Number 2

178 Chapter 7

which are published Census Bureau of the U.S. Department of Commerce, which can be readily accessed on the Internet. Concentration ratios measure the percentage of total industry sales accounted for by the largest n firms, that is

Cn = w1 + w2 + + wn ,

(7.1)

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where ωi = 100(Si/ST), Si the sales of the ith firm, and ST the sales for the entire industry. The U.S. Census Bureau calculates concentration ratios for the larg-est 4, 8, 20, and 50 companies in an industry. Industries with a large number of small firms have concentration ratios are closer to zero percent, which indicates low concentration. Industries that are dominated by a few very large firms have concentration ratios closer to 100 percent. Table 7.3 summarizes the 4-firm concentration ratios (CR) and Herfindahl-Hirschman indices (HHI) for 32 industries in the Unites States in 1992 according to their four-digit Standard Industrial Classification (SIC) code.1 A four digit number assigned to identify a business based on the type of business or trade and manufacturing.

Another problem with concentration ratios is that they are sensitive to how narrowly an industry is defined. Concentration ratios are calculated using standard industrial classifications published by the U.S. Department of Commerce, which are based on the similarity of production processes. These classification, however, ignore substitutability across products, such as glass versus plastic containers, which have a high cross-price elasticity of demand.

Still another problem is that U.S. census data used to calculate concentra-tion ratios are based on domestically produced goods and do not include import competing products. Table 7.3 indicates, for example, that the eight largest motor vehicles and car bodies companies account for 84 percent of industry output. This statistic clearly overstates the actual market share of U.S. automobile companies when foreign automobile manufacturers are included.

Finally, concentration ratios are calculated using national statistics. As such, they ignore the regional distribution of industry sales. Suppose, for example, that an industry has a 4-firm concentration ratio of 0.5, which sug-gests that the industry is not highly concentrated. But, suppose that these firms sell their products in different parts of the country. Regionally, this industry may be highly concentrated, but this fact is masked by the 4-firm concentration ratio that is calculated using national data.

Solved Exercise

An industry consists of 10 firms. The first two firms have sales of $5 million each, the next two firms have sales of $3 million each, and the remaining six

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		Industry Organization		179
	Table 7.3  Measures of Industrial Concentration (1992)
				Value of
			Number	Shipments	4-Firm CR	HHI
	SIC	Industry	of Firms	($million)	(percent)	(percent)
2021	Creamery butter	31	1,034	49	874
2024	Ice cream and frozen desserts	411	5,291	24	293
2037	Frozen fruits and vegetables	182	7,528	28	313
2041	Flour and grain mill products	230	6,294	56	972
2043	Cereal breakfast foods	42	9,799	85	2,253
2046	Wet corn milling	28	7,045	73	1,521
2047	Dog and cat food	102	7,024	58	1,229
2273	Carpets and rugs	383	9,831	40	854
2296	Tire cord and fabrics	12	976	75	2,682
2411	Logging	12,985	13,879	19	158
2511	Wood household furniture	2,636	8,743	20	167
2731	Book publishing	2,504	16,753	23	251
2771	Greeting cards	157	4,196	84	2,922
2812	Alkalis and chlorine	34	2,787	75	1,994
2833	Medicines and botanicals	208	6,439	76	2,999
2841	Soap and other detergents	635	14,762	63	1,584
2911	Petroleum refining	131	136,579	30	414
3221	Glass containers	16	4,860	84	2,162
3274	Lime	57	904	46	693
3312	Blast furnaces and steel mills	135	16,565	37	551
3334	Primary aluminum	30	5,849	59	1,456
3411	Metal cans	132	12,112	56	1,042
3484	Small arms	177	1,384	43	679
3511	Turbines and turbine generators	64	5,843	79	2,549
3562	Ball and roller bearings	123	4,290	51	852
3565	Packaging machinery	590	3,127	16	154
3581	Automatic vending machines	105	816	52	844
3641	Electric lamps	76	3,001	86	2,702
3711	Motor vehicles and car bodies	398	151,712	84	2,676
3823	Process control instruments	822	6,469	27	256
3931	Musical instruments	437	982	25	304
3993	Signs and advertising specialties	4,468	5,424	6	24

Source:  Concentration ratios in manufacturing, 1992 Census of Manufacturers Report MC92-S -2, Washington, DC: U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the Census, 1997.

firms have sales of $2 million each. Calculate the 4-firm and 8-firm concen-tration ratios for this industry.

Solution

Total industry sales are ST = $28 million. From Eq. (7.1), C4 = 18 + 18 + 11 + 11 = 58 percent and C8 = 18 + 18 + 11 + 11 + 7 + 7 + 7 + 7 = 86 percent. The largest eight firms account for 58 percent of total industry sales. The largest eight firms account for 86 percent of total industry sales.

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180 Chapter 7

Herfindahl-Hirschman Index

An alternative measure of industrial concentration is the Hirschman Index (HHI), which is calculated as

HHI = w12 + w22 + + wn2 ,

Herfindahl-

(7.2)

where n is the total number of firms in the industry and ωi is firm i’s percent share of total industry. HHI is superior to concentration ratios because it used data for the entire industry instead of just a few large firms. Moreover, by squaring individual market shares, HHI assigns a greater weight to larger firms. The Herfindahl-Hirschman Index ranges in value from zero to 10,000. An HHI close to zero is typical of an industry consisting of a very a large number of very small firms that is not very concentrated. By contrast, an HHI of 10,000 is an industry consisting of a single firm. Unfortunately, HHI suf-fers from many of the same shortcomings as concentration ratios since it is also calculated using U.S. census data.

While HHI is a better measure of industrial concentration, it suffers from the other shortcomings of concentration ratios. Both measures are sensitive to how broadly or how narrowly industries are classified. Since both mea-sures ignore domestic penetration by foreign firms they tend to overstate the degree of industrial concentration. Lastly, both measures are calculated using data for the entire country and tell us nothing about the degree of local and regional industrial concentration.

The practical significance of the HHI stems from its role in the enforce-ment of U.S. antitrust legislation. The belief that increased industrial concen-tration was detrimental to consumers was initially addressed in the U.S. with the passage of the Clayton Act (1914). This legislation proscribed several business practices that “substantially lessen competition in an industry.” The Clayton Act also gave the U.S. Department of Justice (DOJ) the authority to monitor and, if necessary, prohibit horizontal integration (the merger of two or more firms from the same industry producing near or perfect substitutes). The Celler-Kefauver Act (1950) closed this loophole by extending this man-date to include vertical integration (the merger of upstream and downstream firms in the supply chain) and conglomerate mergers (the merger of two or more firms from different supply chains).

Although the Clayton and Celler-Kefauver Acts gave the federal government the authority to take legal action to block mergers, it was not until 1968 that the Antitrust Division of DOJ published guidelines to reduce uncertainty about proposed mergers that it found unacceptable. Until then, firms might devote substantial financial resources to structure a merger, only to have these efforts undermined by a DOJ lawsuit. Initially, these guide-lines specified that if an industry’s 4-firm concentration ratio was equal to or

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Industry Organization

181

greater than 75 percent, the merger of a firm with a 15 percent or more market share with another firm controlling as little as 1 percent market share would be challenged in the courts. These guidelines, which were amended in 1984, replaced the 4-firm concentration ratio with the Herfindahl-Hirschman Index.

According to the revised guidelines, a proposed merger between two firms in an industry with a HHI of 1,000 or less will not be challenged since it is not a threat to social welfare. If HHI is between 1,000 and 1,800, proposed mergers within the same industry will be reviewed if the resulting index rises by more than 100 points. Finally, an industry with an HHI greater than 1,800 would be considered highly concentrated. In this case, proposed mergers that raise the index by more than 50 points will be challenged. A recent example of this was the proposed takeover of T-Mobile by the American Telephone and Telegraph Company (AT&T).

In March, 2011, AT&T announced its intention to acquire T-Mobile, the American subsidiary of T-Mobile International AG, a division of Deutsche Telekom. The following August, the DOJ filed a lawsuit in federal court to block the proposed merger. In November, the Federal Communication Commission announced that it opposed the proposed $39 billion takeover on the grounds that it was not in the public interest. Less than a month later, AT&T withdrew its tender offer and would write off $4 billion in the current quarter to cover breakup fees owed to T-Mobile’s parent company. Had the proposed merger been approved, it would have catapulted AT&T, the second-largest mobile phone provider in the U.S., into the number one spot, ahead of industry leader Verizon Wireless.

DOJ opposition to the proposed merger came as no surprise. From the beginning, the takeover faced a storm of criticism from smaller wireless net-work competitors. More importantly, the DOJ found that the merger would have raised the Herfindahl-Hirschman Index by 368 points to 3,216—well above the trigger of 50 and 1,800 required for DOJ review under the revised antitrust guidelines. According to the DOJ complaint, AT&T and T-Mobile competed in 97 of the nation’s largest 100 consumer markets. They also com-peted nationwide for business and government customers. AT&T’s acquisi-tion of T-Mobile would result in higher prices, poorer quality services, fewer choices and fewer innovative products for the millions of American consum-ers who rely on mobile wireless services.

Solved Exercise

Two industries consist of 10 firms. Both industries have total sales of $28 million. The two largest firms in industry A have sales of $5 million, the next two firms have sales of $3 million, and the remaining six firms have

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