between 25% and
11% above marginal cost
p - MC 1 1 5
= = Û p = MC
p ei 5 4
p - MC 1 1 10
= = Û p = MC
p e i 10 9

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 1.1. Concentration Measures
n In some cases economists can neither estimate
marginal costs nor residual demand elasticities.
In those cases market shares and
concentration measures are used. High market
shares are usually taken as evidence of market
power (BUT market shares are imperfect
indicators of market power).

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 Chicago School
n Demsetz questions the causality in the
SCP model of large firms leading to big
profits
n Well run and efficient firms become both
large and earn big profits
n Policy implications are completely
different to those of the SCP approach; if
profits are the reward for efficiency then
penalties on the former discourages the
latter!

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 Other approaches /1
n Austrian ; allocation of resources
determined by the ‘votes’ of the
consumers given their ability to spend
n If the entrepreneur guesses correctly
what the consumers want he gets a lot of
the ‘votes’ (profits)
n Hence large profits are the essential
ingredient for the market to adjust to the
consumers wishes

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 Other approaches /2
n Schumpeterian: Big firms are essential for
innovation and in particular for large
technological leaps: they have both the
ability and the willingness to spend big
money for major projects.
n Large market size means market power;
but this is needed for the large R&D
investments to be undertaken and to be
successful.

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 ORTHODOX THEORY
REVISITED
n Markets are imperfect because information is
imperfect.
n Introducing imperfect information and the use
of game theory provides a foundation for
strategic behaviour (conduct!) by the firms.
n Equally in the context of shareholders and
managers in managerial models behaviour can
be explained using the principal-agent theory.
n These theoretical developments are the re-birth
of the orthodox theory and constitute the
theoretical foundations of the new Industrial
Organisation.

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 Feedback mechanisms
n Structure determines conduct, but there
is also a feedback mechanism:
n E.g. successful strategies by a firm eliminate
rivals and make the market more
concentrated
n Government policy and competition
legislation in the form of antitrust and
regulation seeks to affect both
n Conduct of firms may affect government
policy (e.g. lobbying)

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 New industrial organisation
n The key features of the new industrial
organisation are;
n Emphasis on specific industries
n The emphasis on developing models of
firm behaviour
n Empirical work is founded on firm
behaviour

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 New industrial organisation
n Non-coperative game theory consist of
tools that are used to model choice of
agents when the payoff depends on the
choices of other agents
n Payoff interdependency is not monopoly
or perfect competition
n Focuses on nature and form of rivalry in
concentrated markets

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 New industrial organisation
n Strategic decision involves product
characteristics and capacity
n Tactical decision involve short term
actions given current environment e.g
price and output.
n Strategic decions make a firm to follow
a pricing policy or production level

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