ECONOMETRIC MODELING COURSEWORK

1. Introduction:
The comparative statics analysis suggested by Panzar and Rosse for the identification of
market power, is based upon the estimation of a reduced form revenue equation, when
considering that the total revenue is easily observable, unlike the price and quantity. For a
single firm, the equilibrium total revenue is given by the equilibrium quantity times the
equilibrium price. Both the equilibrium quantity and price depend on the cost, demand, and
conduct, and therefore in the revenue function all the shifters of cost and demand must be
included, with particular attention given to the factor prices. There has been considerable
concern about how on-going consolidation in financial systems around the world will affect
competition. Indeed, much of the recent public debate seems to assume that perfect
competition in banking is ideal. This has not always been the case. For much of the last
century, policy-makers focused on stability. The belief that some degree of market power
was necessary to maintain stability in the banking sector led many countries to pursue
policies that, implicitly or explicitly, restricted competition. In this section, the validity of this
perception is explored by examining the theoretical and empirical literature on the effects
that competition and market power have on efficiency and stability. For a better
understanding of each issue, they should first be defined. Obviously, if the definition is more
comprehensive and more efficient, better understanding will be achieved. Some definitions
of competitive advantage are presented below:

 Competitive advantage is the increased rate of attractiveness a firm offers compared

to competitors from customers’ viewpoints. In the literature on competition
strategy, competitive advantage is regarded within the framework of value creation
as anything that increases income over costs.
 Saaty and Vargas believes competitive advantage lies in the properties or
dimensions of each firm enabling it to offer better services than the competitors (i.e.,
better value) to customers
 Competitive advantage is defined as the presentable values of a firm for customers
so that these values outweigh the price paid by the customer
According to the above definitions of competitive advantage, it seems that a direct relation
between customers’ expected values, values offered by the company, and those offered by
the competitors determine the dimensions and conditions of competitive advantage. If the
values presented by the company are closer to customers’ expected values compared to the
values offered by competitors, it can be said that the firm has competitive advantage over
its competitors in one or more indices. This advantage makes the company superior to its
competitors in proximity to customers and capturing his heart.
In different industries, some firms, regardless of whether the average profit of that industry
is low or high, are more profitable than others. This superior performance is a consequence
of possessing special and inimitable factors resulting in higher performance than
competitors. These unique skills and capital have competitive advantage. Four requirements
should be met for resources and skills to be sources of sustainable competitive advantage:
  They should be valuable.
 They should be rare in existing and potential competitors.
 They should not be easily imitable.
 There should be no strategic alternative for that skill or resource
Cost-effective strategies, which makes profit generation a natural requirement for business
owners. simply speaking, business is a tool to convert inputs into outputs. Inputs are basic
factors such as labor, earth, capital, management, and know-how. Outputs are the products
and services a business generates. The simplest way to measure efficiency is by the amount
of inputs used for producing outputs. Efficiency is the ratio of output to input.
2. Concentration ratios and Herfindahl–Hirschman Indices (HHI)
The percentage of market share taken up by the largest firms. It could be a 3 firm
concentration ratio (market share of 3 biggest) or a 5 firm concentration ratio.
Concentration ratios are used to determine the market structure and competitiveness of the
market. For example, an oligopoly is defined when there is a 5-firm concentration ratio of
greater than 50%. The Herfindahl-Hirschman Index (HHI) is a common measure of market
concentration and is used to determine market competitiveness, often pre- and post-
M&A transactions. The Herfindahl-Hirschman Index (HHI) is a commonly accepted measure
of market concentration. It is calculated by squaring the market share of each firm
competing in a market and then summing the resulting numbers. It can range from close to
zero to 10,000. The U.S. Department of Justice uses the HHI for evaluating potential mergers
issues. The Herfindahl-Hirschman Index (HHI) is a common measure of market
concentration and is used to determine market competitiveness, often pre- and post- M&A
transactions. A market with an HHI of less than 1,500 is considered to be a competitive
marketplace, an HHI of 1,500 to 2,500 to be a moderately concentrated marketplace, and an
HHI of 2,500 or greater to be a highly concentrated marketplace. The primary disadvantage
of the HHI stems from the fact that it is such a simple measure that it fails to take into
accounts the complexities of various markets.

HHI= S21+ S22+ S23 +...… S2n

Where:

Sn = The market share percentage of firm n expressed as a whole number, not a decimal
How Does the Herfindahl-Hirschman Index Work?

The closer a market is to a monopoly, the higher the market's concentration (and the lower
its competition). If, for example, there were only one firm in an industry, that firm would
have 100% market share, and the Herfindahl-Hirschman Index (HHI) would equal 10,000,
indicating a monopoly. If there were thousands of firms competing, each would have nearly
0% market share, and the HHI would be close to zero, indicating nearly perfect competition.
The U.S. Department of Justice considers a market with an HHI of less than 1,500 to be a
competitive marketplace, an HHI of 1,500 to 2,500 to be a moderately concentrated
marketplace, and an HHI of 2,500 or greater to be a highly concentrated marketplace. As a
general rule, mergers that increase the HHI by more than 200 points in highly concentrated
markets raise antitrust concerns, as they are assumed to enhance market power of the
Horizontal Merger Guidelines jointly issued by the department and the Federal Trade
Commission (FTC). The primary advantage of the Herfindahl-Hirschman Index (HHI) is the
simplicity of the calculation necessary to determine it and the small amount of data
required for the calculation. The primary disadvantage of the HHI stems from the fact that it
is such a simple measure that it fails to take into accounts the complexities of various
markets in a way that allows for a genuinely accurate assessment of competitive or
monopolistic market conditions.
Example of Herfindahl-Hirschman Index Calculations
The HHI is calculated by taking the market share of each firm in the industry, squaring them,
and summing the result, as depicted in the equation above.
Consider the following hypothetical industry with four total firms:
1. Firm one market share = 40%
2. Firm two market share = 30%
3. Firm three market share = 15%
4. Firm four market share = 15%
The HHI is calculated as:
HHI = 402 + 302 + 152 + 152
= 1,600 + 900 + 225 + 225 = 2,950

This HHI value is considered a highly concentrated industry, as expected since there are only
four firms. But the number of firms in an industry does not necessarily indicate anything
about market concentration, which is why calculating the HHI is important.
For example, assume an industry has 20 firms. Firm one has a market share of 48.59% and
each of the 19 remaining firms has a market share of 2.71% each. The HHI would exactly
2,500, indicating a highly concentrated market. If firm number one had a market share of
35.82% and each of the remaining firms had a 3.38% market share, the HHI would be exactly
1,500, indicating a competitive marketplace.
3. OLS estimation method
Ordinary Least Squares (OLS) is the most common estimation method for linear models and
that’s true for a good reason. As long as your model satisfies the OLS assumptions for
linear regression, you can rest easy knowing that you’re getting the best possible estimates.
Regression is a powerful analysis that can analyze multiple variables simultaneously to
answer complex research questions. However, if you don’t satisfy the OLS assumptions, you
might not be able to trust the results. In this post, I cover the OLS linear regression
assumptions, why they’re essential, and help you determine whether your model satisfies
the assumptions.
Regression analysis is like other inferential methodologies. Our goal is to draw a random
sample from a population and use it to estimate the properties of that population.
In regression analysis, the coefficients in the regression equation are estimates of the actual
population parameters. We want these coefficient estimates to be the best possible
estimates.
Suppose you request an estimate—say for the cost of a service that you are considering.
How would you define a reasonable estimate?
1. The estimates should tend to be right on target. They should not be systematically
too high or too low. In other words, they should be unbiased or correct on average.
2. Recognizing that estimates are almost never exactly correct, you want to minimize
the discrepancy between the estimated value and actual value. Large differences are
bad!
These two properties are exactly what we need for our coefficient estimates!
When your linear regression model satisfies the OLS assumptions, the procedure generates
unbiased coefficient estimates that tend to be relatively close to the true population values
(minimum variance). In fact, the Gauss-Markov theorem states that OLS produces estimates
that are better than estimates from all other linear model estimation methods when the
assumptions hold true.
Seven Classical OLS Assumptions
Like many statistical analyses, ordinary least squares (OLS) regression has underlying
assumptions. When these classical assumptions for linear regression are true, ordinary least
squares produces the best estimates. However, if some of these assumptions are not true,
you might need to employ remedial measures or use other estimation methods to improve
the results.
Many of these assumptions describe properties of the error term. Unfortunately, the error
term is a population value that we’ll never know. Instead, we’ll use the next best thing that
is available—the residuals. Residuals are the sample estimate of the error for each
observation.
Residuals = Observed value – the fitted value
When it comes to checking OLS assumptions, assessing the residuals is crucial!
There are seven classical OLS assumptions for linear regression. The first six are mandatory
to produce the best estimates. While the quality of the estimates does not depend on the
seventh assumption, analysts often evaluate it for other important reasons that I’ll cover.
4. Calculating Banks concentration ratios and HHI.
BANKS
The National Commercial Bank
Al Rajhi Bank
Samba Financial Group
Riyad Bank
Banque Saudi Fransi
The Saudi British Bank
Arab National Bank
Al Awwal Bank
Saudi Investment Bank
Bank AlJazira
Alinma Bank
Bank AlBilad
Above banks concentration ratios and HHI are calculating