Friday, August 15, 2003

Measures of concentration

Two measures are commonly used by economists to judge the relative amount of concentration in any industry. They are the Concentration Ratio and the Herfindahl Index.

Concentration ratio
The concentration ratio is expressed in the terms CRx, which stands for the percentage of the market sector controlled by the biggest x firms. For example, CR3 = 70% would indicate that the top three firms control 70% of a market.

CR4 is the most typical concentration ratio for judging what kind of an oligopoly it is. A CR4 of over 50% is generally considered a tight oligopoly; CR4 between 25 and 50 is generally considered a loose oligopoly. A CR4 of under 25 is no oligopoly at all. We would add that a CR3 of over 90% or a CR2 of over 80% should be considered a super-tight oligopoly.

The problem with this measure is that CR4 does not indicate what the relative size of the four largest companies is. It may be that a CR4 of 80 means that one company controls 50% of the market, while the others have 10% apiece. That's a very different market structure than one where every firm has a 20% share.

Herfindahl (or Herfindahl Hirschman) index
The H index is a far more precise tool for measuring concentration. It is obtained by squaring the market-share of each of the players, and then adding up those squares

The formula for this index is: H  = (%S1)2 + (%S2)2 + (%S3)2 +.(%Sn)2 Here %S stands for the percentages of the market owned by each of the larger companies, so that %S1 is the percentage owned by the largest company, %S2 by the second, and so on. n stands for the total number of firms you are counting.

The H index gives added weight to the biggest companies. The higher the index, the more concentration and (within limits) the less open market competition. A monopoly, for example, would have an H index of S12 or 1002, or 10,000. By definition, that's the maximum score. By contrast, an industry with 100 competitors that each has 1% of the market would have a score of 12 + 12 + 12+ ...12 or a total of 100.

Now that we've seen the limits, a more typical situation might be a duopoly. If each of the two firms has a market shares of 50%, the H index would be (50)2 + 502 =2500 + 2500 = 5000. With two firms that have of 75% and 25% respectively, the H index would be: (75)2+ (25)2 = 5,625 + 625 = 6,250

A 1,000-1,800 value generally indicates moderate concentration. Anything over 1,800 is taken to betoken acute concentration. The US Antitrust Department has traditionally judged the "seriousness" of a merger by using the Herfindahl Index. If a merger or acquisition increases the index by 100 or more or pushes the overall index over 1,000, it is likelier to attract FTC scrutiny.

8:30:23 PM    
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