11.1 Corporate mergers  (Page 3/23)

The four-firm concentration ratio

Regulators have struggled for decades to measure the degree of monopoly power in an industry. An early tool was the concentration ratio    , which measures what share of the total sales in the industry are accounted for by the largest firms, typically the top four to eight firms. For an explanation of how high market concentrations can create inefficiencies in an economy, refer to Monopoly .

Say that the market for replacing broken automobile windshields in a certain city has 18 firms with the market shares shown in [link] , where the market share    is each firm’s proportion of total sales in that market. The four-firm concentration ratio is calculated by adding the market shares of the four largest firms: in this case, 16 + 10 + 8 + 6 = 40. This concentration ratio would not be considered especially high, because the largest four firms have less than half the market.

The concentration ratio approach can help to clarify some of the fuzziness over deciding when a merger might affect competition. For instance, if two of the smallest firms in the hypothetical market for repairing automobile windshields merged, the four-firm concentration ratio would not change—which implies that there is not much worry that the degree of competition in the market has notably diminished. However, if the top two firms merged, then the four-firm concentration ratio would become 46 (that is, 26 + 8 + 6 + 6). While this concentration ratio is modestly higher, the four-firm concentration ratio would still be less than half, so such a proposed merger might barely raise an eyebrow among antitrust regulators.

The herfindahl-hirshman index

A four-firm concentration ratio is a simple tool, which may reveal only part of the story. For example, consider two industries that both have a four-firm concentration ratio of 80. However, in one industry five firms each control 20% of the market, while in the other industry, the top firm holds 77% of the market and all the other firms have 1% each. Although the four-firm concentration ratios are identical, it would be reasonable to worry more about the extent of competition in the second case—where the largest firm is nearly a monopoly—than in the first.

Another approach to measuring industry concentration that can distinguish between these two cases is called the Herfindahl-Hirschman Index (HHI)    . The HHI, as it is often called, is calculated by summing the squares of the market share of each firm in the industry, as the following Work it Out shows.