Concentration Ratio - Explained
What is the Concentration Ratio?
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Table of ContentsWhat is a Concentration Ratio?How to use the Concentration Ratio?Concentration Ratio Formula and InterpretationExample CalculationHerfindahl-Herschman IndexAcademic Research on the Concentration Ratio
What is a Concentration Ratio?
In economics, a concentration ratio refers to the ratio of the market shares of a particular company in relation to the entire market size. This ratio also measures the size of a company or firm in comparison to the size of the whole market. Analysts often consider the 3-firm, 4-firm, 5-firm and 8-firm concentration ratio. CR and the CR, are the most common concentration ratios, while CR refers to the market share of the four largest firms in the market, the CR, means the market share of the eight largest firms.
How to use the Concentration Ratio?
The concentration ratio is an important determinant of whether a particular market or industry of monopolistic, oligopolistic or there is healthy competition among firms. It describes the extent at which few large firms control the market or industry. For instance, if the concentration ratio of one company is almost at 100%, it indicates that such company is the only visible company and operates a monopoly. Low concentration ratio by all firms on the other hand means competition exists in the market. If a four-firm concentration ratio is used, it means the market share of the four largest firms are compared to the entire market or industry.
Concentration Ratio Formula and Interpretation
Whether a CR, CR, 3-firm and 5-firm concentration ratios is used, it is important to know that these formulas have one thing in common. They are calculated as the percentage of the total market shares held by the firms in relation to the value of the entire industry. Typically, a concentration ratio ranges from 0% - 100%, this ratio gives an insight to the level of competition that exists in a market. This means it is also possible an competition to be absent in an industry. Low concentration ratio indicates greater competition in the industry, a ratio between 0% to 50% means the industry is perfectly competitive. The industry however has a oligopolistic tendency when four or five largest firms account for more than 60% of the market share. When only one company has 100% concentration ratio, a monopoly exists.
The illustration below will enhance a rapt understanding of how concentration ratio works; Assuming that companies ABC, LMN, PQR, and XYZ are the largest for companies in an industry, if the aggregate of the market shares of the companies is 80%, with the companies having (30% 15% 18% and 17%) respectively, it means the industry is an oligopoly. If the four companies have less than 60% as the aggregate market share, that means competition exists in the market. A perfectly competitive industry is attained when there is a concentration ratio of 0% to 50%.
While the concentration ratio serves as an indicator of the size of a firm and the competitiveness of an industry, there is an alternative indicator. The Herfindahl-Herschman Index is also used to measure the size of a firm by squaring the percentage share of each firm in the industry and summing it up to arrive at an HHI. The HHI is often regarded as a better indicator of the level of concentration in a market.