[An updated version of this article can be found at Industrial Concentration in the 2nd edition.]
Industrial concentration occurs when a small number of companies sell a large percentage of an industry's product. The most widely used measure of concentration is the so-called four-firm concentration ratio, which is the percentage of the industry's product sold by the four largest producers. If, for example, four firms each sell 10 percent of an industry's product, the four-firm concentration ratio for that industry is 40 percent.
Concentration in the United States
Concentration varies considerably across industries in the United States. In the household laundry equipment, breakfast cereal, and cigarette industries, the four largest companies produce well over 80 percent of the industry's product. At the other extreme the four largest firms in wooden household furniture, fur goods, and women's and misses' dresses sell well under 20 percent. For all U.S. industries the average four-firm concentration ratio is 37 percent. Weighted by industry sales, it is 36 percent. This average has been quite stable for a long time. In 1935 the average four-firm concentration ratio for U.S. industries was 40 percent; weighted by sales it was 37 percent. In 1977 the average was 37 percent, while the weighted average was 39 percent. In other words, there has been no discernible long-run trend toward concentration of industry since the Great Depression.
Effects of Concentration
Why does concentration matter? Economists used to fear that if only a few companies sold an industry's product, those few would collude to raise prices. Wrote conservative economist George Stigler in a 1952 Fortune article titled "The Case against Big Business": "When a small number of firms control most or all of the output of an industry, they can individually and collectively profit more by cooperation than by competition.... These few companies, therefore, will usually cooperate."
Some of the evidence supports this view. Economists who have compared the prices of a particular product or service across geographically separated markets have found that concentration increases prices. These same studies, however, show that the effect of concentration on prices, although statistically significant, is very small. A study of airline markets after deregulation found that airline fares in markets containing two equal-size competitors were 8 percent higher than the fares in similar markets with four equal-size competitors. In other cases, however, industrial concentration had a large effect on prices. One study found that the advertising rates of Irish provincial newspapers were 25 percent lower when three or more newspapers served a particular market area.
Of forty-six articles published before the early seventies on the relationship between concentration and profits (as opposed to prices), forty-two found that the more concentrated an industry, the higher were its profits. However, the correlation was statistically weak. Moreover, the implied effect of concentration on prices was found to be small: the average markup over long-run costs was only 1 to 5 percent higher in concentrated industries.
More recent—and more careful—studies find no statistically significant relationship between industrial concentration and profitability. This is true not only for U.S. industries but also for industries in other countries. This evidence has shifted most economists' viewpoints substantially. Concludes MIT economist Richard Schmalensee, a noted industrial organization scholar: "The relation, if any, between seller concentration and profitability is weak statistically, and the estimated concentration effect is usually small. The estimated relation is unstable over time and space and vanishes in many multivariate studies."
Causes of Concentration
Why are some industries concentrated and others not? One reason is economies of scale. If a company, for example, can lower its average costs by 3 percent by increasing its output by 10 percent, then it must be large to produce its product efficiently. The larger each company in the industry, the more concentrated the industry must be.
Industrial concentration can also be a natural result of competition. If some companies keep producing products that satisfy their customers more than their rivals' products do, consumers will "reward" these companies by buying more from them. The result is that concentration increases. Indirect evidence supports the view that competing successfully causes concentration. Economists have found that the profitability of the largest producers in U.S. industries is positively correlated to industrial concentration. But if a result of industrial concentration is to raise prices, the profits of small firms in an industry should also be correlated with industrial concentration. They are not. The most plausible conclusion, therefore, is that concentration is a reward for being successful.
Of course, horizontal mergers (that is, mergers of companies that produce the same product) are an obvious cause of concentration. Do mergers cause collusion? If they did, the rivals of the merged firms would benefit as well from diminished competition and higher prices. The stock prices of these rivals should then increase when an impending merger is announced. But they do not.
Merger and Antitrust Policy
Economists now understand that industrial concentration is unlikely to cause collusion and that concentration is a natural result of economies of scale and successful competition. This new understanding is now reflected in U.S. antitrust laws. Whereas antitrust officials used to disallow mergers that gave the top four firms a market share of less than 40 percent, they now often approve mergers that would give the top four firms a market share of over 70 percent. The merger of tire producers Michelin and Goodrich is one example. Charles F. Rule, formerly the Reagan administration's chief antitrust official, summed it up: "In the Sixties and Seventies [the evaluation of proposed mergers] was all based on concentration. In the Seventies, as an underpinning, it was wiped out. There was a problem with just using concentration. [In the Eighties], we used it as a screen to tell us when to look further, say, into market operations, price discrimination, previous market share and loss of entry into the market by competitors."
Another reason economists and antitrust officials are less concerned about industrial concentration is that so much competition is global. In 1980 MIT's Lester Thurow, a liberal economist, wrote in The Zero-Sum Society:
In 1986, for example, just three companies—General Motors, Ford, and Chrysler—produced 95 percent of all cars manufactured in the United States. However, the big three accounted for only 70 percent of auto sales in the United States, the remainder being foreign imports. General Motors, Ford, and Chrysler produce only 30 percent of the world's automobiles.
Thurow himself questions antitrust laws on this basis: "If competitive markets are desired, the appropriate policy should be to reduce barriers to free trade.... If one measures the potential gains to be made by enforcing the antitrust laws, as opposed to reducing real barriers to international trade, it is clear that the large gains exist in the area of more international competition."
Thomas W. Gilligan is a professor of finance and business economics at the University of Southern California.
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Brozen, Yale. Concentration, Mergers, and Public Policy. 1982.
Thurow, Lester. The Zero-Sum Society. 1980.
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Gilbert, R. Alton. "Bank Market Structure and Competition: A Survey." Journal of Money, Credit and Banking 16 (1984): 617-45.
Smirlock, Michael, T. Gilligan, and William Marshall. "Tobin's q and the Structure-Performance Relationship." American Economic Review 74 (1984): 1051-60.