IO Chapter 14 Skip 14.3

So far we have discussed how to measure market concentration and the positive and negative ramifications of market concentration, but the question remains, why does market concentration occur and do markets 'naturally' gravitate towards a particular level of concentration?

As with most economic questions, the empirical results are mixed.

Looking at the graphs on p. 242 (figures 14.1 and 2) we see that in France and Germany market concentration by industry looks pretty similar.

But at the same time, when we compare Belgium and France we see differences.

What determines market concentration?

Why does it make more sense to compare France and Germany than France and Belgium?

1. Market size.

A small country, with a small demand, is likely to have more concentrated markets than a large country.

Recall some of your basic microeconomics - what was one reason for extreme market concentration (monopoly) - a 'natural' monopoly, which in turn is a function of what?

2. The shape of the cost curve. So one factor going into the level of market concentration is the cost function, which in turn may be related to technology.

As it turns out, economists have derived a formula to show the theoretical relationship between market size, costs, and market concentration.

Using this formula, economists can estimate what the ideal number of firms in a particular industry should be. This does not of course mean that the ideal number of firms will exist, but allows economists to test whether the market is mimicking what economic theory predicts.

The formula for the optimal number of firms in a given industry is:

n = [(a-c)(S/ F)^½ - 1] (rounding down)

where a is a measure of demand, c and F of costs and S of market size.

Notice that as S increases, n increases. Also note that fixed costs (F) and variable costs (c) are inversely related to the number of firms. Why is that?

There is also the idea in economics that there is a 'minimum efficient scale' (MES).

This refers to the fact that there may be a minimum size which a firm has to attain in order to be competitive (also related to the cost structure and technology.)

Concentration should be positively related to MES.

Think about the LRAC curve.

Firms need to be at or near the bottom of the AC curve in the long run.

What is the relationship between M and AC at various points on the curve?

Economists may examine the ratio of the two costs (AC/MC) for an idea how concentrated it is likely to be.

The technology/cost function forms a barrier to entry, particularly if it takes a large size and a lot of capital to enter a particular industry.

3. The history/regulation in a particular region matter as well.

Access to technology

Access to multiple forms of technology (microbreweries vs. big beer making)

4. Other barrier to entry may be advertising.

As the book points out, advertising costs themselves may be a function of the size of a particular market and so one might see similar numbers of firms in small and big markets, because the entry costs are positively related to the size of the market.

R & D expenditures may be another barrier to entry.

Table 14.1 provides some data on advertising/sales (would have been useful to have had that last chapter.) (p. 251)

In figures 14.3 and 4, size/MES is compared with C4. Notice the truncation (lower bound) in Figure 14.4, as compared to Figure 14.3. Why is size divided by MES, rather than looking simply at size? Because different industries may have different optimal sizes (MES).