EconS 425 - Market Concentration and Power · 2017. 10. 6. · Market Concentration As you can see, measuring market concentration has its issues. We can use it as a proxy for market

EconS 425 - Market Concentration and Power

Eric Dunaway

Washington State University

[email protected]

Industrial Organization

Eric Dunaway (WSU) EconS 425 Industrial Organization 1 / 35

Introduction

One of the purposes of regulation is to reduce abusive market power.

Remember that regulators can break up rms, impose price ceilings,etc.

In order to do this, they need to be able to scientically measureindustries to determine their concentration and how much marketpower the rms wield.

And more importantly, if that market power is abusive.

Today, well look at a few measurements that regulators depend onwhen trying to determine a rms market power.


Market Concentration

The rst thing that a regulator would be interested in is the marketconcentration.

How much of the markets production is done by the largest rms?

There are two main measurements for rm concentration, theconcentration ratio and the Herndahl-Hirschman Index.

Both of these are easily calculated from government census data, theNorth American Industry Classication System (NAICS), whichseparates industries into relevant markets.Lets take a look at both of them.



One of the simplest measures to look at market concentration is theconcentration ratio (CR).

Basically, put the rms in order from largest to smallest.Then, ranking the rms on the horizontal axis, plot the cumulativemarket share that each rm has up to that point.

For example, if there were 3 rms that had a 30%, 50% and 20%share of the market, respectively, our three data points would be

(1, 50), (2, 80), (3, 100)



100

80

50

321

%

Rank



Lets look at a few more examples.

Consider a market with 10 rms, each having a 10% share of themarket.Next, a market with 10 rms, where the largest has 55% of the market,and the other 9 rms have 5% of the market each.Lastly, a market with 10 rms, where the largest 3 have 25% of themarket each, while the remaining 7 split the market evenly (3.57%each) .



100

50

105

%

Rank



As we can see, the second rm starts out much more concentratedthat the either rms, but as we expand to three rms, our nalexample becomes the most concentrated.

This is a potential drawback of the CR method.

A common measurement employed by regulators is the CRnmeasurement, which gives the market share of the n largest rms inthe industry.

Naturally the value of n is very important to our discussion.



Calculating the CR1, CR3, and CR10 values for our example,

First Second ThirdCR1 10 55 25CR3 30 65 75CR10 100 100 100

If the regulator were only looking at the CR1 value, it would appearthat our second market is the highest concentrated.

Likewise, if the regulator looked at the CR3. value, it would appearthat the third market were more concentrated.And if the regulator looked at the CR10 value (for some reason), all themarkets would appear to have the same concentration.



The drawback to the CR method is that it is heavily dependant onhow many rms a regulator looks at.

Common choices used are CR4, CR50 and CR100.

Furthermore, the CR method only tells us about the marketconcentration. It says nothing about how much market power a rmwields.

These two items are correlated, yes, but that usually isnt enough for aregulator to take action.



We can take care of the rst problem by using a concentration index;something that looks at the market as a whole.

The most commonly used one is the Herndahl-Hirschman (HH) Index.

The HH index takes each rm in the market and squares their marketshare, giving an index of the concentration.

HH =n

∑i=1s2i

where si represents rm is market share.



Going back to our examples, starting with the rst market,

HH1 = 102 + 102 + ...+ 102 = 1000

with the second and third markets,

HH2 = 552 + 52 + 52 + ...+ 52 = 3250

HH3 = 252 + 252 + 252 + 3.572 + ... = 1964

These results imply that market two is the most concentrated.

This should be fairly intuitive. Squaring the market size imposes hugepenalties to very large rms.



We can bound the HH index between 0 and 10,000.

A perfectly competitive market will consist of rms that serveapproximately 0 percent of the market.A monopolist serves 100% of the market, which entails a HH indexvalue of 10,000.

A few CR4 and HH Index values from the 2000 census,

CR4 HHBreakfast Cereals 78.4 2521.3

Pharmaceuticals & Medicine 34 506Household Refrigerators 84.5 1998.5

Paper Mills 25.8 259.3



The HH index solves a lot of the problems inherent to the CRnapproach.

Like I said before, it looks at the market as a whole. We wont have tolook at arbitrary cuto¤ points.Second, we can compare markets of di¤erent sizes. All of the examplesI gave were of the same size, but we could have a market with 20rms, etc. and we could still compare it with a market of 10 rms.

The HH index does not, however, directly measure market power.



As you can see, measuring market concentration has its issues.

We can use it as a proxy for market power, but that proxy may not bee¤ective.

There are other issues that cause issues for regulators, as well.

In measuring the market concentration, the markets, themselves, arearbitrarily dened. Its possible that substitutes for a good are not evenincluded in that markets calculations.For example, Pepsi denitely has other soft drinks as substitutues. Butwhat about fruit juices? tea? Those are all considered separate marketsin the government NAICS coding.



Furthermore, cost structures are not captured by this method.

When retailers deal with suppliers, their respective markets could havevery di¤erent structures (more on that later). If one structure wieldsmarket power, those costs must be passed on "downstream."

Also, there are local e¤ects, too.

Most newspapers serve regional markets.NAICS coding groups all newspapers together, so while a largenewspaper has a decent national market share (e.g., USA Today), itprobably has a smaller market share in each region.


Market Power

Truly, we want a way to measure market power.

Remember that market power is how much above marginal cost that arm can charge to a market.

There are several method used, but the most popular (and simplest)by far is the Lerner Index.

The Lerner Index measures what percent of a market price is economicprot for the rm. Mathematically,

LI =p �MCp


Market Power

LI =p �MCp

Note that the Lerner Index has an upper bound of 1 as priceapproaches innity or marginal costs approach zero.

A value of 1 for the Lerner Index represents absolute prots for themonopolist (Innite market power).A value of 0 would imply that p = MC and the market is perfectlycompetitive.

The Lerner Index can technically be negative. It would represent asituation where the rm was making economic losses.


Market Power

Why do we use the Lerner Index? It has a very useful simplication.Starting with a general prot function,

pq(p)� c(q(p))

and di¤erentiating with respect to p, yields

q + pdqdp� c 0(q)dq

dp= 0

Rearranging terms,

pdqdp� c 0(q)dq

dp= �q


Market Power

pdqdp� c 0(q)dq

dp= �q

Dividing both sides by dqdp and replacing c0(q) with MC ,

p �MC = � qdqdp

Now, I divide both sides by p to obtain the denition of the LernerIndex and I move q to the denominator to obtain,

p �MCp

= � 1dqdppq


Market Power

p �MCp

= � 1dqdppq

Recall that dqdppq is just the price elasticity of demand, ε. Thus, the

Lerner Index can be expressed solely by the price elasticity of demand.

LI =p �MCp

= �1ε

Remember that under normal conditions, the price elasticity of demandis negative, so the Lerner Index should be positive.


Market Power

LI =p �MCp

= �1ε

Why is this useful?

Economists love elasticities. They are among the easier things toestimate.In a log-log econometric model, the estimated parameters are allelasticities.

Thus, its actually possible to infer a monopolists costs (usually wellguarded information) if the researcher could observe the market priceand was able to estimate the price elasticity of demand.


Market Power

A few estimated Lerner Index values from Dobbelaere (2004)

Industry Lerner IndexMotor Vehicles 0.174Rubber and Plastic Products 0.314Beverages 0.294Milk and Dairy Products 0Chemical Products 0.205


Market Power

Harberger (1954) was able to use the Lerner Index to empiricallycalculate the deadweight loss from the presence of a monopolist.

While its easy for us to see deadweight loss in our models, in reality, weare missing a lot of information about the private costs of a monopolist.The total amount of deadweight loss (or a multiple of it) is a typicalne that would be imposed on a monopolist.

Remember the calculus denition of deadweight loss,

DWL =Z qCqM[p(q)� c(q)] dq

or, if we assume linear demand and cost functions,

DWL =12(p �MC )(qC � qM )


Market Power

DWL =12(p �MC )(qC � qM )

If we divide both sides by total revenue (pq), we have a proportion ofthe monopolists revenue that is lost due to its presence,

DWLpq

=12p �MCp

qC � qMq

Note right away that the Lerner Index already appears in this ratio.


Market Power

We need to reverse engineer an elasticity denition to keep going.Recall the price elasticity of demand,

ε =dqdppq

under linear demand, we can also write it as

ε =∆q∆ppq

where ∆ represents the di¤erence between the starting value and theending value.


Market Power

ε =∆q∆ppq

When we move from the monopoly price, p, to the perfectlycompetitive price, MC , we also move from qM to qC . In our elasticityformula,

ε =qM � qCp �MC

pq= �q

C � qMp �MC

pq

and rearranging terms, we have

qC � qMq

= �εp �MCp


Market Power

qC � qMq

= �εp �MCp

Substituting this back into our expression for DWLpq ,

DWLpq

=12p �MCp

qC � qMq

= �12

�p �MCp

�2ε

and remember that p�MCp = �1ε from the Lerner Index. Substituting,

DWLpq

= �12

�1ε

�2ε = � 1

2ε=LI2


Market Power

DWLpq

=LI2= � 1

2ε

Thus, we know that the deadweight loss as a ratio of total revenue forthe monopolist is just half of the Lerner Index.

This is really useful, since the total revenue is fairly easy to observe,giving us a value for deadweight loss.

Later work by Cowling and Mueller (1978) used this framework tocalculate that 4-13% of USA GDP was being lost to deadweight lossin the 1970s.


Market Power

Naturally, the Lerner Index has a few limitations.

If there exists more than one rm, and the rms are not identical,additional calculations must be done.Also, having a positive Lerner Index may not imply abusive marketbehavior if sunk costs are taken into account. The monopolist could betrying to recover his earlier investments.Likewise, cost saving technology among some rms in a market couldcause the Lerner Index to be underestimated.


Summary

Determining Market Concentration is a useful "rst-step" tool for aregulator to investigate whether a market is being subject to MarketPower abuse.

Using the Lerner Index, we can nd an e¤ective way to measuremarket power.


Next Time

First and Third Degree Price Discrimination

How to rms group consumers together to get the most out of theiridentifying marks?

Reading: 5.1-5.3


Homework 2-2

Consider a ve-rm industry in which all ve rms are initially thesame size with a market share of 20 percent each. Suppose that asthe result of an aggressive and successful advertising campaign, rm 1raises its market share to 25 percent, while the share of each of theother remaining rms declines to 18.75 percent.

1. What happens to the CR4 and the HH index as a result of this change?2. Which index do you think better captures the change in thecompetitive environment in this case?


Documents

EconS 425 - Market Concentration and Power · 2017. 10. 6. · Market Concentration As you can see, measuring market concentration has its issues. We can use it as a proxy for market