Industry concentration

What Is Industry Concentration?

Industry concentration refers to the degree to which a small number of firms account for a large proportion of the total output or sales within a particular industry. It is a key concept within the broader field of industrial organization, a branch of economics that examines the structure of markets and firms. High industry concentration typically indicates that a few dominant players hold significant market share, potentially influencing pricing, innovation, and overall competitive markets. Conversely, low industry concentration suggests a more fragmented market with many participants and robust competition. Understanding industry concentration is crucial for assessing market dynamics, potential for monopoly or oligopoly power, and implications for economic welfare.

History and Origin

The study of industry concentration and its economic implications gained prominence in the late 19th and early 20th centuries, coinciding with the rise of large industrial trusts and corporations. Economists began to rigorously analyze market structures beyond the perfectly competitive model, acknowledging real-world complexities like barriers to entry and the strategic behavior of firms. The field of industrial organization itself, which provides the theoretical framework for understanding industry concentration, formalized in the mid-20th century, drawing on earlier works by economists like Alfred Marshall. Important figures such as Edward Chamberlin and Joan Robinson contributed significantly to the understanding of imperfect competition and market structures that were neither purely monopolistic nor perfectly competitive. Many formal theories within industrial organization were influenced by, or even borrowed from, the developing body of antitrust laws in the United States and Europe, as legal scholars and policymakers sought to address concerns about concentrated economic power.¹³

Key Takeaways

• Industry concentration measures the dominance of a few firms within a specific market.
• High concentration can suggest reduced competition, potentially leading to higher prices or less innovation.
• The Herfindahl-Hirschman Index (HHI) is a primary tool for quantifying industry concentration.
• Regulatory bodies, such as the Department of Justice and Federal Trade Commission, use concentration measures to evaluate proposed mergers and acquisitions.
• Industry concentration is a key consideration in assessing market power and its impact on consumers.

Formula and Calculation

The most widely used measure for quantifying industry concentration is the Herfindahl-Hirschman Index (HHI). The HHI is calculated by squaring the market share of each firm in an industry and summing the results. This method gives greater weight to firms with larger market shares, providing a more comprehensive view of concentration than simpler measures like the four-firm concentration ratio.

The formula for the HHI is:

$HHI = \sum_{i=1}^{N} (S_i)^2$

Where:

• ( S_i ) = the market share of firm ( i ), expressed as a percentage (e.g., 20% would be 20, not 0.20).
• ( N ) = the total number of firms in the industry.

For example, if an industry has three firms with market shares of 40%, 30%, and 30%, the HHI would be calculated as:

( HHI = (40^2) + (30^2) + (30^2) )
( HHI = 1600 + 900 + 900 )
( HHI = 3400 )

The HHI can range from nearly zero (for an industry with a very large number of very small firms) to 10,000 (for an industry with a single firm holding 100% of the market, i.e., a pure monopoly).

Interpreting Industry Concentration

The interpretation of industry concentration, particularly through the HHI, provides insights into the competitive landscape of a market. Generally, a higher HHI indicates a more concentrated industry, which can suggest less competition and potentially greater market power for dominant firms. Regulatory bodies, such as the U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC), use specific HHI thresholds to classify market concentration levels and guide their assessment of proposed mergers.

For instance, the 2023 Merger Guidelines indicate that markets with an HHI below 1,000 are generally considered unconcentrated.¹² Markets with an HHI between 1,000 and 1,800 are considered moderately concentrated.¹¹ Markets with an HHI above 1,800 are considered highly concentrated.¹⁰ An increase in the HHI resulting from a merger, especially in highly concentrated markets, can trigger closer scrutiny, as it may be presumed to substantially lessen competition or facilitate the exercise of market power.⁸, ⁹ These thresholds are not absolute but serve as important indicators for regulators concerned with preserving consumer welfare and preventing anticompetitive outcomes.

Hypothetical Example

Consider the hypothetical "Global Gadget Manufacturing" industry. Initially, there are five major players:

• GadgetCorp: 35% market share
• TechWiz: 25% market share
• InnovatePro: 20% market share
• FutureDevices: 10% market share
• NextGen Innovations: 10% market share

To calculate the industry concentration using the HHI:

( HHI = (35^2) + (25^2) + (20^2) + (10^2) + (10^2) )
( HHI = 1225 + 625 + 400 + 100 + 100 )
( HHI = 2450 )

Based on the HHI of 2450, the Global Gadget Manufacturing industry would be considered highly concentrated. Now, imagine GadgetCorp proposes to acquire NextGen Innovations. After the acquisition, GadgetCorp's market share would become 45% (35% + 10%). The new market shares would be:

• GadgetCorp (merged): 45%
• TechWiz: 25%
• InnovatePro: 20%
• FutureDevices: 10%

The new HHI would be:

( HHI_{new} = (45^{2) + (25}2) + (20^{2) + (10}2) )
( HHI_{new} = 2025 + 625 + 400 + 100 )
( HHI_{new} = 3150 )

The merger results in an increase in HHI of ( 3150 - 2450 = 700 ) points. This significant increase in an already highly concentrated market would likely lead to intense scrutiny from regulatory policy bodies, potentially challenging the merger due to concerns about reduced competition and increased market power.

Practical Applications

Industry concentration analysis is vital across various real-world financial and economic applications. In capital allocation, investors may consider industry concentration when making investment decisions. Highly concentrated industries might offer the potential for higher profit margins for dominant firms due to reduced competition, but they may also face increased regulatory policy scrutiny or pose risks if one of the few major players faces significant challenges. Conversely, less concentrated industries might offer more growth opportunities for new entrants but could also be characterized by lower profit margins due to intense competition.

Regulators routinely use measures of industry concentration, primarily the HHI, to evaluate proposed mergers and acquisitions. The U.S. Department of Justice and the Federal Trade Commission's Merger Guidelines set specific HHI thresholds that trigger presumptions of competitive harm.⁷ For example, the 2023 guidelines state that a merger resulting in a post-merger HHI greater than 1,800 and an increase of more than 100 points will be presumed to lessen competition significantly.⁶ This ensures that corporate consolidations do not create undue market power that could harm consumers or stifle innovation.

Furthermore, economic researchers, including those at the Federal Reserve, study industry concentration to understand its broader implications for the economy, such as its effects on productivity, wage growth, and financial stability. For instance, research from the Federal Reserve explores how changes in industry concentration affect aggregate productivity and how it can be measured using different data sources.⁵ Other studies examine the relationship between bank concentration and industrial sector concentration.⁴

Limitations and Criticisms

While industry concentration measures like the HHI are widely used, they come with several limitations and criticisms. One significant drawback is that the HHI relies heavily on accurately defining the relevant market. An overly broad or narrow definition of the market can lead to a misleading HHI value. For example, a high concentration in a narrowly defined product market might not reflect the broader competitive landscape if close substitutes exist in other markets.

Critics also point out that the HHI primarily focuses on current market shares and does not fully account for factors such as potential competition from new entrants, technological advancements that can disrupt established industries, or the impact of global markets.³ An industry might appear highly concentrated based on its HHI, but low barriers to entry could mean that the threat of new firms entering the market keeps existing players competitive. Additionally, the HHI does not inherently consider the benefits of scale, such as economies of scale, which might lead to lower prices for consumers even in a more concentrated industry.²

Furthermore, academic papers have discussed the challenges in using HHI regressions to infer causal effects on prices, noting that both price and HHI are equilibrium outcomes influenced by a multitude of demand and supply factors.¹ Some argue that its simplicity, while an advantage for calculation, can be a disadvantage in truly assessing complex market conditions. These criticisms underscore the need for regulators and analysts to consider industry concentration metrics as one tool among many when evaluating market competition and the potential for market power.

Industry Concentration vs. Market Concentration

The terms "industry concentration" and "market concentration" are often used interchangeably, and in many contexts, they refer to the same concept: the distribution of market share among firms within a specific economic domain. Both terms quantify the degree to which a few firms dominate sales or output. The distinction, if any, often lies in the scope of analysis. "Industry concentration" tends to imply a focus on the broader industrial sector as defined by standard industrial classification codes (e.g., the automotive industry, the software industry). "Market concentration," while also applicable to these broad industries, can sometimes refer to a more narrowly defined market segment, perhaps geographically or by product type, that is relevant for a specific competitive analysis, such as for antitrust purposes. For practical application, especially in the context of antitrust laws and regulatory review, these terms are used to assess the competitive landscape and potential for market power within a defined scope of competition.

FAQs

What does high industry concentration imply for consumers?

High industry concentration often implies fewer choices for consumers, potentially higher prices, and less innovation due to reduced competition among a few dominant firms.

How do regulators use industry concentration data?

Regulators, such as the Department of Justice and the Federal Trade Commission, use industry concentration data, primarily the HHI, to assess the competitive impact of proposed mergers and acquisitions. If a merger significantly increases concentration in an already concentrated market, it may be challenged to protect consumer welfare.

Can industry concentration change over time?

Yes, industry concentration can change significantly over time due to factors such as technological disruption, new market entrants, successful diversification strategies, or mergers and acquisitions. Economic censuses and other data sources track these changes.

Is high industry concentration always bad?

Not necessarily. While high concentration can raise concerns about reduced competition, it can also sometimes be a result of economies of scale or superior efficiency by leading firms, which could potentially benefit consumers through lower costs or better products. The overall impact depends on various factors beyond just the concentration number.

What is the relationship between industry concentration and portfolio diversification?

Understanding industry concentration can inform portfolio theory and investment decisions. Investors seeking diversification might avoid over-allocating capital to highly concentrated industries, which could pose higher risks if one or two dominant firms face setbacks. Alternatively, they might strategically invest in such industries if they believe the dominant firms have sustainable competitive advantages.