Concentration Ratio

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Definition of Concentration Ratio:

A concentration ratio is the combined market share of the largest companies in an industry. 

Detailed Explanation:

Suppose you are interested in opening a coffee shop in your neighborhood and want to evaluate your competition because you lack the financial resources to survive an extended price war or pay for an aggressive advertising campaign. A concentration ratio would be helpful in assessing your situation. An industry’s concentration ratio is used to weigh the market power of the leading companies in an industry by measuring the combined market share of the industry’s largest companies. The ratio helps answer questions like: How much of the local business do the four largest companies control? Is there one dominant shop? Are there many smaller companies that you believe you could compete against? (Note, the concentration ratio is only one consideration. For example, if there is only one coffee shop in your area, it would have a monopoly, but that does not mean there isn't room in the market for another coffee shop if there is a demand and the barriers to entry are low.)

An industry’s concentration ratio is calculated by totaling the market shares of its largest companies. Normally, but not always, the four companies with the greatest total sales are used. Economists refer to this as CR4. CR8 would be the concentration ratio derived by totaling the market shares of the eight companies with the largest market shares. For example, assume there are 10 coffee shops in your neighborhood. The table below provides the names and market shares of all 10 shops. CR4 equals 59 percent and CR8 is 89.25 percent. 

A high concentration ratio suggests that it would be difficult to break into a market because the industry has a few dominant companies. A low concentration ratio is common in industries with many companies, such as in monopolistically competitive or perfectly competitive industries. Usually, it is less risky to enter these markets because there are fewer or no dominant companies that could exert pressure on a start-up.

Oligopolies normally have a C4 exceeding 40 percent. Monopolies have a concentration ratio of 100 percent because one company controls the entire market. Perfectly competitive industries have concentration ratios close to zero because there are very many small companies and no company dominates the market. Finally, monopolistically competitive industries have concentrations less than 40 percent, not high enough to be considered an oligopoly, but not low enough to be considered a perfectly competitive industry. You would probably conclude that because of the high concentration ratio, there are already enough coffee shops in your neighborhood, and establishing a profitable one would be difficult. 

A concentration ratio is commonly measured for a region or country. The table below lists the concentration ratios for several industries in the financial sector of the United States in 2012. The credit card issuing industry is a very strong oligopoly and would have high barriers to entry since the largest four companies control approximately 78 percent of the market. Credit unions operate in a monopolistically competitive industry. There are many of them and the largest credit unions have relatively little market power. Visit the Census Bureau website for the concentration ratios of other industries. 

Source: Census Bureau

Economists prefer the Herfindahl-Hirschman Index (HHI) to the concentration ratio when measuring the market power of individual companies in an industry. The HHI includes every company in an industry and gives proportionally more weight to the companies with the greatest market shares. (Sometimes the HHI is provided for only 50 companies because of the challenge of obtaining data for all the companies in an industry.) Like the concentration ratio, market shares are used in the calculation of the HHI. However, the HHI uses the market shares of all the companies, rather than just the largest four or eight companies. The next step in calculating the HHI is to square the market share of each company. Total the squares to derive the industry's HHI. The table below shows how the HHI is calculated for the coffee shops in your neighborhood.

Economists also prefer the HHI because a concentration ratio may lead to the wrong conclusion. For example, it is possible that two industries with different market structures have the same concentration ratio, as demonstrated in the table below. Assume Industry ABC and Industry XYZ each contain 15 different companies. (For Industry ABC these are labeled 1 – 15, and for Industry XYZ the companies are A – O.) Each company’s market share is listed on the table. Both industries have a C4 of 73 percent, but different HHIs. Industry ABC’s HHI equals 1,560 and Industry XYZ’s HHI equals 3,488. The higher HHI suggests that the larger companies in Industry XYZ have more market power than the larger companies in Industry ABC. 

The HHI can range from 10,000 to just above 0. Monopolies have a 10,000 HHI because one company controls 100 percent of the market (100² = 10,000). Generally, highly concentrated industries have HHIs exceeding 3,000. Perfectly competitive industries where there are many companies have HHIs of less than 1,500. Moderately competitive industries have HHIs between 1,501 and 3,000. Most monopolistically competitive and some oligopolies would have scores in this range. Using C4 we would have concluded that both industries are oligopolies. However, the HHI leads to the conclusion that Industry ABC has a monopolistic competition structure and Industry XYZ is an oligopoly. The HHI is considered more reliable because it includes all the companies in an industry.

Frequently two companies may combine forces by merging or one acquiring the other. The objective is usually to gain production or distribution efficiencies. The combination may affect the level of competition and market power in an industry. For this reason, large mergers and acquisitions must be approved by the government. In the United States, the Federal Trade Commission and Justice Department rely on the HHI when evaluating a company’s proposed merger or acquisition. Regulators analyze the index before and after the merger to see how much competition in the industry would be affected by the proposed company. A dramatic increase in the HHI suggests competition in their industry would be harmed by combining the two companies. This could result in the denial of the proposed merger or acquisition. 

Dig Deeper With These Free Lessons:

Market Structure Part II – Monopolistic Competition and Oligopoly
Market Structure Part I – Perfect Competition and Monopoly
Output and Profit Maximization

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