Chapter 3:

Market Concentration

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 Expected Concepts:

• The meaning of market concentration

• Market concentration and structure
• Measurement of market concentration.
• Concentration and market performance
• Method to measure the monopoly power of firms.

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 3.1 Market Concentration
 Is when an industry or market is controlled by a small number of leading producers who are
exclusively or at least very largely engaged in that industry.
 It is also known as degree of seller's concentra­tion in the market.
 Concentration is a measure of the intensity of competition or of market control in a given
market/industry.
 It indicates the potential degree of competition in the market.
 It is an important element of the market structure which plays a dominant role in determining the
behaviour of a firm in the market.
 Two variables that are of relevance in determining such situation are:
1. The number of firms in the industry, and
2. Their relative size distribution. 3
 The major elements of market concentration:
• Concentration in the owner­ship of the industry
• Concentration of decision-making power
• Con­centration of the firms in a particular location or region

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 3.2 Measurement of Market Concentration and Monopoly Power
 The degree of market concentration would vary with the mono­poly power in a
particular industry.
 These indexes have similar things with a minor difference.
 The measures for monopoly power would be more appropriate at firm level.
 They indicate the actual monopoly power exercised by the firms.
 The measures of concentration on the other hand would give us the potential
monopoly power in the market or industry as a whole.
 The concentration is therefore a necessary condition for the monopoly power.

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 Hypothetical cumulative number of firms
Concentration Curves (Largest to smaller concentration curves)

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B. The concentration measure should be a function of the combined market share
of the firms rather than of the absolute size of the market or industry.
C. If the number of firms increases then concentration should decrease. However,
if the new entrant is large enough, then concentration may go up.
D. If there is transfer of sales from a small firm to a large one in the market, then
concentration increases.
E. Proportionate decrease in the market share of all firms reduces the concentration
by the same proportion.
F. Merger activities increase the degree of concentration.
There are several measures suggested for the measurement purpose.
All are equally good or bad.
Let us review them briefly before making a final comment in this regard.
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 A. The Concentration Ratio
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 B. The Herfindahl-Hirschman Index (HHI)
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 This index takes account of all firms in the market (i.e. industry).

 Their market shares are weighted by the market share itself.

 The larger the firm more will be its weight in the index.

 This index would be close to zero when there are a large number of equal-
sized firms;

 The maximum value for the index is one where only one firm occupies the
whole market. This is the case of a monopoly.
 The index will have minimum value when the n firms in the market hold an
identical share. 11
 HHI decreases as n increases.

 The index is simple to calculate and it is popular in use and consistent with the
theory of oligopoly because of its similarity to measures of monopoly power.

 The market is regarded as unconcentrated when this measure gives a value

below 1000 and as highly concentrated above 1800.

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 C. The Entropy Index

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 A value of zero for the entropy index would indicate that there is only one firm
in the market.

 The maximum value that can be taken by the entropy index in the case of firms
with equal market shares would be the log value of the number of firms in the
market.

 The advantage of this measure is that it can be decomposed to show how

different sub-groups (sizes, regions and products….. ) contribute to the overall
level of concentration.

 This may be useful for investigating markets containing strategic groups.14

 This coefficient in fact measures the degree of market uncertainty faced by a firm in
relation to a given customer.

 This will be the situation when number of firms is large enough, i.e. market is not
concentrated.

 For a monopoly firm (n = 1) the entropy coefficient takes the value of zero which means no
uncertainty and maximum concen­tration.
 Thus we find opposite (inverse) relationship between the entropy coefficient E and the
degree of market concentration
 The entropy coefficient is a useful measure of market concentration in the sense that the
population of the firms for which the entropy coefficient is to be computed can be
decomposed or disaggregated into several groups, say on the basis of sizes, regions,
products and the classification of indus­try etc.
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 If there is only one firm in the market (monopoly case), the index takes the value
of 0 (i.e. E = 0), it means no uncertainty and maximum concentration.

 That is the uncertainty for the monopolist in relation to whether it can keep a
random customer is at a minimum.

 Conversely, when all market shares are equal, the uncertainty is maximum, and

Si = 1/n. In this case E = n* 1/n* log n = Log n.

 In industry comprising n equal sized firms, the entropy index is equal to log n.

 So when E = 0, and n =1 it represents monopoly, no uncertainty.

 Observe that there is an inverse relationship between Entropy and market concentration 16
• Both increase in equality of market share and an increase in the number of firms increase
the entropy coefficient but the later factor plays a diminishing role because of the use of
logarithm which implies that addition of an extra firm, when number is already large
enough, becomes less significant from the point of view of market concentration.

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 D. The Lerner Index

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 E. The Profit Ratio

 This was suggested by Bain. According to him, when a firm persistently

earns excess profit for a long period of time, then it should be attributed
to its monopoly power.
 Monopoly power and profit rate are assumed to be linked positively.
 There is some operational significance of this index but it is not always
true that profits accrue because of monopoly power.
 The profit rate index for monopoly power is, thus, a weak proposition.
 It is unsatisfactory as well as unreliable.
 All are merely approximations based individually on some specific property of
the concentrated market.
 It may be difficult to develop a comprehensive index for measuring the market
power. 21
 Determinants of Concentration

 Many questions are raised in consuming concentration indices of different

industries across countries.

 Different authors have different perspectives on the determinants of

concentration.

 There are two approaches to the explanation of the determinants of

concentration. These are:

1. Deterministic approach

2. Stochastic approach
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 1. The Deterministic Approach
 This approach identifies i. Technology/economies of
specific factors that are scale/. Technology, through its
believed to determine the level influence on costs, is at the
heart of the SCP paradigm.
and extent of competition of
different industries across ii. Entry barriers;
time. iii. Mergers;
 In general economic or iv. Government policy;
‘natural’ factors are v. Technological change;
identified as determinants,
vi. Vertical integration;
which include:
vii. Market growth;
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 2. The Stochastic Approach

 Deterministic approach tries to explain the forces that determine

concentration while stochastic approach is concerned with actual
concentration change.

 In contrast to the deterministic approach, the stochastic approach emphasizes

that concentration reflects the net effect of a multitude of uncertain
influences affecting decisions and growth rates of individual firms.

 Among these could be factors such as the following:

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i. Effectiveness of advertising government policies,
campaigns, vii. Changes in managerial or
ii. The successful launch of new other personnel and
products, viii. Change in competitor’s price
iii. The impact of mergers, policy and many others.
iv. Changes in competitive ix. A host of other factors
behaviour influence a firm’s growth
v. Labour relations, the number pattern.
of strikes in a particular year,
vi. The exchange rate or other
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 The approach argues that chance plays a crucial role in explaining
concentration change.
• It is difficult to exhaustively identify the multiple determinant
variables
• It is difficult to determine the relative importance of each factor in
explaining growth of a firm
 So it is futile and unnecessary to attempt to examine the impact of
each separately.
 The combined effect of all these influences may, however, obey certain
rules.
 There are several stochastic models constructed to predict changes in
market concentration.
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 3.3 Concentration and the Market Performance of a Firm
 A firm with substantial monopoly power will tend to charge high price,
produce and sell less output, make high rates of profit, grow faster than
others, capable of doing anything it wants in connection with its business
such as R&D, advertisement and so on.

 Let us presume that concentration is an appropriate measure of such power,

we are then in a position to verify the various propositions of the econo­mic
theory which reflect the relationships between concentration and market
performance of the firm.
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 A. Concentration and Profits

 A firm derives market power or monopoly power in the situation of con­centration.

 Such market power, via market conducts activities or directly leads to an increase in the
profitability of the firm.
 It is frequently assumed that persistency of high rates of profits over a long period is the
conse­quence of high degree of intra industry concentration.
 J. S. Bain was the first to make an empirical study of this proposition, who found it valid
for the U.S. industries.
 The relationship was found so strong that Bain was to argue for the profit rate as an index to
measure the concentration.

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 B. Concentration and Price-cost Margins
 Price-cost margin is another way to define profitability.
 This is a short term view of profitability based on current sales and cost figures.
Say, the average price-cost margin is just a ratio of these two magnitudes.
 Empirical studies particularly those conducted by Collins and Preston
supported the positive relationship between concentration and the price-cost
margin for the American four digit industries.
 Shepherd also confirmed the positive relationship between them for most of the
U.S. industries.
 However (Koch and Fenili) looked at concentration acting as a surrogate for
other determinants of price-cost margins because of its being causally linked
with them.

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 C. Concentration and Growth of the Firm
 Here we will just mention how concentration is relevant for the growth of the firm.
 There are two different streams of thoughts to explain the causal relation­ship between
the two variables.
 According to one view, a firm with market power, as a consequence of
concentration, may prefer to maintain its high rate of profit by restricting the output
and charging high price.
 If it grows, it has to sacrifice some profit margin, and lower price which may not be
in its interest.
 Moreover, there will be all kinds of restrictions imposed by the government to stop
further growth of such firm.
 Thus, we expect that higher the monopoly power of the firm lesser may be its growth.
 The few firms in the concentrated industry may be dominant enough to restrict the
growth of the other firms and to stop the entry of new ones because of the various
barriers to entry at their disposal. 30
 There is, thus, very little prospective for the growth of the firms in a concentrated
industry and so for the over­all growth of the industry itself.
 There are some empirical studies where the inverse relationship between initial
market, concentration and, subse­quent market growth has been verified.
 The second view about the concentration and growth of the firm and hence of the
market, is a positive one.
 In order to maximize the long-term profit, firms may like to grow over time even under
market concentration.
 They may prefer to create excess capacity to meet the future growing demand and to
discourage new entry in the market.
 They may have some short-term sacrifice of profit in order to stimulate long-term
benefits.
 So, we find a case for the positive relationship between initial market concen­tration and
growth of the firms.
 The firms with market power may be finding themselves at ease regarding finances and
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other requirements of growth.
 D. Concentration and Technological Change

 Now let us look into, whether concentrated industries are the most research
oriented and technically progressive.
 It is true that the few firms who enjoy monopoly power in a concentrated
industry will be large enough.
 They will be having stability, financial resources and ability to initiate the
processes of R&D and gain the benefits from them.
 Dasgupta and Stiglitz, clearly showed the situation when market
concentration and innovative activities are positively corre­lated.
 Some scholars believed that it may not be the concentration but the other
attributes of market structure like size of firm, product differentiation
possibilities etc., which may be having collinearity with concentration and
thus causing a spurious positive corre­lation between concentration and
technological change. 32