The recent US
elections has brought to the fore the role of Big Tech. the Big Tech was
unapologetic and unhesitating in its power to swing the vote balance towards
Biden across the country. One might argue that it was the election management
of Democrats in those crucial swing states that tilted the balance in a deeply
divided country. Yet it cannot be denied that the Big Tech using its lock-in
power on information is acting virtually as a supra-constitutional authority.
However, the question that creeps into the mind is obviously how one is going to
quantify this market power. It is easy in qualitative terms through a prism of
perception to argue a certain firm is powerful or not. One can posit a certain
power commands a significant power in deciding the narrative or pushing to the
fore its profits or controlling significantly the dimension of prices. Despite
this, it would be difficult to conceive market power in the absence of a
quantitative measure. The current post surveys the various quantitative measures
that exist and seek to measure market power.
It would be
prudent to begin with the simplest one. This is of course the Concentration
ratio. The concentration ratio measures the combined market share of the
largest firms in a particular industry or a sector. It might be wise to
question how one selects the industry or the sector but considerable literature
has been devoted in classifying the industries and sectors. In fact, for
macroeconomic measures, the government has come with classifications for various
industries, sectors, sub-sectors etc. Therefore, it would not be difficult to
classify the various industries though the definitions and the classifications
often tend to become obsolete with the changing environment. For instance,
Google is often considered as a technology firm whereas in reality it could be
a firm that is more of space selling or information powerhouse or even a media
firm. The same can go with let us say a social media platform like Twitter. Yet
in short run, the classifications work and they get periodically reviewed
across the globe. Second question would obviously be how many firms need to be
counted or factored in for the measure. In practice, it is usually the combined
market share of the four largest firms in the industry. Since four firms are
taken, it is called as four firm concentration ratio. If the three largest
firms were factored in, it would be termed as three firm concentration ratio.
The
concentration ratio indicates the market share in combined terms of the largest
firms in the industry. Higher the concentration ratio implies higher the market
power thus the market assuming the characteristics of oligopoly. Higher three
firm ratio indicates a strong possibility of movement towards monopoly. Yet the
picture one obtains from concentration is misleading. If the four firm
concentration ratio is 80, it indicates a high degree of oligopoly, yet when
decomposed it might be that the largest firm would have 60% market share while
the rest three have a combined market share of twenty percent. This indicates a
strong degree of monopoly. Another case might wherein the three firm
concentration ratio might be 75% yet each of those three firms might command a
market share of twenty five percent each which implies a very highly competitive
tripoly than something indicated in the aggregate picture. To overcome this,
the usual practice is to take market shares of all firms in the market. These
market shares are squared and the sum of these squares is taken as a measure of
market power. In some context, the square root of these sum of squares is
calculated. The squaring up of market shares of all firms eliminates
distortions created by the concentration ratio as indicated above. In the two
instances cited above the latter might yield a lower number relative to the
former. Therefore this measure is more appropriate in seeking to quantify
market power. This measure is called Herfindhal Index. In normal course, higher
Herfindhal index points to greater market concentration while lower values indicate
competitive markets. The figures usually range from 10 to 100 if the square
root of the sum of squares is considered else it is between 100 and 10000.
While the above
two measures seek to quantify the market power through an analysis of market
shares, there is another method that seeks to measure market power through the
pricing policy of the firm. This makes the competitors redundant. The argument
is if the firm commands significant pricing power, it implies a strong market
presence. The more competitive the market is, the less the control the firm has
over the prices. In a perfectly competitive market, the firm does not have
control over the price but only over the output. The prices are determined by
the market and the firm acts as a price taker. Therefore, Lerner index seeks to
measure this pricing power. One way to measure is to identify the reciprocal of
own price elasticity of demand. This is obvious since if the good is elastic and
the competitors are more, the firm is unlikely to price it high. The second
measure talks about the price in relation to marginal cost. In a competitive
market, the firm prices at its marginal cost. As the firm gains market power,
it is likely to price above its marginal cost though the mathematical condition
still remains marginal revenue equating marginal costs. The Lerner index
therefore seeks in quantifying market power through the ratio of excess price
over marginal costs to the price of the good or the service. It can be
expressed as (P-MC)/P wherein P is the price of the good and MC is the marginal
cost. Higher the ratio would imply higher the market power. The lower the ratio
implies low market power. In a perfectly competitive world where firm has to
price at its marginal cost, the Lerner index is zero. However, the difficulty
lies in identifying accurately the marginal costs. This makes it difficult for
use.
Normally to the competition
authorities, it is the Herfindhal index that is of importance. Again, it is not
the absolute measure that might be of importance but the changes in Herfindhal
index that is used to understand the changing currents of the market structures
and dominance. The current post has sought to give a broad primer on measures
of market power. Sometime later on, the post would extend its discussion into
the applied use of these measures through relevant case studies.
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