Set out how the concentration of an industry can be measured
The idea
Concentration measures summarise how much of an industry a few firms control. The N-firm concentration ratio adds the market shares of the largest N firms and is simple but blind to how those shares are distributed among them. The Herfindahl-Hirschman Index squares every firm's share before summing, so a merger between large firms moves it far more than one between small firms. Neither accounts for barriers to entry, which do much to determine pricing power: a concentrated industry that anyone can enter tends to behave more competitively than its share figures suggest.
Formulas
Herfindahl-Hirschman index
HHI = Σ (market share)²
- market share
- each firm's share of the market, squared and then added across every firm
Squaring is what makes it better than a concentration ratio: it weights the large firms more heavily, so it distinguishes ten equal firms from one giant and nine small ones, which a top-four share cannot. It still ignores barriers to entry.
A practice question
What does the Herfindahl-Hirschman Index do that a concentration ratio does not?
- Weights larger firms more heavily by squaring market shares — correct
- Includes firms outside the industryWhy not: Both measures are calculated within a defined market; neither reaches outside it.
- Adjusts for barriers to entryWhy not: Neither measure does. That omission is the main limitation they share.
Squaring shares before summing means a single dominant firm registers far more than several mid-sized ones with the same combined share. The ratio treats them identically.
A harder one
Two industries have identical four-firm concentration ratios of 80%. Why might their HHI values differ markedly?
- Because the HHI includes firms outside the top fourWhy not: It does include the smaller firms, but their squared shares are tiny and cannot account for a marked difference.
- Because the distribution of share among the four differs — correct
- Because the HHI is measured over a different periodWhy not: Both are computed from the same shares at the same moment. The difference is in how the shares are combined.
Four firms at 20% each give a very different HHI from one at 65% and three at 5%. The ratio cannot distinguish them; squaring the shares can.
The hardest tier
Why can a highly concentrated industry still behave competitively?
- Because concentration measures are usually miscalculatedWhy not: The measures are usually right about the shares. What they leave out is how easy entry is.
- Because regulators prohibit price increasesWhy not: Price regulation is rare outside utilities, and the discipline described here is the market's rather than the regulator's.
- Because low barriers to entry mean any attempt to raise prices attracts entrants — correct
Pricing power depends on whether incumbents can be challenged, not on how many there currently are. A contestable market disciplines prices even with few active firms, which is why concentration alone is a weak signal.
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