Which of the following statements best describes the impact of reduced competition through merging of companies on social welfare, as measured by the Herfindahl-Hirschman Index (HHI)?

• A. Mergers that reduce competition have no effect on the HHI or social welfare.
• B. Mergers that reduce competition typically decrease the HHI and increase social welfare due to greater efficiency.
• C. Mergers that reduce competition typically increase the HHI but always increase social welfare.
• D. Mergers that reduce competition typically increase the HHI and decrease social welfare due to higher market power.

Answer: (D)

Verified step by step guidance

1. Understand the Herfindahl-Hirschman Index (HHI): It is a measure of market concentration calculated by summing the squares of the market shares of all firms in the market. The formula is \(HHI = \sum_{i=1}^N (s_i \times 100)^2\), where \(s_i\) is the market share of firm \(i\) expressed as a decimal.
2. Recognize that when companies merge, their combined market share increases, which typically raises the HHI because the sum of squared market shares becomes larger.
3. Analyze the relationship between HHI and competition: A higher HHI indicates less competition and greater market concentration, which often leads to increased market power for the merged firm(s).
4. Consider the impact on social welfare: Reduced competition due to higher market power can lead to higher prices, lower output, and less consumer surplus, which generally decreases social welfare.
5. Conclude that mergers reducing competition usually increase the HHI and decrease social welfare, reflecting the trade-off between market concentration and economic efficiency.