This is “Seller Concentration”, section 7.5 from the book Managerial Economics Principles (v. 1.0).
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Sellers in oligopolies can limit competition by driving out competitors, blocking entry by new competitors, or cooperating with other sellers with market power to keep prices higher than would be the case in a market with strong price competition. In order for sellers to exercise market power, either the market will have fairly few selling firms or there will be some selling firms that account for a large portion of all the market sales. When this happens, the market is said to have high seller concentration. Although high seller concentration in itself is not sufficient for exercise of seller power, it is generally a necessary condition and constitutes a potential for the exercise of seller power in the future. In this section, we will consider two numerical measures of market concentration: concentration ratios and the Herfindahl-Hirschmann Index (HHI).
Both measures of seller concentration are based on seller market sharesThe percentage of all sales that are purchased from a particular firm.. A firm’s market share is the percentage of all market sales that are purchased from that firm. The highest possible market share is 100%, which is the market share of a monopolist. Market shares may be based either on the number of units sold or in terms of monetary value of sales. The latter use of monetary value is convenient when there are variations in the good or service sold and different prices are charged.
Concentration ratiosThe sum of the market shares of the firms having the highest market shares in a market; if the value for one firm is above 90, that firm may function as a monopoly. are the result of sorting all sellers on the basis of market share, selecting a specified number of the firms with the highest market shares, and adding the market shares for those firms. For example, the concentration ratio CR4 is the sum of the market shares for the four largest firms in terms of volume in a market and CR8 is the sum of the eight largest firms in terms of volume. The U.S. Census Bureau periodically publishes concentration ratios for different industries in the United States.See U.S. Census Bureau (2010).
Suppose a market has 10 sellers with market shares (ranked from high to low) of 18%, 17%, 15%, 13%, 12%, 8%, 7%, 5%, 3%, and 2%. The CR4 ratio for this market would be 63 (18 + 17 + 15 + 13), and the CR8 ratio would be 95 (18 + 17 + 15 + 13 + 12 + 8 + 7 + 5).
Although concentration ratios are easy to calculate and easily understood, there are two shortcomings. First, the number of firms in the ratio is arbitrary. There is no reason that a four-firm concentration ratio indicates concentration potential any better than a three-firm or five-firm concentration ratio. Second, the ratio does not indicate whether there are one or two very large firms that clearly dominate all other firms in market share or the market shares for the firms included in the concentration ratio are about the same.
An alternative concentration measure that avoids these problems is the HHIThe sum of the squared individual market shares of all the firms in a market; a value of less than 1000 indicates that a market should be reasonably competitive, whereas a value over 8000 indicates that the market has a firm that may function like a monopoly.. This index is computed by taking the market shares of all firms in the market, squaring the individual market shares, and finally summing them. The squaring has the effect of amplifying the larger market shares. The highest possible value of the HHI is 10,000, which occurs in the case of a monopoly (10,000 = 1002). If, on the other hand, you had a market that had 100 firms that each had a market share of 1%, the HHI would be 100 (1 = 12, summed 100 times). For the previous 10-firm example, the HHI would be 1302. Although there is no inherent reason for squaring market shares, the HHI includes all firms in the computation (avoiding the issue of how many firms to include) and reflects the variation in magnitude of market shares.
As far as interpreting these concentration measures, the following statements provide some guidance on the potential for market power by sellers:
Again, a high concentration measure indicates a potential for exploitation of seller power but not proof it will actually happen. Another important caution about these measures is that the scope of the market needs to be considered. In the case of banking services, even with the mergers that have resulted in higher seller concentration, if you look at measures of bank concentration at the national level, there seems be a loose oligopoly. However, if you limit the scope to banking in a single city or region, it is very likely that only few banks serve those areas. There can be modest concentrations when examining national markets but high concentration at the local level.