Measuring the Concentration of Market Power

Market power, often calculated by the Herfindahl-Hirschman Index, has increased, within several industries, with the advent of globalization and digitization. But does more power mean more efficiency in market outcomes?

Shereein Saraf
Jan 4 · 4 min read
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With industrial development, technological advancement, and globalization, markets have become more concentrated and less competitive. Further, excessive regulations, or the lack thereof, play a part in increasing concentration. Evidence on markets and firms suggests that while the concentration of power has increased in the United States and Japan over the years, European firms follow a relatively mixed market structure. (OECD, 2018)

The microeconomic theory of market structures provides an analysis of the concentration of players in an industry. It does so by comparing their prices, outputs, and profits. The two extreme market forms in an economy are perfect competition and monopoly, but functionally various compound structures exist.

To trace firm-level and market-level prices, outputs, and profits, it is safe to compare the long-run equilibria of price competition and monopoly, which lies where marginal revenue equalizes marginal costs.

In the long-run equilibrium, perfectly competitive industries earn zero profits as they operate at the average total cost. To be simplistic, firms aim to profit and thus reduce the cost of production. Simultaneously, a large number of firms compete and have to bid their goods at competitive prices. So, firms have to choose to operate at the average total cost to earn a non-negative profit and keep them in business.

On the other hand, for a monopoly, profit will be higher than or equal to zero in the long-run equilibrium, depending on the costs curves. In this case, the firm need not produce at the minimum average total cost. Partly because the monopolist unilaterally sets the prices. And partly because the monopolist is producing lesser amounts of goods.

Comparing these two theoretical structures, it follows that perfect competition yields more efficient outcomes than a monopoly. As competitive markets have the least power in setting prices, it is a desirable policy outcome. Monopolies, on the other hand, dictate the prices by capturing considerable shares of market demand.

The policymakers intend to reduce the concentration of power in the hand of one or a few market players to maintain a balanced within the industry. One such way is by imposing regulations, especially anti-trust laws, to promote fair business.

However, measuring market concentration cannot be left to prices, output, and profits alone. It would require a detailed and sophisticated analysis. One such method is comparing the Herfindahl Hirschman Index of an industry.

The Herfindahl-Hirschman Index (HHI) is a measure of industry concentration. Mathematically, it is the sum of squares of market shares of the firms in an industry. It emphasizes that a positive relationship exists between market concentration and industry profits. The higher the index value, the more is the concentration of market power. The theoretical value of this index ranges from zero to 10,000. If there is a perfect monopoly, the index value would be equal to 10,000.

It accounts for the relative size distribution of the firms in a market, measuring competitiveness and concentration. The United States Department of Justice and the Federal Trade Commission use the Herfindahl-Hirschman Index to evaluate all horizontal mergers. If the post-merger Herfindahl index ranges from zero to 100, the market is highly competitive.

If it lies between 1000 and 1800, but the difference between pre and post-merger indices is less than 100, the merger can proceed. But, if this difference exceeds 100, other considerations are taken into account. Similarly, if the post-merger exceeds 1800, and the difference surpasses 100, the merger is anti-competitive.

Thus, the extent of the increase in the Herfindahl Index is much more important than the change in absolute value. However, in practice, these criteria are more lenient. Moreover, measures such as evidence of market performance, structural factors, ease of entry, and extent of price rise post the merger influences such decisions.

The oversimplified interpretation of the Herfindahl Index is appealing until the firms are of relatively equal sizes. The index does not account for economic and financial relationships within the industry, close substitutes present within the market, effects of foreign competition, or a highly concentrated but competitive market with a constrained supplier.

Further, the effect of mergers, and hence concentration, on competition is also ambiguous. Increased consolidation of power could indicate the existence of fewer players and, thus, less competitiveness. However, it could also represent competitive but more efficient firms, thereby increasing the index value.

The bottom line remains that whether competition or concentration, the market must maintain consumer welfare. The motivation behind anti-trust laws was keeping consumer welfare intact. As countries develop, industries prosper, and firm exhaust their economies of scale, smaller firms accumulate into one large corporation to cut costs and increase profits.

Concentration and competition are debatable depending on the structure of the market segment and the firms within it. For industries of strategic importance like power, mining, etc., concentration might lead to proper functioning and efficiency. But the market concentration of giant technology-driven corporations is harmful to the industry as it yields too much power in the hands of a few.

This article was originally published on What-if Economics. View and subscribe to my newsletter to get insights right in your mail.

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