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101 Concepts for the Level I Exam

Concept 21: Concentration Measures


The two concentration ratios used to measure the market power of the firm.

N-Firm Concentration Ratio

  • Sum of the market shares of the N largest firms in an industry.
  • Market share = firm revenue / total market revenue.
  • Advantage: Simple to calculate and understand.
  • Disadvantages: Ignores barriers to entry, does not directly measure market power or elasticity of demand.

Herfindahl-Hirschman Index (HHI)

  • HHI = sum of squared market shares of N largest firms in a market.
  • Ranges from 0 to 1: where 0 indicates perfect competition and 1 indicates a perfect monopoly.

Consider the market share of the following firms:

Firm Revenue/Total market revenue
Bruce 30%
Clark 20%
Flash 15%
Peter 10%
Xavier 10%
James 5%

Compute the following 4-firm concentration ratio and the HHI.

  1. 4-firm concentration ratio prior to and post the merger of Bruce and Clark.
  2. HHI prior to and post the merger of Bruce and Clark.

Solution:

\noindent Solution:

1.Prior to the merger,
Four-firm\ concentration\ ratio=30+20+15+10=75\%
Post the merger, Bruce and Clark become one entity having a market share of 50\%.
Four-firm\ concentration\ ratio=50+15+10+10=85\%
Four-firm concentration ratio fails to capture the large increase in market share of the most dominant firm which has gone up from 30\% to 50\%, while the measure has only gone up by 10\%.

2. Prior to the merger,
HHI={0.30}^2+{0.20}^2+{0.15}^2+{0.10}^2=0.1625
Post the merger,
HHI={0.50}^2+{0.15}^2+{0.10}^2+{0.10}^2=0.2925
HHI shows a larger increase, better reflecting the increase in the market share of the new large firm.