INTRODUCTION:

Market concentration or, more specially, the degree of sellers’ concentration 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 market. 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. In the context of industrial economics the implication 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 implication in the framework of ‘market-structure-conductperformance’ link.

 MEASUREMENT OF MARKET CONCENTRATION AND MONOPOLY POWER : 

In order to test empirically the behavioural hypotheses about the firm and industries, we need a measurement of market concentration. Various quantitative indexes have been suggested for this purpose which we are going to summaries in this section. Some of them are used to measure the monopoly power of the firms and some for market concentration. These two terms, i.e. monopoly power and market concentration, are closely interrelated and can not be separated from each other in the measurement process. 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 similar 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 industry as a whole obviously some firms would be having monopoly power in the situation of market concentration. If the market 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 :

a) The measure must yield an unambiguous ranking of industries by concentration. Consider Figure 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 I₁ , I₂ , I₃ for their industries separately. I₁ is above  I₂ and I₃ 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 I₂ and I₃ respectively.

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 decrease. However, if the new entrant is large enough, then concentration 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 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 

where P_i = market share of i^th  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 20-firm concentration ratio to assess the situation. The higher the concentration ratio the greater the monopoly power or market concentration existing in the industry.

There are some limitations of this index. It does not take the entire concentration curve 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.___ for I₂ and I₃ 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 reserved. 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 broad 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 concentration using the aggregate data more over, 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 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 economics. They are simple to compute, readily available for the manufacturing 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, 

where,  P_i = q_i /Q, q_i  is output of i^th  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 

H decreases as n increases. Inverse of H gives us number equivalent measure 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 measures of monopoly power. Adelman has explored its properties extensively and related it directly to the concentration curve.

The Entropy Index :

This index has been suggested by Hart to measure the degree of market concentration. It uses the formula 

where E is defined as ‘Entropy Coefficient; P_i is the market share of ith firm and n the number of firm. This coefficient in fact measures the degree of market uncertainty faced by a firm in relation to given customer. This will be the situation when number of firms is large enough. i.e. market is not concentrated. For a monopoly firm (n = ) the entropy coefficient takes the value of zero which means no uncertainty and maximum concentration. Thus we find opposite (inverse) relationship between the entropy coefficient E and the degree of market concentration. If there are n firms, all equal in size, then 

Both, increased equality of market shares and an increase in the number of firms increase the entropy coefficient but the latter factor plays a diminishing role because of the use of logarithms which implies that addition of an extra firm, when number is already large enough, it becomes less significant from the point of view of market concentration. In terms of number equivalent the number can be measured as exp (E).

To take into account the number of firms as a determinant of the entropy coefficient one may use the relative measure of the entropy, i.e. the entropy coefficient E divided by the maximum value of the coefficient (log n).

This expression indicates the actual degree of dispersion of market share to the maximum dispersion possible for a given number of firms. The entropy coefficient is a useful measure of market concentration in the sense that the population of the firms for which the entropy coefficient is to be computed can be decomposed or disaggregated into several groups, say on the basis of sizes, regions, products and the classification of industry, etc. to compute separate entropy coefficients for them, a weighted sum of such coefficients would then give the overall entropy coefficient. Such a decomposition is not possible in the case of other indexes of market concentration. 

CONCENTRATION AND THE MARKET PERFORMANCE OF A FIRM

There are many behavioural hypotheses about concentration and market performance which we would like to discuss in brief in this section. As we read in microeconomics, a firm with substantial monopoly power will tend to charge high price, produce and sell less output, make high rates of profit, grow faster than others, capable of doing anything it wants in connection with its business such as R & D, advertisement and so on. Let us presume that concentration is an appropriate measure of such power, we are then in a position to verify the various propositions of the economic theory which reflect the relationship between concentration and market performance of the firm. This will naturally be based on the empirical evidence available so far but no attempt will be made to make an exhaustive survey of this here. Only few selected studies will be referred in connection with the individual hypotheses.

Concentration and Profits :

A firm derives market power or monopoly power in the situation of concentration. Such market power, via market conduct activities or directly leads to an increase in the profitability of the firm. It is frequently assumed that persistency of high rates of profits over a long period is the consequence of high degree of intraindustry concentration. J. S. Bain was the first to make an empirical study of this proposition, who found it valid for the U.S. industries. The relationship was found so strong than Bain was to argue for the profit rate as an index to measure the concentration. Since then there has been a flood of studies on the relationship which by and large supported this but some of them were, of course, very critical also.

There are some difficulties in establishing the correct relationship between the two variables (concentration & profitability) as both of them are subject to ambiguities of measurement which index of measurement is to be used for concentration? There are so many of them. If one measure is taken, it may have strong correlation with profitability, but if another is taken, it may have a weak relationship. Further, measurement of profit rates is also not free from bias. This is generally based on accounting data which ignores certain opportunity cost elements related to own funds or own labour of the entrepreneur in the business some arbitrary valuation are placed for such elements which may induct bias in the relationship. What denominator is to be used to compute profit rate is also not clear sales or assets or production or something like that. Researchers make their own choices for such rates, without giving the proper rationale for that. In spite of such difficulties we should not discard the relationship between concentration and profitability. It is a positive one which is consistent with the theoretical logic, through very precise estimation of which is yet to come.

Concentration and Price-cost Margins :

Price-cost margin is another way to define profitability. This is a short-term view of profitability based on current sales and cost figures. Say the average price-cost margin is just a ratio of these two magnitudes. Empirical studies particularly those conducted by Collins and Preston supported the positive relationship between concentration and the price-cost margin for the American four digit industries. Shephered also confirmed the positive relationship between them for most of the U.S. industries Koch and Fenili however, looked at the concentration acting as a surrogate for other determinants of price cost margins because of its being causally linked with them. they found it as an insignificant predictor of price cost margins when other relevant indicators of market structure like product differentiation, rate of technological change, etc. were also considered side by side. We may not agree with their findings simply because when all such determinants were taken together along with concentration, multicollinearity might have distorted their relationship making concentration insignificant. For its significance, there is a strong theoretical base which cannot be demolished because of statistical inadequacies of measurement. 

In a recent book, Hay and Morris have presented a summary table of 67 studies on market structure and profitability for the period 1971 to 1988. According to this, market concentration was found to be a significant determinant of profitability with expected sign in 28 studies, insignificant in an other 28 studies; and doubtful in the remaining studies. All this reveals that no specific generalization could be made about the relevance of the market concentration as a determinant of profitability although major support is coming for its being a positive factor as per the theory.

Concentration and Growth of the Firm :

The growth of the firm is a topic which requires a full chapter for discussion. Here we will just mention how concentration is relevant for this. There are two different streams of thoughts to explain the causal relationship between the two variables. According to one view, a firm with market power, as a consequence of concentration, may prefer to maintain its high rate of profit by restricting the output and charging high price. If it grows, it has to sacrifice some profit margin, and lower price which may not be in its interest. Moreover, there will be all kinds of restrictions imposed by the Government to stop further growth of such firm. Furthermore, static diseconomies of scale and numerous dynamic factors and bottlenecks all adversely affect the ability of such firm to grow. Thus, we except that higher the monopoly power of the firm lesser may be its growth. The few firms in the concentrated industry may be dominant enough to restrict the growth of the other firms and to stop the entry of new ones because of the various barriers to entry at their disposal. There is, thus very little prospective for the growth of the firms in a concentrated industry and so for the overall growth of the industry itself. There are some empirical studies where the inverse relationship between initial market concentration and subsequent market growth has been verified.

The second view about the concentration and growth of the firm and hence of the market, is a positive one. In order to maximize the long-term profit, firms may like to grow over time even under market concentration. They may prefer to create excess capacity to meet the future growing demand and to discourage new entry in the market. They may have some short-term sacrifice of profit in order to stimulate long-term benefits. So we find a case for the positive relationship between initial market concentration and growth of the firms. The firms with market power may be finding themselves at ease regarding finances and other requirements of growth. They would, therefore, like to avail the opportunities for that other things remaining the same. There are empirical evidences for such proposition also.

There are all kinds of problems in establishing which view is valid. The empirical studies differ in scope, coverage of period, data base and even measurement of concentration and growth. No definite verdict is, therefore, available from them. For the present, the relationship between concentration and growth of the firm and market, is an open issue for further verification.

Concentration and Technological change :

The issues related to technological change and market structure will be examined later on in a full chapter of this book. At this stage, let us look into one aspect of this, that is, whether concentrated industries are the most research oriented and technically progressive. It is true that the few firms who enjoy monopoly power in a concentrated industry will be large enough. They will be having stability, financial resources and ability to initiate the processes of R&D and gain the benefits from them. Dasgupta and Stigliz, in their papers clearly showed the situation when market concentration and innovative activities are positively correlated. There is no conclusive empirical evidence to prove such proposition. In fact, studies conducted by Williamson have shown quite opposite results. Doubts about this have also been expressed by Bliar. It may not be the concentration but the other attributes of market structure like size of firm, product differentiation possibilities, etc, which may be having collinearity with concentration and thus causing a spurious positive correlation between concentration and thus causing a spurious positive correlation between concentration and technological change. Nothing can be said in either way about the relationship. It is open for further empirical verification.

Concentration and other aspects of Market Performance :

We may briefly mention some other aspects of market performance which may be having some association with market concentration stability in the business, which may be judged either by persistency of profit rates or sales volume or market share, is one of them. Greater the market power of a firm the more we expect its stability. The uncertainties faced by the firm may be smaller. Further, if there is high concentration in the market the existing few large firms may maintain their size ranking in order to keep the leadership with them. If the size ranking of the firms, which is defined as ‘turnover’ is changing, this implies that the competitive forces are in action in the market. Lack of such a change, that is, of ‘turnover’ means a lack of competition and a possible tacit or alright collusion. 

 CONTESTABLE MARKETS :

A new type of market structure has been suggested by Baumol Panzar and Willing in 1982 which they named as contestable market. The theory of the market as propounded by them may be taken as an extension of the competitive markets but it has its own relevance in the context of industrial economics as we will see in the following overview of the theory.

Like any other type of market, the theory of contestable markets is based on certain fundamental assumptions.

1) There is at least one incumbent i.e. a firm already existing in the market, and one potential entrant to the market. Potential as well as incumbent firms are assumed to face same set of productive techniques and market demands.

2) There is no legal restrictions on market entry and exit.

3) There are no special costs that must be borne by any entrant as well as incumbent firms. In other words, the technology may offer scale economies but must not require sunk costs. It means that the capital investment is fully recoverable and mobile i.e. it is resaleable or reusable without any loss in earlier business.

4) Incumbent firms can only change prices with a non-zero time lag (price sustainability assumption) but consumers respond to price differences with shorter time-lag.

Given the above conditions a perfectly contestable market operates in a simple way. Incumbent, i.e existing firm in the market fix or post prices for their products. Their prices would remain unchanged for some time. A new firm enters (i.e. hits) the market with somewhat lesser prices for its products than that of the incumbent firms and earns more profit or sales by attracting customers from it rivals, i.e. incumbent firms because of price differences. The incumbent firm respond to the new prices in the market with a time lag after the new firm invades the markets. The incumbent firms may not have much cost disadvantages at this state. They can cut their prices by increasing the scale of production although it takes sometime. By reducing the prices by the incumbent firms some what below the prices of the entrant firm, they reestablish their market share and in fact may increase it attracting customers from the entrant firm. At this stage, the entrant firm leaves the market (i.e. runs away) since the retaliatory pricecuts by the incumbent firms leave no scope for profitable existence for the firm. There are no sunk costs so the firm would not face any problem of capital loss in leaving the market. Thus, the entrant firm may be regarding as following the ‘hit and run’ tactics in the market. This is a major characteristics of the contestable markets.

Suppose the entrant firm charges less prices for its products which are inferior than the product of the incumbent firms. Sooner the consumers will detect these facility products but before that the entrant firm runs away from the market. In the short period of stay in the market such firm makes lot of gains with no prospect of it if the firm continues in the market under the changed situation. 

The contestable market as briefly described above is different from the perfect competition. Although both the types of market assume frictionless free entry and exist, they differ on the number criteria. Under perfect competition the number of sellers and buyers has to be quite large so that each one of them is not able to influence the market individually but under contestable market there is no such restriction. This type of market may be in operation even with one incumbent and one entrant firms. Further homogeneity of the product assumption as under perfect competition need not to be equally valid for the contestable market. in fact, a contestable market paves the way for the multi product firms.

The theory of contestable market as developed by Baumol, Panzar and Willig is an important contribution in industrial organization. It provides the normative base for increase in industrial efficiency under effective threat from the entrant even under monopoly. However, from empirical or operational point of view it has several drawbacks. The assumption of price sustainability, perfect mobility of capital with no sunk costs, etc., may not hold true in practice. Further every firm in the market will be entrant at some point of time. If it follows the ‘hit and run’ tactics then how to justify the existence of the incumbent firms at all. It appears that the notion of ‘contestable market’ is a faulty one and it will take long time before the theory of constable markets is totally acceptable as a working model for operation.

SUMMARY

After going through this unit you will be able to measure the market concentration through the concentration ratio, the Hirschman-Herfindahl index, and the entropy index. You have also understood the connection between the concentration and the market performance.