Market structure plays an important role in any industry. Examining the market structure is essential for firms to perform well and behave rationally. The key characteristics of market structure include the number and size of firms, the existence and height barriers to entry and exit, and the degree of product differentiation. Seller concentration refers to the number and level of distribution of firms producing a particular type of output (Needham, 1978).
Empirical evidence shows that market concentration level determines business behaviour; therefore seller concentration is one of the most often used indicators of industry structure and receives a lot of attention from economists and public policy makers. Hence, this essay is going to discuss seller concentration levels as interest on both theoretical and public policy grounds. It will explain the indices and determinants of seller concentration giving real world examples with a focus on consequences of seller concentration on markets and implications for policy making.
In order to clearly understand the importance of seller concentration, it is essential to look at the different ways it is measured. First of all, seller concentration can be measured at two levels. The first is known as aggregate concentration. Aggregate concentration is measured as the share of n largest firms in the total sales, assets or employment (Lipczynski, Wilson and Goddard, 2005). A good example of aggregate concentration is the share of the five largest Member States in the European Union, value added.
The average share for the non-financial business economy as a whole reached 72. 8 % in 2007 (Euro Stat, 2011). The highest concentration level was for the manufacture of office machinery and computers, and the lowest for the manufacture of food and beverages. These concentration measures generally highlight the larger Member States; with occasional contributions from the Netherlands, Poland, Ireland, Denmark, Belgium, Finland or Sweden (Euro Stat, 2011). The second level of seller concentration is known as industry concentration or market concentration.
It measures the proportion of total market supply that is accounted for by the production of a particular group of firms in the industry. There are many indices being used by policy makers to measure market concentration level. The most widely used indices are concentration ratios, Gini coefficient, Herfindahl- Hirschman index, Hannah and Kay index, entropy coefficient and the variance of logarithms in firm size. The concentration ratio measures the top 4 or 5 firms’ sum of market share. For example, the concentration ratio of grocery market in the UK (2009) was 81. %.
However this ratio does not include the rest of firms and does not consider the distribution of them. As a result, many economists argue that this type of measurement is too simple and more accurate indices should be used. One of such indices is Gini coefficient. This coefficient involves all the firms in the industry and shows the level of inequality in firms’ size distribution.
The value of Gini coefficient varies between 0 and 1, where 1 means that there is one dominant firm in the market (high concentration) (Lipczynski, Wilson and Goddard, 2005). Herfindahl- Hirschman index is calculated by the sum of the squares of the market shares of each firm. Therefore, larger firms get higher weighting to reflect their relative importance in the industry. Hence, the high index points out high level of concentration in the industry. Hannah and Kay criticised some ideas of Herfindahl- Hirschman index and suggested a new index in 1977.
There are more ‘weighted’ sum concentration measures, such as Entropy coefficient, however they are all similar. The results estimated by different indices usually show the same tendencies. However, some deficiencies occur with the use of all these indices. For example, it might be difficult to define the industry correctly, to estimate the size of market or find out the influence of imports and exports. Not only a good analysis and a wide understanding of market structure, but also knowing what leads to high seller concentration can be the basis for effective policies.
Economists emphasise some very important determinants of market concentration, such as economies of scale, barriers to entry, regulation, economies of scope, firm and industry lifecycles, innovation, industry size, product differentiation, and mergers. For example, the ‘economies of scale’ assumes that firms seek to become larger in order to achieve cost efficiencies: the greater output will lead to lower average cost per unit, which may increase firm’s profitability and growth. That is one of the main reasons why firms try to become larger and get the bigger piece of market share.
Larger firms can also produce more diverse products, and thus increase their market share. This is referred to as economies of scope. Barriers to entry refer to ability for a new firm to enter the market. Often, the existing firms make it very difficult for new firms to establish themselves in the market. For example, the existing companies have more flexibility in determining the price of their products and can spend huge amounts of money on advertising – a luxury that smaller companies don’t often have. A good example of an industry that faces barriers to entry is mobile network market.
In the UK, there are 5 leading companies (O2, Vodafone, T-mobile, Orange and 3) which have 97 % of market share (OFcom, 2011). Other companies, such as ‘Lebara mobile’, struggle to gain more market share even though they may provide a very competitive level of service for their customers. One of the ways to gain market share for such companies is not simply to provide a service at a similar level to their competitors but to focus more on product differentiation and innovation. Furthermore, some economists see the relationship between industry lifecycles and concentration level in that industry.
In the early stage of industry there are no specialist suppliers of row materials, so manufacturers engage in backward integration, which leads to high concentration level. However, when industry grows, the number of specialist suppliers of raw materials and the distribution of goods increases, which leads to falling of the concentration level (Stigler, 1968). Furthermore, the size of industry is another essential determinant. There is more competition in larger markets where more firms exist. As a result, the concentration level will be lower in larger industries.
However, the level might increase a lot if firms merge. When firms merge, they increase their market power and achieve economies of scale and scope. Recently, 2 biggest UK mobile network companies T-mobile and Orange merged, becoming the UK’s largest network operator with29. 5 million customers, leapfrogging Vodafone and O2. (The Independent, 2011). Obviously there is a correlation between determinants and consequences of high seller concentration. One of the main consequences of high market concentration is an increase of market power.
Firms become more powerful and it leads to higher prices and sometimes to lower output. More than 2600 mergers have occurred in the US petroleum industry since 1990s. (United States General Accounting Office, 2004). As a result of so many mergers the concentration level of this industry increased substantially. The consequences of such change in concentration level are decrease in ability for new firms enter the market and increase in fuel prices. GAO’s econometric analyses show that oil industry mergers led to higher wholesale gasoline prices of about 2 cents per gallon, on average.
In some states such as California, the price increased by 7 cents per gallon. Higher wholesale gasoline prices were also a result of other factors: low gasoline inventories, which typically occur in the summer driving months; high refinery capacity utilization rates; and supply disruptions, which occurred in the United States (United States General Accounting Office , 2004). This example clearly proves that usually higher concentration leads to higher prices and that can even influence the whole economy. Another important result, that might occur because of greater market concentration is higher unemployment.
In 2004 International Labour Office wrote a report on employment effects of mergers and acquisitions (M&A’s) in commerce. Having analysed a lot of industries and regions, ILO agreed that that M&A’s generally lead to job losses and that the number of jobs in the merged company will commonly be lower than the sum of the jobs in its constituent enterprises. These losses, especially from mature industries with little potential for growth, come about as a result of consolidation and the related organizational restructuring and rationalization of operations, which first reduce and then limit the creation of new jobs (ILO, 2004).
Moreover, this study concluded that the quality of employment and working conditions get worse with the higher level of market concentration. Generally, firms can differentiate their products and gain more market share by raising barriers to entry. This will lead to higher level of seller concentration in the industry. However, Goetz and Gugler (2004) found out that not always higher concentration will result in more differentiated products. They say that more concentrated markets in spatially differentiated industries display less product variety.
The main determinants of this factor are fixed entry and exit costs. Hence, higher concentration might have negative impact on product differentiation. On the other hand, there some positive effects of greater seller concentration. When firms are larger and more powerful, they are able to spend more money on research and development to create or improve products. Schumpeterian hypothesis and empirical evidences show that more concentrated industries stimulate innovation. Moreover, high concerted industries can experience cost savings through rationalization, productive efficiency, economies of scale.
However these advantages do not weight out the negative effects of high seller concentration. Policy makers have some tools to regulate the level of concentration in the economy. Government intervention can influence this level significantly. If government introduce strong policies aimed at increasing competition by discouraging restrictive practices and disallowing mergers that are against the ‘public interest’ it will inhibit concentration (Lipczynski, Wilson and Goddard, 2005).
For example, if two large companies want to merge in the UK, they have to get permission not only from the local government but also from European Commission. In the UK mergers are controlled by Competition Commission (CC). CC is an independent public body which conducts in-depth inquiries into mergers, markets and the regulation of the major regulated industries (CC, 2011). But usually it is very hard for both CC and European Commission to find strong and clear arguments why the merge should be banned. Anyway, European Commission plays an important role trying to increase competition in the EU and decrease market concentration.
Introducing the same currency (Euro), expanding the market (new EU members), creating Schengen Area (free goods and services moving within EU), making the similar tariffs, taxes, excise duties – all these are the excellent examples of strong polices seeking greater competition. In conclusion, it can be said that market concentration is a very important determinant in business. It might influence not only the particular industry but the whole economy. High seller concentration leads to higher prices, more market power and more jobs losses. Although there are some policies trying to beat high market concentration, it is not very effective.
References
- Lipczynski J, Wilson J. and Goddard J. , (2005). Industrial organization. 2nd edition. Harlow: Pearson Education
- Needham D. (1969). Economic analysis and industrial structure. 1st edition. New York : Holt, Rinehart and Winston.
- OFcom (2011). The Communications Market 2009. Available at: http://stakeholders. ofcom. org. uk/market-data-research/market-data/communications-market-reports/c r09/ (Last acceded at 3rd of May, 2011)
- Stigler G. J. (1968) The organisation of industry. 1st edition. Irwin. The Independent (2011) EU approves Orange and T-Mobile merger. Available at: http://www. independent. co. uk/news/business/news/eu-approves-orange-and-tmobile-merger-1914347. html.
- Global (2011). What a difference a year makes. Available at: http://www. tnsglobal. com/news/news-1031D0AACECC42D4857E893355BBEF91. aspx
