The markets are constantly changing and evolving due to factors like new products, new technologies, and emerging production and distribution methods. This dynamism requires competition law, which aims to maintain competition in the markets, to be just as dynamic and continuously evolving.
In line with the above, economic methods are used for evaluating markets, defining product markets or geographical markets, and assessing specific behaviors of enterprises and their effects. Various indexes and tests are taken into account. However, it’s essential to remember that these methods and tests are based on certain assumptions that may not always hold in real-life situations, or some tests that were once fashionable in economic discipline might lead to errors if not used carefully.
Therefore, this article will focus on evaluating three indicators that provide insights into the level of competition in a specific market. These indicators are YOn (Concentration Ratio), HHI (Herfindahl-Hirschman Index), and PCM (Price-Cost Margin):
CRn – Concentration Ratio (CRn)
In its most general sense, CRn represents the sum of market shares of n companies in a specific market, arranged from largest to smallest. Depending on the nature of the business, it’s also possible to measure the concentration ratio using different metrics like sales revenue, production quantity, and employment[1]. The most common metric is CR4, representing the total market share of the four largest companies. While this value provides insights into the concentration of the market, the specific reasons outlined below lead to its limited application in competition law.
HHI – Herfindahl-Hirschman Index
This index, created by economists Orris C. Herfindahl and Albert O. Hirschman, consists of the sum of squares of market shares of firms in a specific market. (For example, if are n firms in a market, and each firm’s market share is represented as a, b, c, …, n, then HHI = a2 + b2 + c2 + … + n2). When market shares are expressed as percentages, HHI values range from 0 to 10,000. When expressed as decimals, they range from 0 to 1.0. Unlike CRn, HHI considers the influence of larger market shares, contributing to a more meaningful representation of market concentration.
This difference can be illustrated with an example: Consider a market with only four firms. If these companies have equal market shares, the HHI value would be 2,500. However, if the market shares are (80, 10, 5, 5), then the HHI value would be 6,550. In both cases, CR4 remains 100.
Since 1982, U.S. competition authorities (Federal Trade Commission and Department of Justice) have used HHI, especially in evaluating mergers and acquisitions. Markets with HHI values below 1,500 are considered “unconcentrated markets,” those with values between 1,500 and 2,500 are termed “moderately concentrated markets,” and markets with values above 2,500 are considered “highly concentrated markets.” Transactions that increase HHI values by more than 200 points in highly concentrated markets are assumed to enhance market power[3].
HHI is a useful tool in evaluating mergers and acquisitions. Still, it also comes with the risk of potentially misrepresenting changes in the “level of competition” in a specific market over different periods. For instance, an increase from an HHI of 1,500 in the first period to 2,000 in the second period may indicate market concentration. However, at first glance, this might be interpreted as a decrease in competition. This is because the market shares of one firm have increased, moving further away from the conditions of a perfectly competitive market where firms are homogenous and none have significant pricing power (atomicity). On the other hand, if the increase in HHI is driven by a firm operating more efficiently and capturing more market share, it should be considered a natural consequence of competition. In short, HHI should not be interpreted as implying that any increase indicates restricted competition, as with PCM.
PCM – Price-Cost Margin
Within the economic theory, prices are equal to marginal costs in a perfectly competitive market. The size of the difference between a firm’s price and its marginal cost indicates the firm’s market power. In practice, the PCM values of firms in a market are aggregated based on their market shares to arrive at a PCM value for that market. Lower PCM values suggest more intense competition in that market.
HHI and CR4 are calculated solely based on market shares, while PCM requires information on the prices and costs of firms in the market and thus depends on market shares to derive the market’s PCM value. PCM, like HHI, provides valuable information about the level of competition in a particular market. However, when moving from theoretical considerations to reality, the heterogeneity of firms in the market, differences in their scales, production technologies, and other factors mean that some firms may be more efficient and operate at lower costs. Therefore, when interpreting the differences in PCM between the two periods, attributing the increase in the second period directly to the exercise of market power and competition restriction may be misleading. This is because, as with HHI, the reason for low-cost firms increasing their market shares and, through weighting, increasing the PCM value in the market is not a restriction of competition but rather arises from more efficient competition.
Evaluation
The three indicators described in this article are characterized by emerging within the Structure-Conduct-Performance Paradigm[4]. Therefore, it’s assumed that markets with fewer firms (concentrated/oligopoly markets) have less competition, and CRn and HHI attempt to define the “structure of the market.” PCM, on the other hand, approaches the issue from a performance perspective.
Another characteristic of these three indicators is that they rely on mechanical calculations and don’t require sophisticated tools like econometric analysis or statistical forecasting. Hence, while there are various derivatives of these three indicators, no alternative that is as strong and widespread has emerged.
On the other hand, the most significant disadvantage of all three indicators is that they don’t necessarily exhibit a monotonic relationship with market competition. For example, increased competition doesn’t always lead to a decrease in HHI; if intensified competition results in a more effective firm increasing its market share, HHI can point in the wrong direction. The same applies to CRn. Regarding PCM, an efficient firm’s increased market share, especially in a measurement weighted by market share, carries the risk of misleading us about the direction of market competition5.
Given that the primary purpose of these three indicators is to provide insights into the level of competition in a specific market, it is essential to start with accurately defining the relevant market. This entails making a precise analysis by considering the unique features of the case, distinguishing from various statistical classifications used in competition law. This analysis necessitates the application of various tests, and the discussion of these tests and their potential risks will be the topic of a subsequent article.
* Head of Inspection and Application Department of the Competition Authority. The views expressed in this study are the author’s own and do not bind the Competition Authority.
** The original version of this article was published in the “Competition Articles” section of the Competition Authority’s website.
1 Competition Terminology Dictionary, Competition Authority Publications, Ankara – 2010; p.107
2 http://en.wikipedia.org/wiki/Herfindahl_index (05.05.2012)
3 http://www.justice.gov/atr/public/guidelines/hmg.htm (05.05.2012)
4 Competition Terminology Dictionary, Competition Authority Publications, Ankara – 2010; p.102
5 Boone, J., J. van Ours, H. van der Wiel (2007), How (not) to measure competition. CPB Discussion Paper No 91.
