Limitations of Concentration Ratios and HHI Information

Despite the obvious attraction of census concentration ratios and HHI data as useful information on the number and size distribution of current competitors, it is prudent to remain cautious in their use and interpretation. Important limitations must be recognized. By not appreciating these limitations, one might make fundamental errors in judging the vigor of competition within industries.

A major drawback of concentration ratio and HHI information is that they take a long time to collect and publish. Data for 1997 were not generally available on the Internet until 2000 and 2001; data for 2002 will be collected in 2003 and published in 2004 and 2005. In many fast-moving markets, these data are obsolete before they are published. Even in less dynamic markets, they provide only an imperfect guide to managerial decision making. As a result, many managers supplement census information with current data available on the Internet from market research firms.

A further important weakness of census concentration ratio and HHI information is that they ignore domestic sales by foreign competitors (imports) as well as exports by domestic firms. Only data on domestic sales from domestic production, not total domestic sales, are reported. This means, for example, that if foreign imports have a market share of 25 percent, the four leading domestic automobile manufacturers account for 66.2 percent (_ 88.3 percent of 75 percent) of total U.S. foreign plus domestic car sales (NAICS 33611), rather than the 88.3 percent, as Table 11.5 suggests. For industries with significant import competition, concentration ratios and HHI data significantly overstate the relative importance of leading domestic firms. Concentration ratios and HHI information also overstate market power for several industries in which increasing foreign competition has been responsible for the liquidation or merger of many smaller domestic firms with older, less efficient production facilities. Despite reduced numbers of domestic firms and the consequent rise in concentration, an increase in foreign competition often makes affected industries more efficient and more competitive rather than less so. The impact of foreign competition is important in many industries, but it is particularly so in manufacturing industries such as apparel, steel, automobiles, cameras, copiers, motorcycles, and television sets.

Another limitation of concentration ratio data is that they are national totals, whereas a relevant economic market may be national, regional, or local in scope. If high transportation costs or other product characteristics keep markets regional or local rather than national in scope, concentration ratios can significantly understate the relative importance of leading firms. For example, the leading firm in many metropolitan newspaper markets often approaches 100 percent of classified advertising and subscription revenues. Thus, a national CR4 for newspapers would significantly understate local market power. Although national four-firm concentration ratios of less than 25 percent usually suggest a highly competitive market, the local or regional character of some markets can make national concentration figures meaningless. Examples of other products with local or regional rather than national markets include milk, bread and bakery products, commercial printing, and ready-mix concrete.

Additional problems occur because concentration ratios and HHI information provide an imperfect view of market structure by including only firms that are currently active in a particular industry. Recall that an economic market includes all firms willing and able to sell an identifiable product. Besides firms currently active in an industry, this includes those that can be regarded as likely potential entrants. Often the mere presence of one or more potential entrants constitutes a sufficient threat to force competitive market behavior in industries with only a handful of established competitors. Major retailers such as Wal-Mart, Target, and Sears, for example, use their positions as potential entrants into manufacturing to obtain attractive prices on a wide range of private-label merchandise such as clothing, lawn mowers, washing machines, and so on.

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