There are several methods used to measure the degree to which oligopolistic industries are concentrated by largest firms. The most often used ways to measure are concentration ratios and the Herfindahl index.
Concentration Ration shoes the percentage of total output produced and sold by industry’s largest firms. For example, three largest U.S producers of iron, supply almost 100% of all iron resource in this country.
When the largest three-four firms in an industry control 40% or more of the market, that industry is said to be oligopolistic. Although concentration ratios offer useful ideas about competitiveness and monopoly power of diverse industries, there are three shortcomings.
- Local Markets
Concentration ratios relate to nations as a whole, where the markets for some goods are highly localized because of expensive transport. For example, the four-firm concentration ratio for tobacco products is just 37% in China, suggesting that this industry is a competitive one. But, when we relate this product to some specific market or town in this country, we may often find that four firms produce about 80% of the total output in that area.
- Inter-industry Competition
Inter-industry competition is competition between the products of one industry and the products of another industry. An example to this kind of competition may serve primary metals in some industries aluminum and copper, since aluminum competes with copper in many applications. (Electric devices, robots, machineries)
- World Trade
The data for products produced in one country only may overstate concentration ratio since in most of cases they don’t account for import competition of foreign suppliers. Although some figures show that domestic firms produce over 90% of the total output for some good, they ignore the fact that some large quantities of that good may be imported. Many of the world’s largest corporations are foreign, so many of them are spread in diverse countries.
The shortcomings of concentration ratio from above apply to many measures of concentration, but one of these can be eliminated: Let’s say in industry “A” one firm produces all market output, but in industry “B” five firms produce 20% of the market. The concentration ratio is 100% in both cases. But industry “A” is pure monopoly, while industry “B” is an oligopoly. Economically, monopoly power is greater in industry “A” is greater than that from industry “B”, this fact isn’t shown by identical 100% concentration ratio.
Herfindahl index solves this problem. This index is the sum of the squared percentage market shares all firms in the industry have. In equation from:
Where %S1 is the percentage share of firm 1, %S2 is the percentage share of firm 2, and so on for each firm in the industry. By squaring percentages this index give more power to firms that have larger market shares, than to smaller ones. In case that a single firm has 100% then the Herfindahl index gives its highest value- 10000. In our industry “B”, Herfinahl index will be 202+202+202+202+202 which results in 2000, which is much more less that 10000 showing less market power.(In a purely competitive industry this index will approach to zero). More market power-higher Herfindahl index.