When firms have significant pricing power, such as in monopolies, the market outcome is inefficient, which means that output is lower, and the price is higher than the perfectly competitive market outcome. Governments have enacted laws to regulate competition.
Regulators often have to measure the degree of concentration and pricing power, often on a what-if basis, which is a challenging task. Nevertheless, an analyst needs to consider the implications of competition (also called antitrust) laws when evaluating any merger transaction. Market pricing power is measured using either econometric approaches or simpler statistics such as concentration ratio and Herfindahl-Hirschman Index (HHI).
In the econometric methods, elasticities of demand and supply are determined. But this suffers from problems of endogeneity, which means that the observed elasticities are interaction of demand and supply and not solely demand or supply.
Elasticities are often calculated using regression analysis, but this requires analysis of a large amount of data. Time series analysis is also an option, but during the long period use, there might be changes in market structure, etc. which might impair the conclusion. Another option is to use cross-sectional data, but this requires extensive data-gathering and data inconsistencies.
The concentration ratio measures the percentage of total market sales made by top N firms.
Even though concentration ratio is simple to calculate, it has two serious drawbacks:
- Concentration is not a definitive measure of pricing power (for example, if barriers to entry are low, even highly concentrated market may lead to an outcome close to perfect competition), and
- The concentration ratio is is unaffected by mergers in the top N firms (for example, if first and second largest firms combine, pricing power would increase for sure, but concentration ratio would remain the same).
Herfindahl-Hirschman Index (HHI)
The Herfindahl-Hirschman Index (HHI) equals the sum of squared market shares of top N firms. If a market is controlled by one firm, HHI is 1 and if there are M firms with equal shares, the HHI would be 1/M.
HHI is commonly used by competition regulators, but, just like concentration ratio, it does not take into account any potential new entrants and elasticity of demand.
Which industry concentration measure most comprehensively considers the effect of industry mergers and acquisitions?
A) Concentration ratio
B) Herfindahl-Hirschman Index
B is correct. Even though there is some impact of a merger on concentration ratio, it is often small. HHI considers the effect of mergers and acquisitions.
Assume that there are only four accounting firms, and their market shares are 40%, 30%, 20%, and 10%. If the 3rd and 4th firms undergo a merger, which of the following is correct about the concentration ratio and HHI of the top four firms?
A) Both the concentration ratio and HHI would remain constant.
B) The concentration ratio would remain constant and HHI would increase.
C) Both concentration ratio and HHI would increase
B is correct.
Since there are only four firms, the four-firm concentration ratio (representing the whole market) would be 100% regardless of whether the merger goes through or not.
$$ Pre-merger HHI = (0.40)^2 + (0.30)^2 + (0.20)^2 + (0.10)^2 = 0.30 $$
$$ Post-merger HHI = (0.40)^2 + (0.30)^2 + (0.20 + 0.10)^2 = 0.34 $$