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Lombard could survey its customers to find out where else they shop. This would certainly identify some competitors, but it might miss others. In particular, Lombard would never hear from customers who live near its store but always shop elsewhere. To identify all of its competitors, Lombard should first ask its customers where they live. The store can identify the contiguous area from which it draws most of its customers, sometimes called the catchment area. If most of its customers live near downtown, then Lombard’s list of competitors should include other downtown sporting goods stores. But suppose, as seems likely, that some downtown residents shop at sporting goods stores outside of downtown. To identify these competitors, Lombard should perform a second survey of local residents (not just its own customers) to find out where they shop for sporting goods.

This is an example of flow analysis—examining data on consumer travel patterns. Although flow analysis is a good starting point for identifying geographic competitors, it is not foolproof. It may turn out that few customers currently shop far from downtown, but they might do so if Lombard and other downtown stores were to raise their prices. Or it may be that many customers who currently shop outside of downtown do so for idiosyncratic reasons—perhaps they are avid hockey players, and downtown stores do not sell hockey gear. With the exception of such exotic merchandise, these distant stores may not be competitors after all.

MEASURING MARKET STRUCTURE

Markets are often characterized according to the degree of seller concentration. This permits a quick and reasonably accurate assessment of the likely nature of competition in a market. These characterizations are aided by measures of market structure.

Market structure refers to the number and distribution of firms in a market. A common measure of market structure is the N-firm concentration ratio. This gives the combined market share of the N largest firms in the market. For example, the 5-firm concentration ratio in the UK pesticide industry is about .75, which indicates that the combined market share of the five largest pesticide sellers in the UK is about 75 percent. (Note that the ratio is reported for a specific product within a specific geographic area.) When calculating market share, one usually uses sales revenue, although concentration ratios based on other measures, such as production capacity, may also be used. Table 5.1 shows 4-firm and 20-firm concentration ratios for selected U.S. industries in 2007.

One problem with the N-firm ratio is that it is invariant to changes in the sizes of the largest firms. For example, a 5-firm ratio does not change value if the largest firm gains 10 percent share at the expense of the second largest firm, even though this could make the market less competitive. The Herfindahl index avoids this problem.3 The Herfindahl index equals the sum of the squared market shares of all the firms in the market; that is, letting Si represent the market share of firm i, Herfindahl 5 Si(Si)2. In a market with two firms that each have 50 percent market share, the Herfindahl index equals

.52 1 .52 5 .5. The Herfindahl index in a market with N equal-size firms is 1/N. Because of this property, the reciprocal of the Herfindahl index is referred to as the numbersequivalent of firms. Thus, a market whose Herfindahl is .20 has a numbers-equivalent of 5. Roughly speaking, such a market is about as competitive as a market with 5 equal-sized firms, whether or not there are exactly 5 firms in the market. When calculating a Herfindahl, it is sufficient to restrict attention to firms with market shares of .01 or larger, since the squared shares of smaller firms are too small to affect the Herfindahl.