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Subject Business Economics
Paper No and Title 1, Microeconomic Analysis
Module No and Title 29, Degree of Monopoly and Concentration
Module Tag BSE_P1_M29
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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TABLE OF CONTENTS
1. Learning outcome 2. Introduction 3. Measurement of the Degree of Monopoly Power 3.1 Elasticity of Demand Approach 3.2 Lerner’s Approach 3.3 Cross Elasticity of Demand Approach 3.4 Rothschild’s Approach 4. Market Concentration 4.1 The Herfindahl Index (HHI) 4.2 The Concentration Ratio (CR) 5. Summary
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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1. Learning Outcome of Monopoly
This module helps you to understand monopoly power; various measures of monopoly power; market concentration and Various measures of market concentration.
2. Introduction
Monopoly power depends upon the capacity of the firms to influence market price and output. Besides by the pure monopolist, monopoly power is also enjoyed by the sellers in all markets in which a monopoly element is present either in a large or small scale. In fact sellers in monopolistic competition, price discriminating monopoly and oligopoly enjoy monopoly power to a certain degree depending upon their power to control price and output.
3.Measurement of Degree of Monopoly Power
As discussed above monopoly power shows the degree of control, a producer or seller exercises over price and output. Therefore, taking into account price and output, various measures of monopoly power have been formulated by economists. Some important measures of monopoly power are discussed below.
3.1 Elasticity of Demand Approach
The elasticity of demand has been regarded by economists as one of the important indicators of the degree of monopoly power. The monopoly power depends upon the extent to which a seller exercises its control over the price and output, which also depends upon the elasticity of demand. Under perfect competition demand is perfectly elastic so that firms enjoy no monopoly power. When the demand curve is less than perfectly elastic, some element of monopoly will be present indicating that the seller will enjoy some degree of monopoly power. This is seen in case of the markets like monopoly, monopolistic competition, oligopoly etc. The seller in this case can increase the price of the product as the demand curve for his product slopes downward. Also the seller can lower the price and increase the quantity supply to grab some buyers from his rivals.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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Therefore, when the demand curve slopes downward, the seller uses his power to change the price. The less the elasticity of demand for his product, the greater the degree of monopoly power and vice versa. When demand is perfectly inelastic the seller can charge any price for his product. With fixed demand the seller will enjoy absolute monopoly power. Thus greater the elasticity of demand, the less the degree of monopoly power enjoyed by the firm. Hence, a measure of monopoly power is given by the inverse of the elasticity of demand as given below:
1 M = 1 e p
Where, in eq.-1, M is the degree of monopoly power and e p is the price elasticity of demand. For example, when price elasticity of demand is 1/5 the degree of monopoly power will be equal to 1/(1/5)=5. Similarly if the elasticity of demand is 5, the degree of monopoly power will be equal to =1/5. Hence, the more the elasticity of demand the less the monopoly power enjoyed by a seller and vice versa.
3.2 Lerner’s Approach
A measure of monopoly power which has gained great popularity is developed by Lerner. Lerner considers perfect competition as the state of maximum welfare and any divergence from it would be considered as the presence of some monopoly power, which as a result leads to inefficient allocation of resources by the monopolist. Lerner argues that when the market is imperfect, marginal cost will equal marginal revenue but price will be higher than marginal cost or marginal revenue at equilibrium. This divergence between price and marginal cost is the indicator of the measure of monopoly power. The greater this divergence between price and marginal cost, the greater is the degree of monopoly power possessed by the monopolist. Lerner’s index of monopoly power is given below.
P MC M = 2 P
Where, in eq.-2, M denotes index of Lerner’s monopoly power, P denotes price and MC denotes marginal cost at the equilibrium level of output of the monopolist.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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In one extreme when the market is perfectly competitive, price is equal to marginal cost. In this case Lerner’s index of monopoly power is equal to zero indicating no monopoly power at all. Thus, when,
P=MC 3
P MC 0 This implies, M 0 4 P P
In the another extreme, when the monopolized product involves no cost of production the marginal cost will be equal to zero and Lerner’s index of monopoly power would be equal to one. That is, when:
MC=0 5
P MC P 0 P This implies, M 1. 6 P P P
Thus Lerner’s index of monopoly power varies between zero and unity. As a result, the closer M is to unity, the greater the degree of monopoly power possessed by the monopolist. For example, let the price of a product be equal to Rs.50 per unit and let its marginal cost be equal to Rs. 30, then,
50 30 20 M= 0.4. 50 50
However, the Lerner index has many limitations and is obviously not a good measure of monopoly power. The Lerner index can be proved to be the inverse of the elasticity of demand in the case of a profit maximizing firm in equilibrium and as a result may be taken as a characterization of the demand for the product of the firm. However, it is no guide to the nature of demand in the case of a non-maximizing firm. While it indicates the divergence between price and marginal cost, it says hardly anything about the degree of market pressure or the extent to which administrative action keep the costs at a lower level. Lerner’s measure is based upon only one aspect i.e. ”control over price”. It ignores the restraints on monopoly power put by potential substitutes. These would BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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come to exist with the entry of new firms into the industry and powerful factors limiting the monopoly power of the existing sellers.
3.3 Cross Elasticity of Demand Approach
The concept of using cross elasticity of demand to measure the degree of monopoly power was first advocated by Kaldor. However, it has been reformulated by Robert Triffin in his famous work ‘Value Theory and General Equilibrium Analysis. Cross elasticity of demand means the proportionate change in quantity demanded of a product as a result of a proportionate change in the price of another product. In the cross elasticity of demand approach, the measure of monopoly power points to the degree of dependence of a firm’s product upon the prices of other firms’ products. If demand for a firm’s product does not depend upon the prices of other firm’s products, then that firm will be completely independent of price and output policies of others and cross elasticity of demand for its product will be zero. The smaller the degree of cross elasticity of demand for the product, the greater the degree of monopoly power enjoyed by it and vice versa. The cross elasticity of demand between the products of two firms, X and Y, can be written as:
q p q p q .p M x y x y x. y 7 qx p y qx p y p y .qx
Where, in eq. 7, M : measure of monopoly power qx : quantity of good x produced by firm X qy : quantity of good y produced by firm Y
The value of M will vary in between 0 to ∞, which shows the degree of monopoly power of the firm. When the demand for the output of firm X is not affected at all by the price of any other firm Y, the cross elasticity of demand for its product will be zero, that is, M=0. In this case the firm X will enjoy absolute monopoly power in pursuing his own price and output policy in the one extreme. In the another extreme, according to Triffin and others, the cross elasticity of demand between the products of various firms under perfect competition is infinite and therefore firms under perfect competition enjoy no monopoly power at all. Hence, pure monopoly having zero cross elasticity of demand enjoys absolute monopoly power and perfectly competitive firm having infinite cross elasticity of demand possesses zero monopoly power. These are two limiting cases. Given these two limits, the less the coefficient of the cross elasticity of demand, the greater the monopoly power and vice versa.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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3.4 Rothschild’s Approach
One measure of the degree of monopoly power has been formulated by K. W. Rothschild to show how far a particular firm controls the market for a commodity. According to Rothschild the degree of monopoly power can be measured by taking the ratio of slope of two demand curves of the firm: one being dd'; the demand curve for the individual firm on the assumption that "competing firms do not change their price or output" and another being DD'; the demand curve on the assumption that "other firms change their price or output in the same or some other predetermined way". Rothschild’s index (M) is given in eq.-8.
ta n A M (8) ta nB
Fig.1: Rothschild’s Index (M)
Rothschild’s index (M) postulates some assumptions concerning the reactions of other firms and varies between 0 and 1. If the demand curve for the product of the individual firm is independent of the reactions of other firms, dd' and DD' coincide. In this case:
tan A M 1 (9) tan B
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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On the other hand if the firm is producing under purely competitive conditions so that its price is market-determined and completely independent of its own discretion, the index is equal to zero. That is,
tan A M 0 10 tan B
Therefore, degree of monopoly power in this case depends upon the extent to which M approaches 1.The more M is nearer to 1 the greater the degree of monopoly power.
4. Market Concentration
The market concentration is functionally related to the number of firms and their respective shares of the total production in a market. Market concentration is associated with industrial concentration. Industrial concentration is concerned with the distribution of production within an industry. Thus market concentration is a measure of competition which positively varies with the rate of profit in industrial organization.
There are two widely acceptable market concentration measures. They are:
i) The Herfindahl-Hirschman Index (HHI) and ii) The Concentration Ratio (CR).
These two concentration measures are discussed below.
4.1 The Herfindahl Index (HHI)
The Herfindahl index, which is also known as Herfindahl–Hirschman Index, or HHI is a measure of the size of firms in relation to the industry. HHI is an indicator of the amount of competition among the firms. It is a measure of concentration widely applied in competition law, antitrust policy and in technology management.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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We can define HHI as the sum of the squares of the market shares of a maximum of 50 largest firms within the industry, where the market shares are expressed in terms of fractions. Thus,
N 2 HHI Si 11 i1
Where, in eq.-11, Si is the market share of firm i in the market, and N is the number of firms. For a competitive industry with no dominant players the index will be very small. The reciprocal of the index shows the number of firms in the industry only if all firms have an equal share. For firms with unequal shares, the reciprocal of the index indicates the "equivalent" number of firms in the industry.
The normalization form of HHI, which ranges from 0 to 1, is written as:
HHI 1/ N HHI * 12 11/ N
Where, N is the number of firms in the market, and HHI is the Herfindahl Index in eq.-12.
If all the market is shared by N firms, then the index can be reformulated as:
1 HHI NV 13 N
Where, in eq.-13, N is the number of firms and V is the statistical variance of the firm shares, defined as:
N 2 (Si 1/ N) V iN 14 N
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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When all firms have equal shares, that is, the market structure is completely symmetric so that Si=1/N for all i then:
V = 0 and HHI = 1/N 15
For a given number of firms in the market a higher variance due to a higher level of asymmetry between firms' shares will result in a higher index value.
4.2 The Concentration Ratio (CR)
Given number of firms, the concentration ratio is a measure of the total output produced in an industry. Concentration ratios measure the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is monopolistic. Thus the concentration ratio is the percentage of market share held by the largest firms in an industry.
m CR m Si 16 i1
th Where, in eq.-16Si is the market share and m indicates the i firm.
The CR4 and the CR8 are the most common concentration ratios, which indicate the market share of the four and the eight largest firms. Generally, these two common ratios are comparable from industry to industry, while concentration ratios for other numbers of firms can also be calculated. Concentration ratios vary from 0 to 100 percent as shown in table-1.
Table 1:Degree of Concentration
CRm Degree of Concentration Market Type 0 % No concentration perfect competition
0% to 50% Low concentration perfect competition to oligopoly 50% to 80% Medium concentration Oligopoly
80% to 100% High concentration oligopoly to monopoly
100% Total concentration Monopoly
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION
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The concentration ratio measures the extent of market control and does not use market shares of all the firms in the industry. It does not provide the distribution of firm size and also does not provide detail about competitiveness of the industry. So in this sense, the Herfindahl index provides a more complete and realistic picture of industry concentration than does the concentration ratio.
6. Summary
Monopoly power shows the degree of control a producer or seller exercises over the price and output. Some important measures of monopoly power are (i) elasticity of demand approach, (ii) Lerner’s Approach, and (iii) cross elasticity of demand approach. In elasticity of demand approach, monopoly power depends upon the extent to which a seller exercises its control over the price and output, which often depends upon the elasticity of demand. In Lerner’s approach, the divergence between price and marginal cost is the indicator of the measure of monopoly power. In the cross elasticity of demand approach the measure of monopoly power indicates the degree of dependence of a firm’s product upon the prices of other firms’ products. According to Rothschild the degree of monopoly power can be measured by taking the ratio of the slopes of two demand curves of the firm: one being the demand curve for the individual firm on the assumption that "competing firms do not change their price or output" and another being the demand curve on the assumption that "other firms change their price or output in the same or some other predetermined way".
The market concentration is functionally related to the number of firms and their respective shares of the total output in a market. There are two widely acceptable market concentration measures. They are (i) the Herfindahl Index (HHI) and (ii) the Concentration Ratio (CR). While, HHI is an indicator of the amount of competition among the firms, CR measures the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is monopolistic. However, the concentration ratio does not use the market shares of all the firms in the industry. In this sense, the Herfindahl index provides a more complete and realistic picture of industry concentration than does the concentration ratio.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND CONCENTRATION