the largest Nfirms in the industry Range: 0-100%4 Firm Concentration ratio: Market share controlled by the largest 4 firms We need a statistic that summarizes the main features of an industry. Such statistic should:•Be a simple measure•Account for the likely event that firms are not symmetric•Evidently, computation of any concentration ratio first requires that we clearly define what is the relevant market

#2: The Herfindahl-Hirshman Index (HHI)69It is defined as the sum of the squares of market shares of each firm in the industryIt accounts for the asymmetry of distribution of sizes and it includes the market shares of all firms in the industryRange:Perfect Competition = 0 Monopolist = 10,000HHI is higher the fewer firms in an industryHHI increases the more asymmetric the distribution of firm sizesniisHHI12

Herfindahl IndexThe m-firm concentration ratio is intuitive but it does not capture important features of the size distribution of sellers, namely, asymmetries in the distribution of these sizes. 70

The Herfindahl-Hirshman Index Example:For Industry A:For Industry B:71415055405022222500252525252222

The Herfindahl-Hirshman Index (HHI)72Below 100 ==> a highly competitive industryBelow 1,500 ==> an unconcentrated industry1,500 - 2,500 ==> moderate concentrationOver 2,500 ==> high concentration

The Herfindahl-Hirshman Index (HHI)73

The Herfindahl-Hirshman Index (HHI)74

How to predict behavior?In perfect competition, behavior is predictableBut when there is a small number of competitors, prediction is more challenging“A natural way to incorporate the reactions of rivals into your analysis of strategic options is to assign probabilities to their likely actions or reactions and then choose the decision that maximizes the expected value of your profit, given this probability distribution. But this approach has an important drawback: How do you assign probabilities to the range of choices your rivals might make? Better to “get inside the minds” of your competitors, figure out what is in their self-interest, and then maximize accordingly. However, your rivals’ optimal choices will often depend on their expectations of what you intend to do, which, in turn, depend on their assessments of your assessments about them. How can one sensibly analyze decision making with this circularity?”Besanko, 2007

Game TheoryHow to read payoff matrixRows, then columnsStrategy 1Strategy 2Strategy 1A , BA , BStrategy 2A , BA , BCompany ACompany BPayof for Company A if A adopts Strategy 1, and B adopts Strategy 2Payof for Company B if A adopts Strategy 1, and B adopts Strategy 2

Game TheoryPrisoner’s DilemmaConfessDon’t ConfessConfess-10, -100, -11Don’t Confess-11, 0-1, -1Prisoner 1Prisoner 2

How to read Prisoner’s DilemmaYou are Prisoner 2. If Prisoner 1 confesses, what is your best strategy? confess. You will only spend 10 years in prison instead of 11.If Prisoner 1 doesn’t confess, what is your best strategy? again, confess. You will spend no time in prison, instead of 1 year. Your “dominant strategy” is to confess.ConfessDon’t ConfessConfess-10, -100, -11Don’t Confess-11, 0-1, -1Prisoner 1Prisoner 2The rational pursuit of self-interest leads each party to take an action that is ultimately detrimental to their collective interest

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