Analysts are interested in investing in markets with high pricing-power as it drives profitability. If there are very few large firms in an industry, then the price tends to be high and the quantity supplied low. When there is a possible merger, analysts should consider the impact of competition law (anti-trust law) as regulators might prevent the merger to keep the industry competitive. In many countries, competition law has been introduced to regulate the degree of market competition in different industries of different countries.
Econometric approaches can be used for measuring market concentration or market power. Some key points in this context are as follows:
Simpler approaches to estimate elasticity that avoid the drawbacks in regression analysis include the N-firm concentration ratio and Herfindahl-Hirshman Index (HHI).
N-Firm Concentration Ratio and HHI
N-Firm concentration ratio: It is the sum of the market shares of the largest N firms. It is almost zero for perfect competition and 100 for monopoly.
For example, in an industry, assume the five largest firms in the industry have a market share of 25%, 15%, 10%, 10% and 10%. The 5-firm concentration ratio would be 70%.
Herfindahl-Hirschman Index (HHI)
Simple and commonly used by regulators.