Subject 7. Identification of Market Structure

Measuring market power is complicated. Ideally, econometric estimates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elasticity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures.

The N-firm concentration ratio is the percentage of market output generated by the N largest firms in the industry. The ratio is used as an indicator of the relative size of firms in relation to the industry as a whole. It may also assist in determining the market form of the industry. The larger the measure of market concentration, the less competition exists in the industry.

The concentration ratio is simple to compute. However, it does not directly quantify market power, meaning it does not take the possibility of entry into account. Another disadvantage is that it ignores mergers among the top market players.

The Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman index is the sum of the squared market shares of the top N largest firms in the industry.

H = M12 + M22 + M32 + ... + MN2

where Mi is the market share of an individual firm.

Suppose there are a total of four firms in a specific industry. Three firms have a 20% share each and one has a 40% market share, H = 0.202 + 0.202 + 0.202 + 0.402 = 0.28.

The advantages of the Herfindahl index are that it reflects more firms in the industry and it gives greater weight to the companies with larger market shares.

Properties of the Herfindahl index:

  • It is always smaller than or equal to 1. In a monopoly, the HHI is 1.
  • One can classify the competition structure of a market based on this ratio. For example,

    • An H below 0.1 indicates a competitive market.
    • An H of 0.1 to 0.18 indicates moderate competitive.
    • An H above 0.18 indicates uncompetitive.

  • If all firms have an equal share, H = N x (1/N)2 = 1/N. Note that the reciprocal of the index shows the number of firms in the industry.
  • When the firms have unequal shares in the industry, the reciprocal of the index indicates the "equivalent" number of firms in the industry. Using the above example, the market structure is equivalent to having 1/0.28 = 3.57 firms of the same size.

Limitations: HHI fails to consider barriers to entry and firm turnover. For example, for some industries, few firms may be currently operating in the market but competition might be fierce, with firms regularly entering and exiting the industry. Even potential entry might be enough to maintain competition.

User Contributed Comments 7

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Shelton: All firms have equal shares => H=1/N
AmyJ: How do you classify an industry that has a four firm concentration ratio between 40% and 60%?
mikeburns: the higher the number for concentration ratio (4-firm or HHI) the more concentrated the competition, i.e. less competitive
cleopatraliao: Concentration ratio&market share r 2 different things...so theres no direct relationship btn concentration ratio&the HHI.
schweitzdm: HHI is not mentioned in LOS
TUNG: schweitzdm: HHI is included in the required reading, summary and textbook questions! I am positive it's required knowledge for us.
fzhou: Also note that 1+2+...+N=1 in the formula H=M_1^2+M_2^2+...M_N^2