1. Chapter 3. Market Structure and Market Power
Measures of market structure: concentration curve, concentration ratio, and HHI
Definition of market
Measure of market power: Lerner Index
Empirical measures of monopoly

2. Introduction Industries have very different structures
numbers and size distributions of firms relative to the size of the market
ready-to-eat breakfast cereals: high concentration
newspapers: low concentration
How best to measure market structure?
concentration curve is possible
But a single index may be preferable
Concentration Ratio or Herfindahl-Hirschman Index (HHI)
SCP model: given market structure => how firms behave in such a market.
New IO: how the firm’s strategic behavior can affect the structure of the market.
Both agree that the market structure affects what happens in the market place.
The natural question is: how can we characterize a market’s structure in a meaningful way.
Some markets have just two or three firms. Some have 10 or 12 of unequal size. When there are 20 firms, does it matter if one firm has 60 % of the market and the other 19 have just a bit more than 2 percent each?
Alternatively, can we measure market structure in such a way that enables us to make some inference of market power?
Can we creat an index that allows us to say how close or how far a market structure is from competitive ideal?

3. Illustrative Concentration Curve Rank Size Cumulative Market Share CR4
100 B 80 C 60 A 40
Arrange market share from the largest to the smallest.
Market share for the largest firm, the sum of the next two largest firms, the sum of next three largest firms…….
Industry A has 10 firms and each has 10 % of market share
Industry B has 21 firms: the largest has 55% of market share; the remaining 20 firms all have 2.25%
Industry C has 8 firms: the first 3 have 75% with 25% each; the remaining 5 have 5% of market share for each.
Drawback of CR- the industry concentration ratio ranks differ by CRn. 20
Rank Size 4 8 12 16 20

4. Measure of concentration
Compare two different measures of concentration:
Firm Rank Market Share Squared Market (%) Share
625 25
625 25
625 25
CRn is the market share of the top n firms.
Cr4 and Cr8
HHI = summation of squared market share, si. 25 25 25 25
Concentration Index
CR4 = 80
H = 2,000

5. } } } Concentration index is affected by, e.g. merger
Firm Rank Market Share Squared Market
(%) Share
Assume that firms
4 and 5 decide
to merge 25
Market shares
change
625 25
625 25
625 } 5 } 25 } 10
100 25
The Concentration
Index changes 25
The advantage of HHI over CR: HHI reflects the combined influence of both unequal firm sizes and the concentration of activity in a few large firms. That is, rather than just reflect a single point in the concentration curve, the HHI provides, in a single number, a more complete sense of the shape of that curve. HHI is preferred to CR. 25 25
Concentration Index
CR4 = 80 85
H = 2,000
2,050

6. Measurement Problem: What is a market?
No clear consensus
the market for automobiles
should we include light trucks; pick-ups SUVs?
the market for soft drinks
what are the competitors for Coca Cola and Pepsi?
With whom do McDonalds and Burger King compete?
Presumably define a market by closeness in substitutability of the commodities involved
how close is close?
how homogeneous do commodities have to be?
Does wood compete with plastic? Rayon with wool?
Measurements of a market structure, CRn or HHI, are based on an assumption that we can clearly identify a well-defined market.
Automobile industry: is it relevant to passenger cars or should we include trucks, vans, motorcycles…..
Does Pepsi compete only against other carbonated beverages, or other beverages such as bottled water, fruit juices, iced teas, milk…….?
Without clear definition of market, any summary stat for market structure is arbitrary.

7. Market definition 2 Definition is important
without consistency concept of a market is meaningless
need indication of competitiveness of a market: affected by definition
public policy: decisions on mergers can turn on market definition
Staples/Office Depot merger rejected on market definition
Coca Cola expansion turned on market definition
Standard approach has some consistency
based upon industrial data
substitutability in production not consumption (ease of data collection)
Typically economists measure substitutability in consumption by the cross price elasticity of demand.
eta_ij = (dq_i/dp_j )(p_j/q_i)

8. Market definition 3 Government statistical sources (Census Bureau)
Standard Industrial Classification (SIC)
From 1997, North American Industry Classification System (NAICS) after the North American Free Trade Agreement (NAFTA)
The measure of concentration varies across countries
Use of production-based statistics has limitations:
is based on similarity of production process rather than the substitutability of consumption which can put different industry products in the same market
The international dimension is important
Boeing/McDonnell-Douglas merger
relevant market for automobiles, oil, hairdressing
The census bureau categorizes the US market into manufacturing, primary metals, agriculture, and forestry and each has numeric codes => subdivided further two digit codes, three digits, 4, 5 and 6 levels. => compute total outputs of each market => Cr4 and HHI

9. Market definition 4 Geography is important
- Geographic boundaries of market: one or two competitors for local newspaper/ many competitors nationally; considering foreign trade, market share in production basis differs from market share in consumption basis
Vertical relations between firms are important
most firms make intermediate rather than final goods
firm has to make a series of make-or-buy choices
upstream and downstream production
measures of concentration may assign firms at different stages to the same industry
do vertical relations affect underlying structure?
Cr4 and HHI tend to have problem with the geographical and vertical consideration.
Upstream market – Raw material phase
Downstream market – processing/retailing

10. Market definition 5 In sum: market definition poses real problems
Firms at different stages may also be assigned to different industries
bottlers of soft drinks: low concentration
suppliers of soft drinks: high concentration
the bottling sector is probably not competitive
In sum: market definition poses real problems
existing methods represent a reasonable compromise

11. The Role of Policy Government can directly affect market structure
by limiting entry
taxi medallions in Boston and New York
airline regulation
through the patent system
by protecting competition e.g. through the Robinson-Patman Act

12. Measuring Market Power/Performance
Market structure is often a guide to market performance
But this is not a perfect measure
can have near competitive prices even with “few” firms
Measure market performance using the Lerner Index
P-MC
Highly concentrated => the industry does not have many small firms i.e., a few firms
Lerner index: how well a market performs from an efficiency point view => measures how far the outcome is from the competitive ideal
LI = P

13. Market Performance 2 P-SsiMCi LI = P
Perfect competition: LI = 0 since P = MC
Monopoly: LI = 1/h – inverse of elasticity of demand
With more than one but not “many” firms, the Lerner Index is more complicated: need to average.
suppose the goods are homogeneous so all firms sell at the same price
Si = market share
P-SsiMCi
LI = P

14. For a competitive firm:
For a monopoly firm:

15. Lerner Index: Limitations
LI has limitation:
Measurement: as with “measuring” a market
Depends on market definition
Meaning: measures outcome but not necessarily performance
Difficult to measure MC/sensitive to functional form and specification
if there are sunk entry costs that need to be covered by positive price-cost margin => high LI even if there are numerous firms
low price by a high-cost incumbent to protect its market while keeping a low cost rival from entering the market => low LI even if there small number of firms (LI shows competition deceptively)
Like Cr4 and HHI, LI is a summary measure
The difference is that the LI is not so much a measure of how an industry’s production is structured as is a measure of the market outcome. The greater is the LI, the farther the market outcome lies from the competitive case- the more market power is being exploited => LI is the direct measure of market competition.

16. Welfare loss from Monopoly
 CS = -(A + B)
 PS = (A - C)
DL =  CS +  PS
= - (B + C) d P MC A B Pc C D MR Q Qc

17. Empirical Application: How Bad is Market Power Really?
Harberger (1954) exercise - Welfare Loss (WL) is: 1
WL =
(P – MC)(QC – Q) 2
Welfare Loss in relation to sales: WL 1
(P – MC)
(QC – Q) = Q PQ 2 P
This can be expressed as:

18. How Bad is Market Power Really? - continued
Pure monopolist case:
Harberger (1954): for 73 non-pure monopolist manufacturing industries assuming = 1. Multiplying the result by each industry’s output value and summing over all industries he estimates a total welfare loss from monopoly power of about two-tenths of one percent of GDP

19. Fast-Food Outlets
McDonald’s
Burger King
Wendy’s