The Critical Choice Between the Concentration Ratio and the H-Index in Assessing Industry Performance Author(s): Leo

Sleuwaegen and Wim Dehandschutter Source: The Journal of Industrial Economics, Vol. 35, No. 2 (Dec., 1986), pp. 193-208 Published by: Blackwell Publishing Stable URL: http://www.jstor.org/stable/2098358 . Accessed: 12/05/2011 18:46
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THE JOURNAL OF INDUSTRIAL ECONOMICS Volume XXXV December 1986

0022-1821 $2.00 No. 2

THE CRITICAL CHOICE BETWEEN THE RATIO AND THE H-INDEX CONCENTRATION ASSESSING INDUSTRY PERFORMANCE*
LEO SLEUWAEGENAND WiM DEHANDSCHUTTER

IN

The paper shows that in addition to the theoretical relevance of choosing between the Hirschman-Herfindahl index and the concentration ratio, both measures may provide empirically very different information to assess industry performance.It is shown that the correspondence between the two measures can be represented by a horn-shaped figure. The implications of this horn-shaped relationship are investigated in the context of specifying empirical profitability-concentration models. Among different specification effects tested, it is shown that the neglect of the hornrelationship may bias the results towards the identification of a critical concentration ratio.

INTRODUCTION

Tus PAPER analyzes some of the implications of the relationship between the Hirschman-Herfindahl index (from now H-index) and the k-firm concentration ratio (Ck) within the context of empirical models dealing with price-cost margins and concentration. In the first section of the paper, it is shown that the mapping of all H-index values for given Ck values does not correspond to a simple function, but follows the pattern of a horn. From using several properties of this hornshaped relationship, alternative hypotheses about the choice between the two concentration measures in specifying empirical profit-concentration relationships are tested on a sample of US industries in section II. With the H-index considered as the appropriate (Ckencompassing) concentration measure, we further investigate the specification effects of using several k-firm concentration ratios as surrogate variables in profitability regressions. Among the different effects tested, the empirical identification of a critical concentration ratio in section III shows up as a remarkable (artifact)result. The last section of the paper summarizes the results in view of the current practice of using concentration measures to assess industry performance.
*We would like to thank the members of the INdustry and Company Analysis Program for the very stimulating discussion from which the present paper originated. We gratefully acknowledge the helpful comments from Raymond D. Bondt, Denis de Crombrugghe, Charles Baden Fuller. Also the constructive comments from an anonymous referee and the Editor of this Journal were very helpful in improving the final text. The usual disclaimer applies.

(INCAP)

193

194

AND WIM DEHANDSCHUTTER LEOSLEUWAEGEN

INDICES BETWEENCkAND H CONCENTRATION I. THE HORN RELATIONSHIP

It is well known from theory that price-cost margins may be directly related to different measures of concentration, depending on the prevailing conduct of firms within the industry. Within this framework, the k-firm concentration ratio
Ck=

Z si (si denoting the market share of firm i, belonging to

i= 1 n

the

k largest firms) is consistent with collusive price-leadership oligopoly (Saving [1970]) while the H-index, H=
E si2 (n, the number of firms in the

industry) is related to noncooperative Cournot-Nash behaviour (Cowling and Waterson [1976]). In view of the theoretical relevance of choosing between the H-index and the concentration ratio, several studies have explored the extent to which the concentration ratio and the H-index provide differentinformation (see Curry and George [1983] for a recent survey). The analyses in these studies are not easy to interpret and sometimes produced conflicting results (see, for instance, Hause [1977] and Schmalensee [1977]). The conflict seems to be due to the statistical nature of the studies, whereby the results are heavily dependent upon the particular samples of industries used in the analyses. In order to illustrate this problem we have plotted in Figure 1 and Figure 2 the C4 ratio against the H-index, for Belgian and US industry data, respectively. For Belgium we can show the plot for a continuous range of C4 from 0 to 1. Unfortunately for the US data, presumably because of confidentialityreasons, the range stops at C4 = 0.87. This is very regrettable, since it is especially in
H 1.0-

0.9 0.80.7/

0.6/ o q

0.50.4-

/
00

0 o

z~
0

0.3-

0.4-

lb o%

0-00

0.2~~~~~~~
0.1 0-

0.2

0.4

0.6

0.8

1.0 C4

Figure1 The HornRelationship BelgianIndustries (1981) for

THE CONCENTRATION RATIO AND THE H-INDEX H 1.0-

195

0.90.8-

0.70.6-

0.5-

0.40.3-

0.2~~~~~~~~~~
0.1 00 0.2 0.4 0.6 0.8 1.0

Figure2 (1956) for TheHornRelationship US Industries

C4

the top range that the relationship between C4 and H becomes very interesting and (possibly) divergent. Conclusions drawn for the particular US sample (Schmalensee [1977]) may therefore be very different from those based on the Belgian sample (or a Japanese sample, as in Hause [1977]). The statistical problem may be understood better by exploiting some of the mathematical properties of the two concentration indices in order to find the set of possible combinations between the two measures. From studying these properties we find that the ranges of possible H-index values corresponding to given Ck values follow the pattern of a horn. As proven in the appendix, the limiting boundaries are given by the following formulae: min H = Ce/k
max H = Ck2

k being the number of firms included in the concentration ratio

if
Ck > <

l/k 1/k (the linear piece in the graphs,

max H =

Ck/k

if Ck

except for a small fraction if k(l - Ck)Ck not an integer number (see appendix)).

is

This suggests that the relationship between C4 and H cannot, contrary to what has been suggested before, be linearly approximated. Given the possible ranges of the H-index in the horn, a concentration ratio is likely to be (although it need not be) a bad proxy for the H-index in concentrated industries. Therefore,the horn-shaped relationship provides an answer to the very different degrees of correlations and kinds of relationships between Ck and H, found in studies where differentsamples of industries were used.

196
H-1.00.9-

AND WIM DEHANDSCHUTTER LEOSLEUWAEGEN

0.80.70.60.50.40.30.20.1 00 0.2 0.4 0.6 0.8 1.0

CK Figure3 Numberof Firmsk witha Varying TheHornRelationship

k=4

Several interesting properties of the horn emerge. First, from the boundary formulae it is possible to analyze the effects of varying k, the number of leading companies included in the concentration ratio, on the shape of the horn. This is done in Figure 3. It shows the narrowing of the horn for decreasing values of k. The lower bound tilts up, as does the linear part of the upper bound (shown for C2 and C4). Second, the maximum value of H in the region Ck > l/k as well as its minimum value over the whole range assume an infinite number of firms. Considering a finite number of firms does not fundamentally affect the horn shape of the relationship. Figure 4 shows the upper and lower bound for n = 10.1 The figure illustrates how the finite (actual) number of firms helps to explain why empty regions occur in the actual Herfindahl distribution within the horn. Third, a conditional (upon Ck) numbers equivalent H-index appears, which provides information to analyze the degree of concentration within industries (Adelman [1969]). This conditional numbers equivalent H is given by the straight line, which is also the maximum (except for the eventual fraction) for values of Ck lower than l/k. The fact that many industries fall below it implies that the number of firms in these industries is larger than the (conditional) strict minimum number and that the variance of the sizes is not able to tilt their H-index above the line. Given their Ck-ratio these industries are relatively unconcentrated in terms of the H-index measure.
I Using the transfer principle (see appendix), in this case the upper bound is calculated from letting nine (n-1) firms hold an equal share, (1- Ck)/(n-k), and the tenth (dominant) one the remainder.The lower bound is given by (Ck,/k)+(1 -Ck)2/(n-k).

THE CONCENTRATION RATIO AND THE H-INDEX H 1.0-

197

0.90.80.70.60.50.4-

0.30.20.1 00 0.2 0.4 0.6 0.8 1.0

C4 Figure4 witha Finiteand FixedNumberof Firms,Equalto 10 TheHornRelationship

Fourth, the horn-shaped relationship can be related to the concept of iso-concentration curves, introduced by Davies [1979]. Assuming lognormal firm size distributions, Davies related curves representing fixed values of some concentration measure to n, the number of firms in the industry, and a2, the variance of their sizes. This property makes it easy to find for each iso-Ck curve the implied range of H (comparable to a vertical slice in the horns shown above). The interested reader can verify that from the definitions of the H-index ( = exp (2I2/n) under lognormality) Davies' results imply a widening range of H as Ck increases, confirming the horn-like pattern (see also Hart [1979]).
H. THE CHOICE OF CONCENTRATION MEASURE IN EMPRICAL MODEL SELECTION

In the previous section it was argued that a distinction between the C4 and the H-index is justified on both theoretical and empirical grounds. This raises the question how to specify the empirical relationship between profitability and industrial concentration. One possible approach to tackle the specification problem is to assume that the choice problem is simple with only one of the two concentration measures being relevant to include in empirical (cross-section) industry profitability models. Assume this measure to be the H-index. It then becomes possible to predict what results will be obtained when other concentration measures are substituted for the H-index. If the assumption holds this would imply the testable hypothesis that, for the sample considered, the results obtained for the H-index model can account for those obtained with some Ck

198

AND WIM DEHANDSCHUTTER LEOSLEUWAEGEN

ratio as explanatory variable and not vice versa. This "encompassing" property, as it is known in the econometrics literature (see Hendry and Richard [1983]), may be explicited as follows. Consider the two "competing" hypotheses with alternatively H and Ck as regressors for explaining industry profitability:
J

(1) (2)

(r/R)i = f6o +fIHCi + (n;/R),= bo + &1 Ck,i+

|jzji +8Hi

= 2

where index i denotes the industry and Zji denotes other regressors than concentration measures. The cHi and ECi are error terms assumed to be independently and normally distributed. However, since high profit industries are often characterised by some "extreme" firms entailing less averaging-out of errors, we expect eHi and ici to be subject to heteroscedasticity. Describe similarly the H - Ck relationship by (3)
Hi = xO+OlCki+vi

where, following the horn-shaped relationship, vi is not expected to be stationarily distributed. Substituting (3) in (1) yields:
J

(4)

(n/R)i = fio + #I oo+ #1al Cki + ,

jZji + (H1i +f1 vi)

Hence, if (1) and (3) are true, someone estimating (2) is in fact estimating (4) and is able to deduce from (1) and (3) what results will be obtained from estimating (4). Thus, if (3) is a "true" relation, we are led to the following testable hypotheses: (i) Nesting both Ck and H as regressors in one equation should result in a coefficient of Ckinsignificantly differentfrom zero. In terms of (2) and (3) this hypothesis implies (requiring no additional testing, see Hendry and Richard + [1983, p. 140]) 51 = clx1/l.Similarly, 5j= ljforj = 2,..., J and 60 = PBo flpo. (ii) The smaller k, the number of leading companies in Ck, the more the estimation results of model (2) using Ck will approach those obtained using the H-index as concentration measure. This follows from the results in the previous section where it was shown that the horn becomes narrower and a linear approximation of the H-index by the Ck-ratio better for decreasing values of k. Furthermore, we expect the non-stationarity of the error term in (3) to show up in the profitability regression where Ck is used as independent variable. Although the non-stationarity applies to other moments than the variance, and unless eHi and vi have strong negative correlation, we expect it to augment the measured degree of heteroscedasticity.

THE CONCENTRATION RATIO AND THE H-INDEX

199

(iii) Given the horn-shaped relationship, it follows that the choice between H and Ck in profit regressions should not matter too much for low concentration industries (C4 < 0.50) but may become very important for high concentration industries (C4 > 0.50). Moreover (unless the condition H < Ck/kis satisfied over the whole sample (cfr. section I)), we would expect a significant shift in magnitude of the estimated Ck coefficient for the groups of high and low concentration industries. These points are tested against US data, which enables us to relate our findings to previous work, where the same or similar data were used. In line with many other studies the following empirical specification is posited to test the above hypothesis: (5) (r/R) = f(CON, H, KO, GRO,ADV,CDR)

The dependent variable (r/R) is defined as the percentage gross return before taxes on sales for the industry in 1958. The reason why we took the year 1958 is explained by the absence of H-index data for more recent years (see hereafter)(source: Collins and Preston [1968]). CON is one of the following concentration measures: C4, C8, C20 for the industry. H is the corresponding Hirschman-Herfindahl index. The data were taken from Nelson [1963] and cover H-indices and Ck ratios computed from the same US census data. It appears this is the only data set available containing such information for a large sample of US industries. Unfortunately, these data relate to the year 1956. As already mentioned, another problem with the published data is that the most concentrated industry in the sample has a four firm concentration ratio equal to 0.87. As we argued, it is especially in the missing, very concentrated industries that the choice problem becomes very important (compare Figures 1 and 2 in section I). Nevertheless, we assume the data set to contain enough information for tests on it to be of interest. KO is the capital-output ratio for the industry in 1958 (source: Collins and Preston [1968]). GRO measures industry growth in sales between 1954 and 1958. ADV stands for the advertising to sales ratio of the industry (source: Ornstein [1977]). CDR is a cost disadvantage ratio measured as the value added per worker-hour of the four largest firms divided by the average value added per worker-hour in the industry (source:Nelson [1963]). Matching the different data sources resulted in a sample of fifty-four comparable four-digit SIC industries. The tests, corrected for heteroscedasticity,2are presented in Tables I-III. The "nesting"regression (column (6) in Table I) clearly supports our basic
2 In estimating the differentequations, we found support for the heteroscedasticity assumption. The absolute values of the residuals correlated strongly with (ir/R)i. the fitted profitability (taken as the best estimate of E((7r/R)i Ii), the conditional mathematical expectation of industry profitability). We correspondingly assumed the error term variance to be Uj2 = U2E(ir/R)f and used 7r'R as weight factor in the weighted least squares regressions (see Kmenta [1971, pp. 261-264]).

200

AND WIM DEHANDSCHUTTER LEOSLEUWAEGEN TABLE I

REGRESSIONS OF INDUSTRY

PROFITABILITY ON VARIOUS MEASURES OF CONCENTRATION: ALL INDUSTRIES

(6) CONSTANT H
C4

(7) -0.062 (-0.786) 0.519 (4.062)

(8) -0.139 (-1.475) 0.208 (3.546)

(9) -0.166 (-1.574)

(10) 0.170 (1.386)

-0.055 (-0.528) 0.557 (1.671) -0.021 (-0.141)

C8 C20 CDR GRO ADV KO R2 S.E.R. 0.112 (1.892) 0.276 (1.364) 0.844 (4.305) 0.131 (2.615) 0.480 0.071 0.114 (2.059) 0.279 (1.358) 0.837 (4.274) 0.127 (2.553) 0.480 0.070 0.137 (2.321) 0.298 (1.403) 0.838 (4.112) 0.133 (2.593) 0.432 0.073

0.194 (3.153) 0.143 (2.323) 0.351 (1.604) 0.912 (4.476) 0.124 (2.363) 0.400 0.075 -0.077 (- 1.232) 0.025 (0.345) 0.249 (1.059) 1.143 (5.046) 0.122 (2.140) 0.209 0.086

in errorof regression.) are S.E.R. = standard (Values parentheses t-ratios,

H-encompassing hypothesis (i). The coefficient of C4 is not significantly different from zero and the inclusion of C4 leaves, in comparison with the H-only regression (column (7)), the goodness of fit, as good as unchanged. Similar results obtain for C8 and C20 (not shown). In line with the encompassing property of the H-index model, the estimated coefficients of the concentration ratio variables closely resemble the products of the H-coefficient in regression (7) with their respective coefficients in the H on Ck regressions of Table II (except for C20, which regression displays a large standard error). Regarding the second testable point, the specification of different Ck ratios, a look at the R2 series (calculated from unweighted residuals) reveals that of all the concentration ratio models, the model with C4 has the highest explanatory power. Completely in line with our expectations, the C8 and C20 models display an increasingly deteriorating performance. The correlation of H with C20 seems to be too small for the concentration ratio to be able to serve as a surrogate variable for the H-index at all, which regression (10) clearly points out. These results compare very well with the recent work by Kwoka [1981] who, using recent data, finds a similar decrease in the explanatory power of Ck ratio profitability models for k increasing from I to 10. The non-stationarity hypothesis involving a widening of the residual term

THE CONCENTRATION RATIO AND THE H-INDEX TABLEII EIGHT- AND TWENTY-FIRM REGRESSION THEH INDEXON THEFOUR-, OF CONCENTRATION RATIO:ALL INDUSTRIES

201

(11) CONSTANT C4 C8 C20 R2 S.E.R. 0.872 0.029 -0.076 (-7.286) 0.365 (18.840)

(12) -0.098 (-5.360) 0.317 (11.747)

(13) -0.022 (-0.615)

0.165 (3.700) 0.726 0.042 0.208 0.072

in errorof regression.) are S.E.R.= standard (Values parentheses t-ratios,

for high profit industries which becomes stronger when Ck is used as surrogate variable finds support in an estimated widening of the absolute value of the residuals of equations (8) and (9) versus equation (7).3 With C20 the linear approximation was too poor to yield any significant result, consistent with the widening of the horn. Finally, in order to test hypothesis (iii), stating that the choice between the Ckratio and the H-index is less important for low concentration industries, the sample of industries has been split up into two groups: one group of industries with a C4 smaller than 0.50 and another group of industries with a C4 greater than or equal to 0.50. These groups contain about the same number of observations.4 The main results from the profitability regressions for both groups are given in Table III. This table shows that there is indeed no real difference in goodness of fit between the models including either the
3The estimated relationship for the profitability model with the H-index (regression(7))is

I HI= -0.01 +0.297r/R.

(-0.63) (3.38) With C4 as regressor(regression(8)) the corresponding result is
I c41= -0.04 + 0.33 Ir/R.

(-0.84) (3.76) This result can be related to the heteroscedasticity test for the H-C4 relationship, yielding 101= 0.Ol+0.09H, (2.79) (2.93) of and the estimated value of f1P 0.52. Similar results obtain for C8. A similar check giving strong support to the H-index encompassing property (excluding the reverse case with C4) can be conducted with the residual variances (the square of S.E.R. in the tables), given that corr (H, 0) = 0.08: var (
;t4)

var (tH)+fl2var (e) + 2p1 corr (tH,0) var (H)var(e)

4These numbers equal 28 and 26 for the unconcentrated and concentrated industries respectively.The threshold point of 50 percent is chosen arbitrarily(see next section).

202

LEO SLEUWAEGEN AND WIM DEHANDSCHUTTER

TABLEIII REGRESSIONS INDUSTRYPROFITABILITY CONcENTRA110N:LOW AND HIGH CONCENTRATION OF ON INDUSTRIES

Low Concentration(C4 < 0.50) Estimate of Concentration Coefficient H

C4 0.812

High Concentration(C4 > 0.50) Estimate of Concentration Coefficient

0.505

R2
0.585

Corresp.R2 (H on Ck)

R2
0.465

Corresp.R2 (H on Ck)
-

C8 C20

(1.607) 0.184 (1.650) 0.097 (1.254) 0.057 (0.807)

0.589 0.577 0.567

0.873 0.772 0.622

(1.993) 0.321 (2.200) 0.378 (2.089) -0.107 (-1.161)

0.419 0.359 0.347

0.766 0.517 0.038

(Values in parentheses are t-ratios.) Ck or H-indices for the sample of low concentration industries. This contiasts sharply with the results for high concentration industries, where the H-index model shows up as the superior performer and the Ck models gradually deteriorate in goodness of fit. The change in magnitude of the estimated coefficient of Ck is also in line with the formulated hypothesis and may again be related to the H-Ck regressions of which the corresponding R2 are presented in a separate column. This point will be developed more extensively in the next section.

HI. CRITICAL CONCENTRATION RATIOS

A remarkable empirical finding that has been repeatedly discussed in the literature is the emergence of a critical concentration ratio in the relationship between industry profitability and concentration. Scherer [1980, pp. 279-280] reports it as follows: "The results for a diversity of profitability indices and U.S. industry samples are remarkably uniform:virtually all show a distinct upsurge in profit rates as the four-firm concentration ratio passes through a range somewhere between 45 and 59 percent. They lend support to Chamberlin's hypothesis that respect for mutual oligopolistic interdependence tends to coalesce at some critical level of seller concentration." Clearly, the studies Scherer refers to did not look at the problem to what extent this discontinuity might be the result of misspecification. Again, given the H-index encompassing property and from looking at the existing hornshaped relationship between Ck and H it is reasonable to hypothesize that a better performance of a discontinuous relationship between profitability and the concentration ratio is likely to show up as a specification artifact. Various types of critical concentration ratios have been proposed in the literature. The best known are those which introduced a dichotomous

THE CONCENTRATION RATIO AND THE H-INDEX

203

variable which takes a value equal to zero up to a critical level of the four (eight) firm concentration ratio and then becomes equal to one after that level (see for example White [1976]). Other studies, which found a systematic relationship of profitability with concentration, have, in addition to introducing the dichotomous variable, investigated whether a significant change in slope at the critical concentration ratio occurs in the estimated model (see for example Dalton and Penn [1976]). Similarly, Rhoades and Cleaver [1973] have identified a critical ratio after which a systematic positive association of profitability with concentration occurred which did not show up before that level. In a recent study, Bradburd and Over [1982] have identified two critical concentration ratios in the relationship between profitability and concentration.5 By making differentscatter diagrams of possible H-C4 associations within the horn, it can be verified that these differentproposed critical concentration ratio models are easily reconcilable with the specification problem of using C4 instead of H as concentration variable. Figures (5a-5d) show these different plots, for E(r/R) = =rHi. Obviously, from these figures alone we cannot conclude that the studies which considered these different types of critical concentration ratios have used a misspecified model. Ideally, the H-index encompassing hypothesis should be tested separately on a number of different data sets before more general conclusions can be drawn. Given the H-index encompassing property we would interpret the introduction of critical concentration ratios as a means to mitigate some of the difficulties caused by misspecification. Particularly the evidence presented in Table III of the foregoing section for the groups of low concentration and high concentration industries would help to understand the empirical success of a discontinuous model as presented in Figure 5b.6 In searching whether a discontinuous relationship of profitability with concentration is superior it may be more appropriate to consider different regimes of the model with respect to all explanatory variables (see also White [1976]). Such an approach has been followed with the estimated models in Table IV where all the coefficients of the variables are allowed to change if the industry has a C4 higher than the critical level. The variables with suffix D denote the products of the original variable with D, a dummy variable equal to one when the industry has a C4 greater than 0.59. Conformly with previous
5 In this connection it is also interesting to look at William Shepherd'swork who derived from his empirical results relating to the years 1963-1969 a horn-shaped relationship between profitability and the four firm concentration ratio (see Shepherd [1972, Figure 2, p. 33]). 6 In connection with the split up of industries, it should be noticed that for low concentration industries (C4 < 0.50) the possible range of the H-index (0-0.25) is only half of the C4 counterpart. For a discrete (actual) number of firms, this maximum value becomes even much smaller, which might help to explain why, for the sample of low concentration industries considered in this analysis, H has a maximum of only 0.08 (and hence a small variance), while the maximum of C4 equals 0.49. This implies that relative to the range of C4 the low concentration industries are indeed very unconcentrated in terms of their corresponding H-index.

204

LEO SLEUWAEGEN AND WIM DEHANDSCHUTTER

The High 0 0.2 Figure 0.4 5c Concentration CRIT 0.6 0.8 Relationship C4;1 o[ Different Types of Critical Figure 5

THR

THi

The

0o 0.2

Etszr/R)j

Figure 0.4 Dichotomous 5a CRIT 0.6 0.8 Relationship C4; 1

Two Concentration 0 RatiosCritical 0.2 Levels Figure 0.4 of 5d CRIT 0.6 0.8 oLCh/ CRIT Concentration C4; 1

THi

THi

E tir/R);

The

o_X

0.2 Figure 0.4 Discontinuous 5b CRIT 0.6

*L

0.8 Relationship : C4;

THECONCENTRATION RATIO AND THEH-INDEX

205

TAnu IV REGRESSIONS INDUSTRYPROFITABILITY CONCENTRATION: DISCONTINUOUS OF ON THIE MODEL

(14)

(15)

(14)

(15)

CONSTANT H
C4

0.055 (0.570) 0.514 (1.626) 0.715 (3.048) 2.338 (4.724) 0.202 (4.626) 0.035 (0.575) 0.626 0.063

-0.074 (-0.739)
0.138

D HD
C4D GROD

-0.235 (- 1.479) -0.179 (-0.394) -0.716 (-2.197) -1.472 (-2.665) -0.155 (- 1.489) 0.365 (2.885)

-0.569 (-2.885)
0.351

GRO ADV KO CDR

R2

S.E.R.

(1.603) 0.707 (3.237) 2.298 (5.018) 0.202 (4.964) 0.035 (0.601) 0.632 0.059

ADVD KOD CDRD

(1.823) -0.659 (-2.166) -1.598 (-3.122) -0.093 (-0.993) 0.396 (3.742)

in are S.E.R.= standard of regression.) error (Values parentheses t-ratios,

work, the choice of 0.59 as critical level of concentration among possible other critical concentration ratios in the range indicated by Scherer was based on the superior goodness of fit of the model with this particular critical C4 level. Table IV indicates, relative to the continuous linear model, a substantial gain in goodness of fit for the discontinuous model. The goodness of fit of the C4 and the H-index model is about the same. As expected, for the C4 model a statistically significant change in concentration coefficients occurs which does not show up for the H-index model. As argued in the beginning of this section, this finding can be related to the superior goodness of fit of a discontinuous model of the H-Ck relationship:7 1t
=

-0.039 - 0.103 D + 0.262 C4 + 0.205C4D (-3.044) (-1.711) (8.517) (2.469)

(R2 = 0.904 and S.E.R. = 0.0254)

It might be noticed that the estimated change in

C4

coefficients of

7Restrictingthis model to a linear spline function, yielding a continuous broken line does not reallychangethe goodnessof fit. The SPLINE variable,puttinga as relationship, as on restriction themodelis defined max{C4-0.59, 0} = -0.043 +0.275 C4+0.261 SPLINE R (-3.463) (9.576) (3.939) (R2= 0.902andS.E.R.= 0.0255)

206

LEO SLEUWAEGEN AND WIM DEHANDSCHUTTER

the discontinuous profitability model is larger than implied by the H-Ck regression results. However, this differenceis statistically insignificant and is dependent on the choice of the critical concentration level (cfr. Table III). More importantly, conform with our a priori hypotheses, the H-index does not show any significant sign of a shift in behaviour. For the H-index model a "critical"C4 value seems to have more meaning (using the goodness of fit criterion) in delineating different regimes of the model with respect to the other regressors.
IV. CONCLUSION

The range of all possible H-indices for a given Ckratio widens for increasing values of the last variable. The resulting horn-shaped relationship implies that for highly concentrated industries the H-index and the Ck ratio cannot easily be substituted for each other. This knowledge has been used in some econometric model tests presented in this paper. With the H-index as the superior measure it was shown for a sample of US industries how the neglect of the horn relationship between the H-index and the Ck ratio may bias the results towards the empirical identification of a critical concentration ratio in the relationship between profitability and concentration. The tests presented in this paper are based on US data from one particular (unfortunately old and truncated) data set. Ideally, if more recent H-index data would become available, these tests should be repeated on a larger number of data sets.
LEO SLEUWAEGEN AND WIM DEHANDSCHUTTER, ACCEPTED FEBRUARY 1986

INCAP, Departmentof AppliedEconomics, K. U. Leuven, Dekenstraat2, 3000 Leuven, Belgium.

APPENDIX

it From the definitionof the H-index,whichsatisfiesthe transfer principle,8 follows to maximum valuemustcorrespond that,fora givenCk,its conditional (A.1) H(m)= (Ck-(k1)m)2 +(k1)m2 +((1 - Ck)/m)m2 +(D2-D)m2 Ith firm in the industryand D is the fraction wherem is the share held by the k + We impliedby the division(1- Ck)/m.9 mayrewrite equation(A.1)as follows:
8 This principle (also Dalton Principle) implies that the transfer of a part of the share of a firm to a bigger one increases concentration (see Hannah and Kay [1977, p. 48]). 9Strictly, m can only be interpreted as the market share of the k+ Ith firm, provided that (1 -Ck)/m > 1. This problem becomes relevant for k = 1 (C1 > 0.5) for which (A.1) still applies. Notice that in this last case a maximum always implies m = Ck, stressing the importance of the fraction in (A.1) fork _ 1.

THE CONCENTRATION RATIO AND THE H-INDEX

207

H(m) = Ck+S(m)+(D where S(m) -2(k-

2-D)m2

1)mCk+((k-

1)2 +(k-

1))m2 +(1 -Ck)m

To prove that Ck is a maximum, given that D2 < D, it suffices to prove that S < 0. To prove this we study the shape of the function S with respect to m. Taking the derivative yields the following condition: -Dm <0
am

if m < w(Ck), where w(Ck) = Ck(2k-1)-i <

k) ~~~~~~~2(k2-

It follows that the maximum value of S given Ck is either 0 at m = 0, or positive at m = Ck/k (the maximum possible value of m given Ck).Thus, the maximum depends on the problem whether for a given m = Ck/k a value of S > 0 can be found. After some algebra, this condition boils down to the following very simple condition:
Ck <

l/k

This condition states that for a maximal H-index, given Ck,the minimum value m = 0 applies in the range Ck > 1/k yielding a maximum H value equal to C2. The maximum value m = Ck/k applies in the range Ck 1/k implying a maximum H value equal to Ck/k, if k (1- Ck)/Ckis taken as an integer number, disregarding the fraction D in A(1). The latter maximum value corresponds to the straight part of the upper bound line in the figures presented in section I. The minimum value limiting boundary poses no particular problem. Just as the maximum, it requires an infinite number of firms where each firm outside the k largest group holds a negligible market share, while the k largest firms are equally distributed, each with a market share equal to Ck/k.

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