7 Market Concentration Market concentration or, more specially, the degree of sellers’ concentra- tion in the market, is an important element of the market structure which plays a dominant role in determining the behaviour of a firm in the mar- ket. By market concentration we mean the situation 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. Two variables that are of relevance in determining such situation are: (i) the number of the firms in industry, and (ii) their relative size distribution. How these two dimensions cause different forms of the market structure having vital consequences for the pricing and output decisions of the firms, has been discussed in Chapter 4 under monopoly, oligopoly and perfect competi- tion, etc. That constitutes a part of the standard material on the traditional theory of the firm. In the context of industrial economics, however, the implications of market concentration are far wider than whatever we find in the theory of the firm. It will be our attempt in this chapter to focus on such implications in the framework of ‘market-structure-conduct-perform- ance’ link or any subset of this. For example, concentration in the own- ership of the industry, concentration of decision-making power, and con- centration of the firms in a particular location or region, etc., all being elements of market concentration, may have considerable impact on the market performance of the firms such as profitability, price-cost margin, growth, technological progress and content. These links are to be under- stood properly, because all of them are very much relevant from the point of view of decision-making and regulation of industries. This chapter will deal with the positive aspects of market concentration, leaving the regu- latory or normative side for a later chapter. As usual, the chapter will have few sections, each one dealing with a specific aspect of the market concentration. The first section will be devoted to some theoretical186 Industrial Economics implications of the concentration, the second one will deal with its meas- urement aspect, the next two will be devoted to empirical evidences about the concentration in industries and its impact on firm’s behaviour and performance and finally the policy implications will be analysed in brief. 7.1 MARKET CONCENTRATION: SOME THEORETICAL DEDUCTIONS Market concentration is a feature of the imperfect competition where few firms dominate the entire industry. To understand the mechanism by which market concentration determines the economic behaviour of such firms vis-a-vis that of others in the industry, we have to use some theoretical models or deductions which will, of course, be integral parts of the microeconomic theories of oligopolistic and monopoly markets. It is not necessary to review such theories again. A brief sketch of them has al- ready been presented in Chapter 4. Here let us concentrate on simpler approaches to show the relevance of the number of firms and their relative size distribution for the economic behaviour (conduct and performance) of the firms. Let us assume that there are few large firms along with many smaller firms selling a homogeneous product at a uniform single price. This is what we call as ‘homogeneous oligopoly’. The large firms will be having interdependence among themselves in the sense that variations in the price or supply of any one of them will have significant effect on the market supply, equilibrium market price and revenue of all other firms. This is certainly a situation of market concentration affecting the firms. It can be made explicitly known with the help of the following mathematical deri- vation. Let the total market supply for the product be specified as Q units and the market demand function be: P=f(Q)=fG,+Gt-..+G,+---+4) (7.1) where P = product price; g, = output of ith firm, i=l,...,nand ¥q,=Q. The revenue function for ith firm is given by R,=Pq, (7.2) Differentiating (7.2) with respect to q,, the marginal revenue for the ith firm will be as,Market Concentration 187 8, sp 80 BR Lp yg SP. 52 713 34, N30 Ba; (7.3) where 22 - 1, since an increase of one unit of output by ith firm means one unit increase in the total market supply. Equation (7.3) can be rewritten as, BR pf, %.O. AP 34, =r[ig P $| os) where q,/Q is the market share of the ith firm We have assumed uniform price for the industry which changes if ‘output of any big firm changes. Let us define ‘the market quantity elas- ticity of price’ (eg) as the percentage change in market price with a mar- ginal per cent change in the market quantity supplied,’ that is, eo=t5 P 75) Substituting (7.5) in (7.4), we get HE -P[1+4-0} = yee) (7.6) This equation shows that marginal revenue for the ith firm depends on product price, market share in output for the firm and quantity-elasticity of price. If the firms are of uneven sizes then the average marginal revenue for the firm in the industry be written as, 4 4 4 MR = 4 (MR,) + o (MR,) +... + o (MR,) 7) Market shares of the firms are being taken as weights to compute the average marginal revenue (MR). Making the substitution for MR,, MR, . .. MR, from equation (7.6) and simplifying, we get MR =P ! “3(3) «| ' R.L. Bishop, ‘Elasticities, Cross Elastic Eco. Review, 42 (1952), pp. 779-803. and Market Relationships’, Am.188 Industrial Economics or MR =P [1 +H - eg] (78) 2 where 2 (3) = H is the Herfindahl index of concentration. This equation says that average marginal revenue depends on product price (p), concentration index (H) and the elasticity coefficient (e) . If all n firms are of equal size then H = I/n which tends to zero as n becomes greater and greater as in competitive situation. If so, the marginal revenue will be almost equal to price. This is the familiar result for the competitive market. If there is only one firm then H = 1, and so we get the monopoly extreme of the market structure which is the most concentrated situation. Between these limits of H, we get the various degrees of market concen- tration, and marginal revenue for the firms varies in direct proportion of that, Remember eg is negative (it is inverse of the price elasticity of de- mand); the marginal revenue cannot therefore be greater than product price. Marginal revenue will be positive when eg is less than one which is the situation where price elasticity is greater than one, i.e. ep (- < 1, when e, > 1. The deviation of marginal revenue from the price is a direct consequence of the monopoly power prevailing in the market due to market concentration. In fact, this provides a measurement of the mo- nopoly power as we will see in the next section. Let us now examine the situation when firms are selling a differentiated product with different prices. If a large firm (or firm when there are only few of them) makes changes in the price and/or quantity of its product, it will affect the market shares of all other firms in the market. How the number of the firms and their relative size are relevant in this situation is the question before us to answer. A simple approach to analyse thi ation is provided by Bishop* who used the price and cross elasti this, According to him, when a firm makes changes in its product price, all other prices remaining same, the quantity of output supplied by the firm as well as by other firms will change. The responsiveness of the changes in quantity of outputs as a result of the price change is given by the price elasticity of demand for the firm and the cross elasticity of 2 ‘This index will be discussed in Section 7.2. 3 RL. Bishop, op. cit.Market Concentration 189 demand for the other firms. These elasticities have already been defined in Chapter 5. But in the present context, let us write them as, ba A 8, éi 4G = own elasticity = and (7.9) e,, = cross elasticity = ba i py, 4 where j stands for remaining n — 1 firms. Let ¢,, be —5. It means with one per cent decrease (or increase) in the price the firm finds five per cent increase (or decrease) in the sale of its product. When total market demand for the closely substitute goods is constant, an increase in the supply of any one variety means a decrease in the total supply of all other varieties by the same magnitude. Thus, when the firm gets 5 per cent increase in its sales, it means 5 per cent reduction in the sales of all other firms. And, if there are n — 1 remaining firms so each one will get 5/(n-1) per cent decrease in the sales by one per cent decrease in the price of ith firm. This means ey =~ S/n — 1). This shows the relationship between ‘own elasticity’ and ‘cross elasticity’ as, (7.10) where n is the number of firms assumed to be equal in size. If n is very large, e, will be very low tending towards zero. The impact on other firms becomes negligible. However, for a small group of firms, i.e. concentrated industries, ¢,, will be considerably high. It means, if we write (7.10) as, n-1l=- se (7.11) 7 The ratio of the two elasticity coefficients (own vs. cross) is giving us the number of firms in the market which is one aspect of the market concen- tration. If the firms are not of equal size still this ratio may be used as a ‘number equivalent’ to show the concentration as Bishop argued. In such situation the cross elasticities will have to be averaged by taking appropri- ate weights for the size differences of the firms. Inequality in the size distribution of the firms is a crucial factor for market concentration. In the case of larger firms, fluctuations in their outputs or prices will affect the outputs and prices of all other firms in the190 Industrial Economics industry but there may not be any such effect if a small firm changes its output or price. Since larger firms’ decisions affect the industry as a whole, they therefore, face counter policies from the rivals and so are interde- pendent on each other in this respect. This is an important feature of the oligopolistic or concentrated industries. A small firm, however, acts more or less independently since its policies are not going to affect the other firms significantly. Because of the interdependence in the market among the larger firms, they (ie. larger firms) prefer to have some kind of formal or informal collusion to avoid rivalry among themselves. When this would be the situation, we expect market performance to be different than what it would be if there is no collusion or concentration in the industry. The size distribution of the firms in an industry or market, thus, has important implications for market concentration independent of the number of firms. There are some other effects of the number and size distribution of the firms on business conduct. One of them is the ability of each firm in the market to keep watch over the activities of the other firms. For this, a firm has to devote considerable managerial efforts to collect the information about various aspects of the rival firms’ activities such as prices, products, sales activities, investment, etc, The cost of such information gathering or market intelligence increases with the increase in the number of firms of equal size. However, if the market is concentrated then only large firms are to be watched for this purpose. Lesser the number of such firms more intensive will be the check on them by the rivals. Whenever such firms adopt some secret policies in order to increase their sales or any other aspect of business, the probability of their being discovered by the rivals will be quite high because of the intensive inter-firm checks on each other and hence the probability of the retaliatory actions by them will be more.* All firms will be aware of this fact, so they may not deviate much from their established normal practices of business. In fact, as Stigler has shown, the expected variance of a firm’s sales due to random switching of cus- tomers will be least under such situation, that is when market is more concentrated.* There is another important aspect of the concentrated markets. If the market is having some price variation across the firms because of product differentiation or something else, the customers would then search for the lowest price supplier. If the number of suppliers is large enough, as in * See L. Hannah and J. Kay, Concentration in Modern Industry, London, 1977, Ch. 2 > G.. Stigler, ‘A Theory of Oligopoly’, Journal of Political Economy, 72 (1964), pp. 44-61Market Concentration 191 food stuff retailing, the search cost for the consumer may be quite high, more than the expected price reduction gain by the search. In the case of the concentrated markets, since there will be few a large firms dominating the market, it will be possible for the customer to initiate the search at a lower cost for the lowest price supplier, say, he has to collect only few price quotations in this situation.® The oligopolistic firms would be know- ing this fact well. They may, therefore, keep their prices almost at the same level to protect their individual interest. This may be one of the reasons for the price-stickiness in such a market. Using some theoretical deductions, what we have tried in this section is that concentration, that is, the degree in which an economic activity in the market is dominated by a few large firms, will have important imp] cations for the behaviour of the firms. To keep the material at introductory level only a few aspects of the concentrated firms were examined here. The complete theory of the oligopolistic or concentrated market is, how- ever, very much wider which is beyond the scope of this book.’ In the context of market concentration, one would naturally be inter- ested in knowing the factors that cause such a situation. While discussing the standard forms of market structure in Chapter 4 such factors have already been listed under monopoly market form. They are called as ‘bar- riers to entry’. All of them may be placed in the three general categories namely: (i) absolute cost advantages, (ii) product differentiation barriers, scale economy barriers. Absolute cost advantages may arise from (1) control of superior production techniques by established firms main- tained either by patents, or by secrecy; (2) exclusive ownership by estab- lished firms of superior deposits of resources required in production; (3) inability of entrant firms to acquire necessary factors of production (man- agement services, labour, equipment, materials) on terms as favourable as those enjoyed by established firms and (4) less favoured access of entrant © GJ. Stigler, ‘The Economics of Information’, Journal of Political Economy, 69, (1961), pp. 213-235. 7 For full theoretical discussion on concentration see Hannah and Kay, op. cit.; IN. Koch, Industrial Organization and Prices, Prentice-Hall, New Jersey 1974, Ch. 12-14; J.M. Blair, Economic Concentration: Structure, Behaviour and Pub- lic Policy, Harcourt Brace Inc., N.Y., 1972; W.J. Felner, Competition Among the Few, Knopt, N.Y., 1949; Paolo Sylos-Labini, Oligopoly and Technical Progress, Harvard University Press, Cambridge, Mass, 1962; GJ. Stigler, “The ‘Theory of Oligopoly’, J.P.A., 72 (1964), 44-61. Hay, D.A. and D.J. Morris (1991), op. cit., Ch. 3.192 Industrial Economics firms to liquid funds for investment reflecting a higher effective interest cost or in simple unavailability of funds in the required amount. Simi- larly, product differentiation advantages (or barriers to new firms) arise from (1) patent control of superior product designs by established firms; (2) the possible accumulated preference of buyers for established firms’ products and their reputation; (3) ownership or contractual control of fa- vourable distributive outlets by established firms, and (4) advertisement, marketing strategies, R&D and other conditions favourable to the estab- lished firms’. In the same way, scale economy barriers arise when (1) the real economies of scale accrue to the established firms by virtue of their having attained the minimum efficient size absolutely and in relative term to the size of the market, and (2) the pecuniary benefits accruing to the established firms as compared to new one. If economies of scale are large enough then the established firms are likely to have larger market shares and be able to inflict penalties on the newcomers and small firms. Further, there are other factors, like collusive activities of the estab- lished oligopolistic firms, pricing policies such as ‘limit pricing’ tactics, merger activities, and poor or inefficient economic administration by the government etc., which may perpetuate market concentration. We may say that certain imperfections in the market backed by some institutional forces (e.g. patents, licenses, controls) and technological forces (economies of scale etc.) cause concentration in the market. Which factors dominate in this is a matter which cannot be answered a priority. It requires empirical investigations. As mentioned above, the barriers to entry cause market concentration which is further reinforced by some barriers to exit. In principle business units are free to leave the market, i.e. close down. However, as seen in reality, there might be some market obstacles which restrict the option of the firms to close down. Sunk cost, compensation to workers and other staff members, loss of good-will in the market, long term contractual obligating and social pressure of employment maintenance, are a few of such factors which we call as barriers to exist. Greater the sunk cost more difficult will be to leave the market, similarly greater the compensation liability more difficult will be to leave the market by a firm. Large firms in a market will find it extremely difficult to leave the market as compared to smaller firms. The smaller firm may leave the market because of lesser impact of the barriers to exit but larger firm will remain in the market in spite of the loss in profit. The result is that the market concentration will go up when smaller firms leave the market but larger firms do not. Instead * J.B. Bain, Industrial Organization, pp. 260-261.Market Concentration 193 of closing down large firm prefers to be taken over by other firms or improve their market position by other ways, i.e. through diversification, R&D, change in organization and so on? 7.2 MEASUREMENT OF MARKET CONCENTRATION AND MONOPOLY POWER In order to test empirically the behavioural hypotheses about the firms and industries, we need a measurement of market concentration. Various quan- titative indexes have been suggested for this purpose which we are going to summaries in this section. Some of them are used to measure the mo- nopoly power of the firms and some for market concentration. These two terms, ic. monopoly power and market concentration, are closely interre- lated and cannot be separated from each other in the measurement proc- ess. The degree of market concentration would vary with the monopoly power in a particular industry, or we may also say that existing firms acquire monopoly power if market is concentrated. The indexes that we are going to discuss here would therefore be indicating to us almost simi- lar things with minor differences. The measures for monopoly power would be more appropriate at firm level. They indicate the actual monopoly power exercised by the firms. The measure of concentration on the other hand would give us the potential monopoly power in the market or indus- try as a whole. Obviously some firms would be having monopoly power in the situation of market concentration. If the number of firms and their relative sizes in the market are changing, we expect a change in the monopoly power of the firms. The concentration is, therefore, a necessary condition for the monopoly power although it is difficult to say that there is one to one proportionality between them. Before discussing the indexes it will be useful here to mention some general conditions or requirements which should be satisfied by each one of them. This helps us in screening the indexes while making the final choice for empirical work. The conditions are:!° PA. Geroski, Market Dynamics, Oxford, Basil Blackwell 1991 provides excel- lent discussion on barriers to entry; Caves, R.E. and Proter M., ‘Barriers to Exit’, in RJ. Masson and P.W. Qualls, Essays in Industrial Organization in Honour of J.S. Bain, Barlinger 1976. ' Hannah and Kay, op. cit., M. Hall and N. Tideman, ‘Measures of Concentra- tion’, J. of Am. St. Association, 62 (1967) pp. 162-168; C. Marfels, ‘Absolute and Relative Measures of Concentration Reconsidered’, Kyklos, 24 (1971), A.P. Jacquemin and H.W. De Jong, European Industrial Organization, The Macmillan Press Ltd., London, 1977, Ch. 2.194 Industrial Economics (a) The measure must yield an unambiguous ranking of industries by concentration. Consider Fig. 7.1 in which concentration curves, i.e. the graphs between cumulative number of firms from largest to smallest and cumulative percentage of market supply are shown by 1,, Ip 1 for three industries separately. 1, is above /, and 1, every- where. It means the industry which is represented by it is more concentrated than the other two. However, there is ambiguity in the ranking of the second and third industries represented by J, and [, respectively. Market supply cumulative % 4 ——h I ‘Cumulative |___ no of firms 0 4 8 12 (Largest to smallest) Fig. 7.1 Hypothetical cumulative number of firms (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 de- crease. However, if the new entrant is large enough, then concen- tration 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. The Concentration Ratio ‘The most popular and perhaps simplest index for measurement of market concentration or monopoly power of the few firms is the use of theMarket Concentration 195 concentration ratio, that is, the share of the market or industry held by some of the largest firms. The market share of such firms may be taken either in production or sales or employment or any magnitude of the market. In symbolic form the concentration ratio is written as C= P, m= 4,8, 10, 12,...,20,... im where P, = market share of ith firm in descending order. The normal practice is to take the four-firm (m = 4) concentration ratio but if the total number of firms operating in the market is large enough then one has to compute the 8-firm or even 20-firm concentration ratio to assess the situ- ation. The higher the concentration ratio the greater the monopoly power or market concentration existing in the mdustry. There are some limitations of this index. It does not take the entire concentration curve (as shown in Fig. 7.1) into account; it rather indicates market concentration at a point of the curve. The ranking of industries depends on the point chosen. If the point is changed there may be changes in the ranking of the industries also. This is the situation shown in Fig. 7.1 for 1, and /, curves. On the basis of the 4-firm concentration ratio, industry 3 is more concentrated than industry 2, but on the basis of the 12-firm concentration ratio the ranking is reversed. For the 8-firm concentration point both are equally concentrated. There is thus some ambiguity as to which point is to be chosen. Further, the concentration ratios depend to a great extent on how the market is defined. A board market would tend to reduce the computed concentration ratio whereas a narrow one would usually have the opposite effect. This means, in the standard industrial classification, the concentration ratios will be lower for the two-digit major industry group than the ratios for the three-digit industries in the same group. The data for the finer classification of the industries may not be available, hence it may be difficult to have precise idea of market concen- tration using the aggregate data. Moreover, it may not be comparable with other industries’ or countries’ data. There are other limitations also. The ratio do not reflect the presence of or absence of potential entry of firms; they, being based upon national figures, do not say anything about the regional market power; they do not describe the entire number and size distribution of firms, only a part of that is considered by them; they do not say anything about the monopoly power of the individual firms in the market and ignore the role of imports in the domestic market. The ratios may give conflicting picture of the concentration with the use of different variables for size of the firms. In spite of the limitations, the ratios are widely used in industrial196 Industrial Economics economics. They are simple to compute, readily available for the manu- facturing sectors, and capable of measuring market concentration with a finer classification of the industries. They are consistent with the economic theory, as we know that, other things being equal, monopolistic practices are likely to be in operation to a greater extent where a small number of the leading firms account for the bulk of any industry’s output than where the industry’s output is evenly distributed among the firms. The Hirschman-Herfindahl Index It is the sum of the squares of the relative sizes (i.e. market shares) of the firms in the market, where the relative sizes are expressed as proportions of the total size of the market.!! Symbolically, Herfindahl Index (H) = © (P,? where P, = q,/Q, q, is output of ith firm and @Q is total output of all the firms in the market, and n is the total number of firms. 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. 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. This will be equal to 1/n, that is a=E(1)=4 isin H decreases as n increases, Inverse of H gives us number equivalent meas- ure of the market concentration. The index is simple to calculate. It takes account of all the firms and their relative sizes, it is therefore popular in use and consistent with the theory of oligopoly because of its similarity to "' O.C. Herfindahl, ‘Concentration in the Steel Industry’, Ph.D. thesis, Columbia University, 1950; A.O. Hirschman, “The Paternity of an index’, American Eco- nomic Review, 54, (1964), p. 761.