Industry Concentration

common technology standards (for high-definition television or DVDs, for instance) so as to promote overall market growth. Firms in the same market also might join in shared research and development programs. Coopetition also occurs when a company and its input supplier cooperate to streamline the supply chain, improve product quality, or lower product cost. In short, oligopoly analysis embraces both the threat of substitutes and the positive impacts of complementary activities.

Finally, the potential bargaining power of buyers and suppliers should not be overlooked. For instance, the pricing behavior of a final goods manufacturer depends on the nature of the customers to whom it sells. At one extreme, its customers—say, a mass market of household consumers—may have little or no bargaining power. The manufacturer has full discretion to set its price as it wants (always taking into account, of course, overall product demand and the degree of competition from rival firms). At the other extreme, a large multinational corporate buyer will have considerable bargaining clout. Typically, such a buyer will have the power to negotiate the final terms of any contract (including price), and indeed it might hold the balance of power in the negotiation. (The producer might need the large buyer much more than the buyer needs the producer.) In the extreme, the buyer might organize a procurement and ask for competitive bids from would-be goods producers. In this way, the buyer uses its power to maximize competition among the producers so as to secure the best contract terms and price. (Negotiation and competitive bidding are the subjects of Chapters 15 and 16, respectively.) Of course, the same analysis applies to the firm’s relationships with its suppliers. We know from Chapter 7 that the firm will receive the best possible input prices if its suppliers compete in a perfectly competitive market. On the other hand, if the number of suppliers is limited or if actual inputs are in short supply, bargaining power shifts to the suppliers who are able to command higher prices.

As noted earlier, an oligopoly is dominated by a small number of firms. This “small number” is not precisely defined, but it may be as small as two (a duopoly) or as many as eight to ten. One way to grasp the numbers issue is to appeal to the most widely used measure of market structure: the concentration ratio. The four-firm concentration ratio is the percentage of sales accounted for by the top four firms in a market or industry. (Eight-firm and twenty-firm ratios are defined analogously.) Concentration ratios can be computed from publicly available market-share information. Ratios also are compiled in the U.S. Census Bureau, released by the government at five-year intervals. Table 9.1 lists concentration ratios for selected goods and services compiled from both sources. Notice the progression from highly concentrated to less concentrated industries.

TABLE 9.1

Concentration Ratios for Selected Goods & Services

Concentration Ratio

Product or Service 4 Firms 8 Firms 20 Firms

Laundry machines Warehouse clubs 98 94

Refrigerators Web Search Aluminum refining Beer Tobacco Glass containers Rental cars Personal computers Carbon black

92 91 90 90 90 87 87 87 84 Cellular phone service 82 Aircraft 81

Breakfast foods 80

Office supply stores Ammunition Tires Running shoes Metal cans Aircraft engines Burial caskets Bottled water Vacuum cleaners Bookstores Lawn equipment Flat glass Stockings Motor vehicles 80 79 78 77 77 74 74 72 71 71 71 70 69 68

Domestic air flights Motion pictures Drug stores Cable television

65 64 63 62 Photocopying machines 61 Farm machinery Men’s shoes 59 57

Elevators Snack foods 56 53

Nuclear power Investment banking Oil refining Soap 53 52 48 47 100 100 98 95 99 92 95 95 96 92 99 94 94 92 81 89 93 96 95 81 83 85 96 78 84 98 85 86 83 96 66 79 83 65 82 70 61 76 77 73 60

Concentration Ratio

Product or Service 4 Firms 8 Firms 20 Firms

Paper mills Coffee

46 43 Television broadcasting 43 Rubber 43

Ski facilities Software 42 39

Toys Boat building Internet service Book publishing Basic chemicals Supermarkets Internet shopping Pharmaceuticals 36 35 34 33 33 32 31 30

Newspapers Women’s dresses Life insurance Office furniture Advertising agencies Concrete Hotels Motor vehicle parts Elder care homes Funeral homes Electric power Furniture stores

29 28 27 26 24 23 23 19 19 16 15 14 Management consulting 14 Used car dealers 13

Furniture 11

Trucking Bolts, nuts, screws Restaurants 9 9 9

Liquor Stores

8 Musical groups and artists 7 Veterinary services 7

Legal offices 2.6

Florists 2.1

Auto repair Dry cleaners 1.7 1.4 67 58 56 65 53 47 51 43 49 48 44 46 37 47 45 68 60 59 85 69 63

39 44 69 75

34 29 28 28 28 23 17 27 19 19 14 19 15 12 12 13 11 8

42 33 40 35 42 30 18 54 27 26 16 30 21 19 17 19 20 9 4.6 9.0 2.9 4.5 2.6 4.3 2.2 3.9

Source: U.S. Bureau of the Census, 2007, and industry reports.

TABLE 9.1

(continued)

Market concentration has a ready interpretation. The higher the concentration ratio, the greater is the degree of market dominance by a small number of firms. Indeed, a common practice is to distinguish among different market structures by degree of concentration. For example, an effective monopoly is said to exist when the single-firm concentration ratio is above 90 percent, CR1 90. A market may be viewed as effectively competitive when CR4 is below 40 percent. If CR4 40 percent, the top firms have individual market shares averaging less than 10 percent, and they are joined by many firms with still smaller market shares. Finally, one often speaks of a loose oligopoly when 40 percent CR4 60 percent and a tight oligopoly when CR4 60percent. Monopolistic competition, discussed in the previous chapter, typically falls in the loose-oligopoly range.

About three-quarters of the total dollar value of goods and services (gross domestic product or GDP) produced by the U.S. economy originate in competitive markets, that is, markets for which CR4 40. Competitive markets included the lion’s share (85 percent or more) of agriculture, forestry, fisheries, mining, and wholesale and retail trade. Competition is less prevalent in manufacturing, general services, and construction (making up between 60 and 80 percent of these sectors). In contrast, pure monopoly accounts for a small portion of GDP (between 2 and 3 percent). Tight oligopolies account for about 10 percent of GDP, whereas loose oligopolies comprise about 12 percent.2 In short, as Table 9.1 shows, while concentrated markets are relatively rare in the U.S. economy, specific industries and manufactured products are highly concentrated.

Because the notion of concentration ratio is used so widely, it is important to understand its limitations. The most serious limitation lies in the identification of the relevant market. A market is a collection of buyers and sellers exchanging goods or services that are very close substitutes for one another. (Recall that the cross-elasticity of demand is a direct measure of substitution. The larger the impact on a good’s sales from changes in a competitor’s price, the stronger the market competition.) Concentration ratios purport to summarize the size distribution of firms for relevant markets. However, it should be evident that market definitions vary, depending on how broadly or narrowly one draws product and geographic boundaries.

First, in many cases the market definitions used in government statistics are too broad. An industry grouping such as pharmaceutical products embraces many distinct, individual product markets. Numerous firms make up the overall consumer-drug market (concentration is low), but individual markets (drugs for ulcers and blood pressure) are highly concentrated. Similarly, government statistics encompass national markets and therefore cannot capture local monopolies.

2As one might expect, categorization of market structures by concentration is not hard and fast. The preceding data are based on W. G. Shepherd, The Economics of Industrial Organization, Chapter 3 (Upper Saddle River, NJ: Prentice-Hall, 2003).

Newspapers are a dramatic case in point. Based on CR4, the newspaper industry would seem to be effectively competitive for the United States as a whole. But for most major cities, one or two firms account for nearly 100 percent of circulation.3

Second, the census data exclude imports—a serious omission considering that the importance of imports in the U.S. economy has risen steadily (to some 13 percent of GDP today). In many industries (automobiles, televisions, electronics), the degree of concentration for U.S. sales (including imports) is much less than the concentration for U.S. production. Thus, many industries are far more competitive than domestic concentration ratios would indicate.

Finally, using a concentration ratio is not the only way to measure market dominance by a small number of firms. An alternative and widely used measure is the Herfindahl-Hirschman Index (HHI), defined as the sum of the squared market shares of all firms:

HHI s1 2 s2 2 . . . s 2 n

where s1 denotes the market share of firm 1 and n denotes the number of firms. For instance, if a market is supplied by five firms with market shares of 40, 30, 16, 10, and 4 percent, respectively, HHI 402 302 162 102 42 2,872. The HHI index ranges between 10,000 for a pure monopolist (with 100 percent of the market) to zero for an infinite number of small firms. If a market is shared equally by n firms, HHI is the n-fold sum of (100/n)2, or (n)(100/n)2 10,000/n. If the market has 5 identical firms, HHI 2,000; if it has 10 identicalfirms, HHI 1,000. The Herfindahl-Hirschman Index has a number of noteworthy properties:

1.The index counts the market shares of all firms, not merely the top four or eight. 2.The more unequal the market shares of a collection of firms, the greater is the index because shares are squared. 3.Other things being equal, the more numerous the firms, the lower is the index.

Because of these properties, the HHI has advantages over concentration ratios; indeed, the HHI is used as one factor in the Department of Justice’s Merger Guidelines. (Under antitrust laws, the government can block a proposed merger if it will substantially reduce competition or tend to create a monopoly.) Concentration ratios and the HHI are highly correlated. Because they are available more readily (and easier to compute), concentration ratios are quoted more widely.

3The Bureau of the Census presents concentration ratios starting for broad industry categories and progressing to narrower and narrower groups (so-called six-digit categories). The categories in Table 9.1 are at the five- and six-digit levels. As we would expect, concentration tends to increase as markets are defined more narrowly. Many researchers believe that five-digit categories best approximate actual market boundaries.