Question

1. Explain why the condition of production and allocative efficiency tend to not emerge in monopolistic markets. Explain why a firm should shut down when the given market price is below its average variable costs.

2. Explain why HHI measures are superior to the four-firm concentration ratio for assessing the level of potential market power in an industry.   Explain why HHI measures are not effective at identifying potential collusion or price fixing in the industry.

Answer 1

Question 1

Usually, in a monopolistic competitive market, firms puts the price greater than their marginal costs. It means market will not have production efficiency. Allocative efficiency emerges when a product is produced at a level maximized by social welfare.

A firm implements shutdown of production when revenue from sale of products produced cannot even compensate the variable costs of production. Then,the firm will suffer huge loss when it produces.

Shutdown occurs if average revenue is below average variable cost at the profit maximizing positive level of output. Producing anything would not generate enough revenue to balance the associated variable costs by producing some output would add extra costs in addition to revenue to the costs unavoidable being incurred. Without production, firm loses only fixed costs.

Question 2

HHI means Herfindahl-Hirschman Index. Four-firm concentration ratio is used to indicate the degree to which an industry is oligopolistic and the market extent control held by the four largest firms in the industry. The four-firm concentration ratio is calculated based on the market shares of the largest firms in the industry.

The ability of a firm to raise its price over marginal cost is said to be market power.  Market power exercised by a dominant firm that it raises prices above competitive levels, may stifle consumer demand, generate efficiency losses and harm the public interest. In addition, firms with significant market power or dominance may implement strategies to further reduce competition and enhance their position in the market. The importance of assessing market power is related to the future of regulation.

HHI is an index of the number of firms in the market and their market shares. While the four-firm concentration ratio adds market shares of a small number of firms in the market, the so-called Herfindahl index considers the full distribution of market shares. HHI is more adequate for a full market setup, than observing a particular concentration ratio in one firm. HHI provides a better measure of concentration as it captures both the number of firms and the dispersion of the market shares.

HHI measures are not effective at identifying potential collusion or price fixing in the industry. High concentration measured by HHI may facilitate collusion in certain situations, but may lead to more price wars. More the number of price-fixing cases brings homogeneous markets suggests that collusive behavior is a greater problem in such markets. However, it cannot be determined whether this problem is because of greater detectability of collusion in similar product markets or a greater tendency of firms to collude in such markets. The difficulty of identifying the reason for collusive behavior makes it difficult to select the best one.