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Principles of Economics

11.1 Corporate Mergers

Principles of Economics11.1 Corporate Mergers
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How Economies Can Be Organized: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 Consumer Choices
    1. Introduction to Consumer Choices
    2. 6.1 Consumption Choices
    3. 6.2 How Changes in Income and Prices Affect Consumption Choices
    4. 6.3 Labor-Leisure Choices
    5. 6.4 Intertemporal Choices in Financial Capital Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  8. 7 Cost and Industry Structure
    1. Introduction to Cost and Industry Structure
    2. 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
    3. 7.2 The Structure of Costs in the Short Run
    4. 7.3 The Structure of Costs in the Long Run
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  9. 8 Perfect Competition
    1. Introduction to Perfect Competition
    2. 8.1 Perfect Competition and Why It Matters
    3. 8.2 How Perfectly Competitive Firms Make Output Decisions
    4. 8.3 Entry and Exit Decisions in the Long Run
    5. 8.4 Efficiency in Perfectly Competitive Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Monopoly
    1. Introduction to a Monopoly
    2. 9.1 How Monopolies Form: Barriers to Entry
    3. 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  11. 10 Monopolistic Competition and Oligopoly
    1. Introduction to Monopolistic Competition and Oligopoly
    2. 10.1 Monopolistic Competition
    3. 10.2 Oligopoly
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  12. 11 Monopoly and Antitrust Policy
    1. Introduction to Monopoly and Antitrust Policy
    2. 11.1 Corporate Mergers
    3. 11.2 Regulating Anticompetitive Behavior
    4. 11.3 Regulating Natural Monopolies
    5. 11.4 The Great Deregulation Experiment
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  13. 12 Environmental Protection and Negative Externalities
    1. Introduction to Environmental Protection and Negative Externalities
    2. 12.1 The Economics of Pollution
    3. 12.2 Command-and-Control Regulation
    4. 12.3 Market-Oriented Environmental Tools
    5. 12.4 The Benefits and Costs of U.S. Environmental Laws
    6. 12.5 International Environmental Issues
    7. 12.6 The Tradeoff between Economic Output and Environmental Protection
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  14. 13 Positive Externalities and Public Goods
    1. Introduction to Positive Externalities and Public Goods
    2. 13.1 Why the Private Sector Under Invests in Innovation
    3. 13.2 How Governments Can Encourage Innovation
    4. 13.3 Public Goods
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Poverty and Economic Inequality
    1. Introduction to Poverty and Economic Inequality
    2. 14.1 Drawing the Poverty Line
    3. 14.2 The Poverty Trap
    4. 14.3 The Safety Net
    5. 14.4 Income Inequality: Measurement and Causes
    6. 14.5 Government Policies to Reduce Income Inequality
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  16. 15 Issues in Labor Markets: Unions, Discrimination, Immigration
    1. Introduction to Issues in Labor Markets: Unions, Discrimination, Immigration
    2. 15.1 Unions
    3. 15.2 Employment Discrimination
    4. 15.3 Immigration
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
  17. 16 Information, Risk, and Insurance
    1. Introduction to Information, Risk, and Insurance
    2. 16.1 The Problem of Imperfect Information and Asymmetric Information
    3. 16.2 Insurance and Imperfect Information
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  18. 17 Financial Markets
    1. Introduction to Financial Markets
    2. 17.1 How Businesses Raise Financial Capital
    3. 17.2 How Households Supply Financial Capital
    4. 17.3 How to Accumulate Personal Wealth
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  19. 18 Public Economy
    1. Introduction to Public Economy
    2. 18.1 Voter Participation and Costs of Elections
    3. 18.2 Special Interest Politics
    4. 18.3 Flaws in the Democratic System of Government
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  20. 19 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 19.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 19.2 Adjusting Nominal Values to Real Values
    4. 19.3 Tracking Real GDP over Time
    5. 19.4 Comparing GDP among Countries
    6. 19.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 Economic Growth
    1. Introduction to Economic Growth
    2. 20.1 The Relatively Recent Arrival of Economic Growth
    3. 20.2 Labor Productivity and Economic Growth
    4. 20.3 Components of Economic Growth
    5. 20.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Unemployment
    1. Introduction to Unemployment
    2. 21.1 How the Unemployment Rate is Defined and Computed
    3. 21.2 Patterns of Unemployment
    4. 21.3 What Causes Changes in Unemployment over the Short Run
    5. 21.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  23. 22 Inflation
    1. Introduction to Inflation
    2. 22.1 Tracking Inflation
    3. 22.2 How Changes in the Cost of Living are Measured
    4. 22.3 How the U.S. and Other Countries Experience Inflation
    5. 22.4 The Confusion Over Inflation
    6. 22.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  24. 23 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 23.1 Measuring Trade Balances
    3. 23.2 Trade Balances in Historical and International Context
    4. 23.3 Trade Balances and Flows of Financial Capital
    5. 23.4 The National Saving and Investment Identity
    6. 23.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 23.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  25. 24 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Demand/Aggregate Supply Model
    2. 24.1 Macroeconomic Perspectives on Demand and Supply
    3. 24.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 24.3 Shifts in Aggregate Supply
    5. 24.4 Shifts in Aggregate Demand
    6. 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 24.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  26. 25 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 25.1 Aggregate Demand in Keynesian Analysis
    3. 25.2 The Building Blocks of Keynesian Analysis
    4. 25.3 The Phillips Curve
    5. 25.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  27. 26 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 26.1 The Building Blocks of Neoclassical Analysis
    3. 26.2 The Policy Implications of the Neoclassical Perspective
    4. 26.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  28. 27 Money and Banking
    1. Introduction to Money and Banking
    2. 27.1 Defining Money by Its Functions
    3. 27.2 Measuring Money: Currency, M1, and M2
    4. 27.3 The Role of Banks
    5. 27.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  29. 28 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 28.1 The Federal Reserve Banking System and Central Banks
    3. 28.2 Bank Regulation
    4. 28.3 How a Central Bank Executes Monetary Policy
    5. 28.4 Monetary Policy and Economic Outcomes
    6. 28.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  30. 29 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 29.1 How the Foreign Exchange Market Works
    3. 29.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 29.3 Macroeconomic Effects of Exchange Rates
    5. 29.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  31. 30 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 30.1 Government Spending
    3. 30.2 Taxation
    4. 30.3 Federal Deficits and the National Debt
    5. 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 30.5 Automatic Stabilizers
    7. 30.6 Practical Problems with Discretionary Fiscal Policy
    8. 30.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  32. 31 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 31.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 31.2 Fiscal Policy, Investment, and Economic Growth
    4. 31.3 How Government Borrowing Affects Private Saving
    5. 31.4 Fiscal Policy and the Trade Balance
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  33. 32 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 32.1 The Diversity of Countries and Economies across the World
    3. 32.2 Improving Countries’ Standards of Living
    4. 32.3 Causes of Unemployment around the World
    5. 32.4 Causes of Inflation in Various Countries and Regions
    6. 32.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  34. 33 International Trade
    1. Introduction to International Trade
    2. 33.1 Absolute and Comparative Advantage
    3. 33.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 33.3 Intra-industry Trade between Similar Economies
    5. 33.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  35. 34 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 34.3 Arguments in Support of Restricting Imports
    5. 34.4 How Trade Policy Is Enacted: Globally, Regionally, and Nationally
    6. 34.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  36. A | The Use of Mathematics in Principles of Economics
  37. B | Indifference Curves
  38. C | Present Discounted Value
  39. The Expenditure-Output Model
  40. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
    22. Chapter 22
    23. Chapter 23
    24. Chapter 24
    25. Chapter 25
    26. Chapter 26
    27. Chapter 27
    28. Chapter 28
    29. Chapter 29
    30. Chapter 30
    31. Chapter 31
    32. Chapter 32
    33. Chapter 33
    34. Chapter 34
  41. References
  42. Index

By the end of this section, you will be able to:

  • Explain antitrust law and its significance
  • Calculate concentration ratios
  • Calculate the Herfindahl-Herschman Index (HHI)
  • Evaluate methods of antitrust regulation

A corporate merger occurs when two formerly separate firms combine to become a single firm. When one firm purchases another, it is called an acquisition. An acquisition may not look just like a merger, since the newly purchased firm may continue to be operated under its former company name. Mergers can also be lateral, where two firms of similar sizes combine to become one. However, both mergers and acquisitions lead to two formerly separate firms being under common ownership, and so they are commonly grouped together.

Regulations for Approving Mergers

Since a merger combines two firms into one, it can reduce the extent of competition between firms. Therefore, when two U.S. firms announce a merger or acquisition where at least one of the firms is above a minimum size of sales (a threshold that moves up gradually over time, and was at $70.9 million in 2013), or certain other conditions are met, they are required under law to notify the U.S. Federal Trade Commission (FTC). The left-hand panel of Figure 11.2 (a) shows the number of mergers submitted for review to the FTC each year from 1999 to 2012. Mergers were very high in the late 1990s, diminished in the early 2000s, and then rebounded somewhat in a cyclical fashion. The right-hand panel of Figure 11.2 (b) shows the distribution of those mergers submitted for review in 2012 as measured by the size of the transaction. It is important to remember that this total leaves out many small mergers under $50 million, which only need to be reported in certain limited circumstances. About a quarter of all reported merger and acquisition transactions in 2012 exceeded $500 million, while about 11 percent exceeded $1 billion. In 2014, the FTC took action against mergers likely to stifle competition in markets worth 18.6 billion in sales.

The graph on the left shows that the number of mergers have dropped substantially since 2000. The graph on the right shows that the majority of mergers in 2012 were between $100 million and $150 million.
Figure 11.2 Number and Size of Mergers (a) The number of mergers in 1999 and 2000 were relatively high compared to the annual numbers seen from 2001–2012. While 2001 and 2007 saw a high number of mergers, these were still only about half the number of mergers in 1999 and 2000. (b) In 2012, the greatest number of mergers submitted for review was for transactions between $100 and $150 million.

The laws that give government the power to block certain mergers, and even in some cases to break up large firms into smaller ones, are called antitrust laws. Before a large merger happens, the antitrust regulators at the FTC and the U.S. Department of Justice can allow the merger, prohibit it, or allow it if certain conditions are met. One common condition is that the merger will be allowed if the firm agrees to sell off certain parts. For example, in 2006, Johnson & Johnson bought the Pfizer’s “consumer health” division, which included well-known brands like Listerine mouthwash and Sudafed cold medicine. As a condition of allowing the merger, Johnson & Johnson was required to sell off six brands to other firms, including Zantac® heartburn relief medication, Cortizone anti-itch cream, and Balmex diaper rash medication, to preserve a greater degree of competition in these markets.

The U.S. government approves most proposed mergers. In a market-oriented economy, firms have the freedom to make their own choices. Private firms generally have the freedom to:

  • expand or reduce production
  • set the price they choose
  • open new factories or sales facilities or close them
  • hire workers or to lay them off
  • start selling new products or stop selling existing ones

If the owners want to acquire a firm or be acquired, or to merge with another firm, this decision is just one of many that firms are free to make. In these conditions, the managers of private firms will sometimes make mistakes. They may close down a factory which, it later turns out, would have been profitable. They may start selling a product that ends up losing money. A merger between two companies can sometimes lead to a clash of corporate personalities that makes both firms worse off. But the fundamental belief behind a market-oriented economy is that firms, not governments, are in the best position to know if their actions will lead to attracting more customers or producing more efficiently.

Indeed, government regulators agree that most mergers are beneficial to consumers. As the Federal Trade Commission has noted on its website (as of November, 2013): “Most mergers actually benefit competition and consumers by allowing firms to operate more efficiently.” At the same time, the FTC recognizes, “Some [mergers] are likely to lessen competition. That, in turn, can lead to higher prices, reduced availability of goods or services, lower quality of products, and less innovation. Indeed, some mergers create a concentrated market, while others enable a single firm to raise prices.” The challenge for the antitrust regulators at the FTC and the U.S. Department of Justice is to figure out when a merger may hinder competition. This decision involves both numerical tools and some judgments that are difficult to quantify. The following Clear it Up helps explain how antitrust laws came about.

Clear It Up

What is U.S. antitrust law?

In the closing decades of the 1800s, many industries in the U.S. economy were dominated by a single firm that had most of the sales for the entire country. Supporters of these large firms argued that they could take advantage of economies of scale and careful planning to provide consumers with products at low prices. However, critics pointed out that when competition was reduced, these firms were free to charge more and make permanently higher profits, and that without the goading of competition, it was not clear that they were as efficient or innovative as they could be.

In many cases, these large firms were organized in the legal form of a “trust,” in which a group of formerly independent firms were consolidated together by mergers and purchases, and a group of “trustees” then ran the companies as if they were a single firm. Thus, when the U.S. government passed the Sherman Antitrust Act in 1890 to limit the power of these trusts, it was called an antitrust law. In an early demonstration of the law’s power, the U.S. Supreme Court in 1911 upheld the government’s right to break up Standard Oil, which had controlled about 90% of the country’s oil refining, into 34 independent firms, including Exxon, Mobil, Amoco, and Chevron. In 1914, the Clayton Antitrust Act outlawed mergers and acquisitions (where the outcome would be to “substantially lessen competition” in an industry), price discrimination (where different customers are charged different prices for the same product), and tied sales (where purchase of one product commits the buyer to purchase some other product). Also in 1914, the Federal Trade Commission (FTC) was created to define more specifically what competition was unfair. In 1950, the Celler-Kefauver Act extended the Clayton Act by restricting vertical and conglomerate mergers. In the twenty-first century, the FTC and the U.S. Department of Justice continue to enforce antitrust laws.

The Four-Firm Concentration Ratio

Regulators have struggled for decades to measure the degree of monopoly power in an industry. An early tool was the concentration ratio, which measures what share of the total sales in the industry are accounted for by the largest firms, typically the top four to eight firms. For an explanation of how high market concentrations can create inefficiencies in an economy, refer to Monopoly.

Say that the market for replacing broken automobile windshields in a certain city has 18 firms with the market shares shown in Table 11.1, where the market share is each firm’s proportion of total sales in that market. The four-firm concentration ratio is calculated by adding the market shares of the four largest firms: in this case, 16 + 10 + 8 + 6 = 40. This concentration ratio would not be considered especially high, because the largest four firms have less than half the market.

If the market shares in the market for replacing automobile windshields are:
Smooth as Glass Repair Company 16% of the market
The Auto Glass Doctor Company 10% of the market
Your Car Shield Company 8% of the market
Seven firms that each have 6% of the market 42% of the market, combined
Eight firms that each have 3% of the market 24% of the market, combined
Then the four-firm concentration ratio is 16 + 10 + 8 + 6 = 40.
Table 11.1 Calculating Concentration Ratios from Market Shares

The concentration ratio approach can help to clarify some of the fuzziness over deciding when a merger might affect competition. For instance, if two of the smallest firms in the hypothetical market for repairing automobile windshields merged, the four-firm concentration ratio would not change—which implies that there is not much worry that the degree of competition in the market has notably diminished. However, if the top two firms merged, then the four-firm concentration ratio would become 46 (that is, 26 + 8 + 6 + 6). While this concentration ratio is modestly higher, the four-firm concentration ratio would still be less than half, so such a proposed merger might barely raise an eyebrow among antitrust regulators.

Link It Up

Visit this website to read an article about Google’s run-in with the FTC.

QR Code representing a URL

The Herfindahl-Hirshman Index

A four-firm concentration ratio is a simple tool, which may reveal only part of the story. For example, consider two industries that both have a four-firm concentration ratio of 80. However, in one industry five firms each control 20% of the market, while in the other industry, the top firm holds 77% of the market and all the other firms have 1% each. Although the four-firm concentration ratios are identical, it would be reasonable to worry more about the extent of competition in the second case—where the largest firm is nearly a monopoly—than in the first.

Another approach to measuring industry concentration that can distinguish between these two cases is called the Herfindahl-Hirschman Index (HHI). The HHI, as it is often called, is calculated by summing the squares of the market share of each firm in the industry, as the following Work it Out shows.

Work It Out

Calculating HHI

Step 1. Calculate the HHI for a monopoly with a market share of 100%. Because there is only one firm, it has 100% market share. The HHI is 1002 = 10,000.

Step 2. For an extremely competitive industry, with dozens or hundreds of extremely small competitors, the value of the HHI might drop as low as 100 or even less. Calculate the HHI for an industry with 100 firms that each have 1% of the market. In this case, the HHI is 100(12) = 100.

Step 3. Calculate the HHI for the industry shown in Table 11.1. In this case, the HHI is 162 + 102 + 82 + 7(62) + 8(32) = 744.

Step 4. Note that the HHI gives greater weight to large firms.

Step 5. Consider the example given earlier, comparing one industry where five firms each have 20% of the market with an industry where one firm has 77% and the other 23 firms have 1% each. The two industries have the same four-firm concentration ratio of 80. But the HHI for the first industry is 5(202) = 2,000, while the HHI for the second industry is much higher at 772 + 23(12) = 5,952.

Step 6. Note that the near-monopolist in the second industry drives up the HHI measure of industrial concentration.

Step 7. Review Table 11.2 which gives some examples of the four-firm concentration ratio and the HHI in various U.S. industries in 2009. (You can find market share data from multiple industry sources. Data in the table are from: Verizon (for wireless), The Wall Street Journal (for automobiles), IDC Worldwide (for computers) and the U.S. Bureau of Transportation Statistics (for airlines).)

U.S. Industry Four-Firm Ratio HHI
Wireless 91 2,311
Largest five: Verizon, AT&T, Sprint, T-Mobile, MetroPCS
Automobiles 63 1,121
Largest five: GM, Toyota, Ford, Honda, Chrysler
Computers 74 1,737
Largest five: HP, Dell, Acer, Apple, Toshiba
Airlines 44 536
Largest five: Southwest, American, Delta, United, U.S. Airways
Table 11.2 Examples of Concentration Ratios and HHIs in the U.S. Economy, 2009

In the 1980s, the FTC followed these guidelines: If a merger would result in an HHI of less than 1,000, the FTC would probably approve it. If a merger would result in an HHI of more than 1,800, the FTC would probably challenge it. If a merger would result in an HHI between 1,000 and 1,800, then the FTC would scrutinize the plan and make a case-by-case decision. However, in the last several decades, the antitrust enforcement authorities have moved away from relying as heavily on measures of concentration ratios and HHIs to determine whether a merger will be allowed, and instead carried out more case-by-case analysis on the extent of competition in different industries.

New Directions for Antitrust

Both the four-firm concentration ratio and the Herfindahl-Hirschman index share some weaknesses. First, they begin from the assumption that the “market” under discussion is well-defined, and the only question is measuring how sales are divided in that market. Second, they are based on an implicit assumption that competitive conditions across industries are similar enough that a broad measure of concentration in the market is enough to make a decision about the effects of a merger. These assumptions, however, are not always correct. In response to these two problems, the antitrust regulators have been changing their approach in the last decade or two.

Defining a market is often controversial. For example, Microsoft in the early 2000s had a dominant share of the software for computer operating systems. However, in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. A narrowly defined market will tend to make concentration appear higher, while a broadly defined market will tend to make it appear smaller.

There are two especially important shifts affecting how markets are defined in recent decades: one centers on technology and the other centers on globalization. In addition, these two shifts are interconnected. With the vast improvement in communications technologies, including the development of the Internet, a consumer can order books or pet supplies from all over the country or the world. As a result, the degree of competition many local retail businesses face has increased. The same effect may operate even more strongly in markets for business supplies, where so-called “business-to-business” websites can allow buyers and suppliers from anywhere in the world to find each other.

Globalization has changed the boundaries of markets. As recently as the 1970s, it was common for measurements of concentration ratios and HHIs to stop at national borders. Now, many industries find that their competition comes from the global market. A few decades ago, three companies, General Motors, Ford, and Chrysler, dominated the U.S. auto market. By 2014, however, these three firms were making less than half of U.S. auto sales, and facing competition from well-known car manufacturers such as Toyota, Honda, Nissan, Volkswagen, Mitsubishi, and Mazda. When HHIs are calculated with a global perspective, concentration in most major industries—including cars—is lower than in a purely domestic context.

Because attempting to define a particular market can be difficult and controversial, the Federal Trade Commission has begun to look less at market share and more at the data on actual competition between businesses. For example, in February 2007, Whole Foods Market and Wild Oats Market announced that they wished to merge. These were the two largest companies in the market that the government defined as “premium natural and organic supermarket chains.” However, one could also argue that they were two relatively small companies in the broader market for all stores that sell groceries or specialty food products.

Rather than relying on a market definition, the government antitrust regulators looked at detailed evidence on profits and prices for specific stores in different cities, both before and after other competitive stores entered or exited. Based on that evidence, the Federal Trade Commission decided to block the merger. After two years of legal battles, the merger was eventually allowed in 2009 under the conditions that Whole Foods sell off the Wild Oats brand name and a number of individual stores, to preserve competition in certain local markets. For more on the difficulties of defining markets, refer to Monopoly.

This new approach to antitrust regulation involves detailed analysis of specific markets and companies, instead of defining a market and counting up total sales. A common starting point is for antitrust regulators to use statistical tools and real-world evidence to estimate the demand curves and supply curves faced by the firms that are proposing the merger. A second step is to specify how competition occurs in this specific industry. Some possibilities include competing to cut prices, to raise output, to build a brand name through advertising, and to build a reputation for good service or high quality. With these pieces of the puzzle in place, it is then possible to build a statistical model that estimates the likely outcome for consumers if the two firms are allowed to merge. Of course, these models do require some degree of subjective judgment, and so they can become the subject of legal disputes between the antitrust authorities and the companies that wish to merge.

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