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# Market/Industry concentration. Definition and causes of market concentration

What information would you want to know before entering a new market?

• How many firms are in the industry?
• How competitive is the market?
• Is there demand for my product/service?
• How much money will I need to enter?

What is market structure?
Factors or dimensions of a market that affect managerial decisions:

1. Number of firms in the industry
2. The relative size (ie. concentration) of firms in the industry
3. Technology/cost considerations
4. Demand
5. Ease of entry/exit

How could you measure the competitiveness of a market?
Industry Concentration

What does it mean for an industry to be concentrated?
An industry is “concentrated” when a few large firms control the industry (ie. Auto, Airline, etc)

How is industry concentration related to market competitiveness?
Industry concentration and market competitiveness are inversely related

How can you measure industry concentration?

C4
Four-firm concentration ratio (C4): the fraction of total sales generated by the four-largest firms in the industry (ranges from 0 = extrememly competitive to 1 = highly concentrated)

C4 = (S1+S2+S3+S4)/St = w1+w2+w3+w4

Sn = sales of the firm n
St = Total industry sales
Wn = market share of firm n

How can you measure industry concentration?

HHI
Herfindhal-hirschman Index (HHI): the sume of the squared market share of firms in a given industry multiplied by 10,000 (ranges from 0 = extremely competitive to 10,000 = monopoly)

HHI = 10,000 Σ Wn^2
=10,000 Σ (Sn/St)^2

Sn = sales of the firm n
St = Total industry sales
Wn = market share of firm n

What do C4 and HHI capture? Why are they useful?
-How crowded or competitive is the market
-Used by the Justice Department when determining whether to approve a merger

How do these two measures relate? How are they different?
-The measures tend to be positively correlated (ie. industries with higher hour-firm concentration ratios tend to have higher HHIs)
-C4 based on the largest four firms in the industry, while the HHI is based on the market shares of all firms
-HHI is based on squared market shares, while the C4 ratio is not, the HHI thus places greater weight on firms with relatively larger market shares

Limitations of the C4 & HHI
Questions you must ask before interpreting concentration ratios?
-Do the measures account for foreign imports?

• Do the relevant companies compete at a national, regional, or local level?
-In what product segments do firms actually compete?

Market Structure
-Refers to factors such as the number of firms that compete in a market, the relative size of the firms (concentration), technological and cost conditions, demand conditions, and the ease with which firms can enter or exit the industry.
-Structures affect the decisions the prudent manager will make.

Firm Size
-Changes in competitors’ strategies
or changes in market conditions can change a firm’s relative position within an industry—or potentially change the viability of the industry itself.

Industry Concentration
-Another factor that affects managerial decisions is the size distribution of firms within an industry; that is, are there many small firms within an industry or only a few large firms?
-The optimal decisions of a manager will depend on which concentration.

Concentration Ratios
-Concentration ratios measure how much of the total output in an industry is produced by the largest firms in that industry.
-The most common concentration ratio is the four-firm concentration ratio (C4).

C4 Ratio
-The fraction of total industry sales produced by the four largest firms in the industry.
-Let S1, S2, S3, and S4 denote the sales of the four largest firms in an industry
-St denote the total sales of all firms in the industry.

C4 = S1 + S2 + S3 + S4 /St

-Equivalently, the four-firm concentration ratio is the sum of the market shares of the top four firms:
where:

C4 = w1 + w2 + w3 + w4
w1 = S1/St
w2 = S2/St
w3 = S3/St
w4 = S4/St

-When an industry is composed of a very large number of firms, each of which is very small, the four-firm concentration ratio is close to zero.
-When four or fewer firms produce all of an industry’s output, the four-firm concentration ratio is 1.

HHI
-The Herfindahl-Hirschman index
-The sum of the squared market shares of
firms in a given industry, multiplied by 10,000 to eliminate the need for decimals.
-By squaring the market shares before adding them up, the index weights firms with high market shares more heavily.

HHI = 10,000 SUMMATION (w^2i)

-Value lies between 0 and 10,000.
-A value of 10,000 arises when a single firm (with a market share of w1 = 1) exists in the
industry.
-A value of zero results when there are numerous infinitesimally small firms.

Limitations of Concentration Measures

1. Global Markets
-That is, in calculating C4 and HHI, the Bureau of the Census does not take into account the penetration by foreign firms into U.S. markets.
-This tends to overstate the true level of concentration in industries in which a significant number of foreign producers serve the market.
2. National, Regional, and Local Markets
-In many industries, the relevant markets are local and may be composed of only a
few firms.
-When the relevant markets are local, the use of national data tends to understate the actual level of concentration in the local markets.
3. Industry Definitions and Product Classes.
-The definition of product classes used to define an industry also affects indexes.
-As a general rule, products that are close substitutes (have large, positive cross-price
elasticities) are considered to belong to a given industry class.

#### Industry Concentration

Industry concentration refers to the degree at which a small number of firms make up the total production.

##### Low concentrated industry
• All firms in the industry provide a significant production capacity in the market.
##### High concentrated industry
• A few top firms control the largest production capacity of the whole market which reduces competitiveness.

### Factors that increase market concentration

1. Concentration increases when innovation increases the size of some firms while lowering the cost of production. This result in firms’ economies of scale and the power to control prices and the market at large
2. Concentration can increase when the top firms gain control of important resources, squeezing out the smaller firms. This results in monopolistic, and oligopolistic markets, where few large firms control the market reducing competition.
3. Concentration can increase if few firms become technologically advanced over time, making production more effective and efficient.
4. Coordinated Interaction: A small group of firms exerts power over the market by cooperating in restricting output or by setting prices. This is common in oligopoly markets that involve firms with a stable market share, and which maintain common prices.
5. Differentiated products: In some markets, most products are differentiated in the eyes of the customers and other products are not considered good substitutes for one another. Firms that sell differentiated products may collude to set prices.
6. The similarity of substitutes: Market concentration is increased when two firms that sell equally-desirable products merge.

Market concentration can be managed at the detriment of some consumers.

#### References

• Brozen, Yale. Concentration, Mergers, and Public Policy. New York: Macmillan, 1982.
• Carlton, Dennis W., and Jeffrey M. Perloff. Modern Industrial Organization. 3d ed. Reading, Mass.: Addison-Wesley, 2000.

## Revision

What is Dual Product Market and what does it have to do with the entertainment industry?

1. The firm markets product or
service directly to the consumer.
2. Also sells advertising time or
space to other firms who wish to
reach their targeted consumers.
Common in the entertainment
industry. Ex: Super Bowl

Industrial Organization
How firms behave

Four Types of Market Structure:
Perfect Competition, Monopolistic Competition, Oligopoly, Monopoly

Perfect Competition
-There are so many firms that adding or taking away firms will not effect them. -There are no barriers to entry or exit.

Product: N/A
Barriers to Entry: High
Price: Maker
Ent. Ex: Pro Sports

Market Concentration
A market concentrated if it is dominated by a limited number of large firms.
Measures of concentration:
-CR8 (concentration ration of top 8 firms in a certain sector)
-CR4 (concentration ration of top 4 firms in a certain sector)
-HHI
-Lorenzo Curve

Lorenzo Curve
Graph that identifies the difference between perfect equity and what is actually happening

-Illustrates the inequality of maker share among different firms
-Best used when number of firms >4

Both CR4 and CR8 measure what?
The percentage of market share (usually in revenue) accounted for by the top 4 (CR4) or 8 (CR8) latest firms

An increase in concentration ratio suggests.. what?

A greater market power

Not sensitive to individual power held by a single firm

Criteria for CR4, CR8:
Concentration: CR4 : CR8
High : >(or equal to) 50% : (or equal) 75%
Moderate : 34% to 49% : 51% to 74%
Low :< (or equal to) 33% : < (or equal) 50%

The Herfindahl-Hirschman Index (HHI)
The Herfindahl-Hirschman Index (HHI) is a more sophisticated measure and is calculated by summing the squared market shares, expressed as percentages, for all firms in a given industry

-As the index increases, the # of firms declines indicating greater market power of the remaining firms

-Drawback: requires knowledge of the market shares of all firms

Criteria of HHI:
Concentration : HHI
High: : >1,800
Moderate: : 1,000 to 1,799
Low: : <1,000

4 Types of Pricing Policies under the conduct component of the IO model
-Depends on market structure type.
-The most observable behavior.

4 Common Types of Pricing:
1.Demand oriented pricing
2.Target return pricing
3.Competition oriented pricing
4.Industry norm pricing

Demand Oriented Pricing
Price is set via market forces of supply and demand

Target Return Pricing
Prices are based on the desired amount of profits

Competition Oriented Pricing
Prices are based on competitors prices- in oligopolies

Industry norm Pricing
Prices are set by the industry rather than the market (Ex: DVD, and CDs)

What are some legal tactics used in market conduct that also work as barriers to entry?
-Encompasses the entire range of legal actions used by firms.
-Works as a barrier to entry
-Patents & copyrights are most visible
•Patent disputes – smart phone
•Copyright disputes – piracy or use of audio and video content
-Public policy in the form of antitrust or competition legislation
•Collusion

Why does the entertainment industry lend itself to cultural objectives? What are some of theses objectives?
-Intent is that society is to be well informed on public issues and events and citizens are able to “share their stories”. (U.S. is a melting pot)

• Achieved through regulation, taxes and subsidies.
-Foreign ownership restrictions.
-Important for our society to share cultural stories

Productive efficiency
Is producing at the lowest cost for a given level of technology

From a economic and policy perspective, performance is viewed from a societal point of view.
-From a economic and policy perspective, performance is viewed from a societal point of view.

•Allocative efficiency
•Productive efficiency
•Technological progress
•Equity
•Cultural objectives
•Diversity of views

Allocative efficiency
Is producing what people want in an optimal manner: MR=MC (profit maximization)
-to be allocatively efficient a firm must be productively efficient.
-Does not work the other way around

Diversity of Views
Universally recognized by democracies as a desirable objective for media industries

-Implies that people are exposed to a wide- range of sources and opinions Ex: survivor on ABC, amazing race on CBS

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