To determine how concentrated an industry is, examine its market structure. If the number of firms in the industry is relatively small, the industry is probably an oligopoly. On the other hand, if a company dominates a market, the industry is a monopoly.
Herfindahl-Herschman Index (HHI)
The Herfindahl-Herschman index is an economic indicator of industry concentration. It is calculated by taking the market share of competing firms and squaring the sum. Usually, only the 50 largest firms are included in the calculations. The higher the HHI score, the greater the concentration. A lower value means that competition is healthy and there is an even match between firms in the same industry. The Herfindahl index has a range from 0 to 1.0 and a rise in the index indicates that a company has gained market power.
The Herfindahl index depends on the definition of market share. If the firms in an industry have market share of 80%, the Herfindahl index is 0.658. In contrast, if one firm has 81% of the market, the Herfindahl index would be higher. This means that an industry with higher concentration levels is less competitive.
Unlike other industry concentration measures, the Herfindahl-Herschman index does not account for barriers to entry. If there are multiple firms with equal market shares, the index approaches zero. If there is only one firm in a particular market, the index will reach 10,000, indicating a monopoly. As the Herfindahl-Herschmann index is a simple measure, it often fails to take into account the complexity of markets. For example, an industry with four firms will have a high HHI value, while a market with more than four firms will have little or no competition.
When considering industry concentration, it is important to remember that the closer the market is to a monopoly, the more concentration there is. The CR4 measure in the financial services industry indicates that there are more firms competing in the market, while CR1 indicates that a single firm controls more than 90% of the market.
Using HHI as an industry concentration indicator is a useful tool in measuring market concentration. However, there are a few limitations to the index, and the HHI cannot be applied directly to all industries. However, it is an effective way to compare industry concentration, if used correctly.
In a similar vein, the Simpson diversity index is used in ecology and the inverse participation ratio in physics. For example, if three firms produce 40% of the market, and Company 2 produces 20%, then the HHI for the entire industry would be 3,508. This would be a high concentration level, and the merger would violate antitrust laws. However, if the merger does not result in a monopoly, it is unlikely to violate antitrust laws.
Geographic scope can also be an issue. A single firm may dominate a product segment in a country with no competition. Similarly, two firms in the food industry may have a 50% share of market share based on output volume.
Industrial concentration is a structural characteristic of a business sector, a measure of the degree of production dominance of large firms. While this pattern was once considered a sign of market failure, more recent research has shown it to be a sign of superior economic performance. The new thinking about industrial concentration was first formulated by Yale Brozen, who called it a “revolution in economics”. Today, industrial concentration remains an important public policy issue.
Although industrial concentration levels tend to follow a mean reversion trend, transient economic shocks can influence concentration levels. For example, the proportion of economic activity accounted by the most concentrated industries declined by 65 percent between 2002 and 2017. While there is no strong evidence to support an association between increasing industrial concentration and poor economic outcomes, it has been found that higher concentration levels tend to be associated with higher economic performance, higher productivity, and higher employee compensation.
One of the main questions related to industrial concentration is whether it increases competition. While it is true that concentration breeds market power, this power can increase profits at the expense of consumers. It is possible that a single dominant firm can set its own prices. Nevertheless, hundreds of econometric studies have found that a more concentrated industry is more profitable.
One common measure of the degree of industry concentration is the CR4 ratio, which measures the combined market shares of the top firms in an industry. This index takes into account factors such as sales, employment, number of outlets, and customers. If the concentration ratio is near 100 percent, the industry is considered highly concentrated. However, when the concentration ratio is near zero, it indicates that there is perfect competition, meaning that all firms have a comparable share of the market.
While industrial concentration is important, it does not automatically guarantee pricing power. Industries with a high concentration rate are typically capital intensive and have high barriers to entry and exit. As a result, companies with a high concentration ratio need to increase output to stay competitive. This can lead to overcapacity in the industry.
One alternative indicator of market concentration is the Herfindahl-Herschman Index. This index is calculated by squaring up the market shares of each firm in an industry and then summing the squared results. The HHI has a fairly high correlation with the concentration ratio. This alternative measure is a better indicator of market concentration.
The HHI shows the overall concentration of major occupational groups, but not the specific industries in which an occupation is used most intensively. Industrial concentration can also be measured using location quotients. The standard location quotient is the ratio of the employment of an area to national employment. The industry quotient, on the other hand, shows the employment of individual occupations within a specific industry.
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