A Fallacy of Division: The Failure of Market Concentration as a Measure of Competition in U.S. Banking

Empirical literature and related legal practice using concentration as a proxy for competition measurement are prone to a fallacy of division, as concentration measures are appropriate for perfect competition and perfect collusion but not intermediate levels of competition. Extending the classic Cournot-type competition model of Cowling and Waterson (1976) and Cowling (1976) used to derive the Hirschman-Herfindahl Index (HHI) of market concentration, we propose an adaptation of this model that allows collusive rents for all, none, or some of the firms in a market. Application of our model to data for U.S. commercial banks in the period 1984-2004 confirms that concentration measures are unreliable competition metrics. While collusion is prevalent in the banking industry at the state level, the critical market shares at which market power is achieved, rents earned from collusion, and collusive concentration levels vary widely across states. These and other results lead us to conclude that a fallacy of division exists in concentration-based competition tests.