The concentration ratio indicates the size of organizations in relation to their industry as a whole. Concentration ratio is the total market output produced by the n largest firms in an industry, expressed as a percentage. Market output may be defined by market capitalization, sales volume, or any other metric describing the dominance of a company relative to its competitors.
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Understanding the concentration ratio
Concentration ratio is used as a measure of market monopolization. That is, whether an industry is comprised of many smaller firms or a few, larger firms. Markets characterized by the former tend to be more competitive with concentration ratios under 50%. Conversely, markets characterized by the latter tend to be less competitive with concentration ratios over 50%. In cases where a single firm dominates its industry, the concentration ratio may be near 100%.
The four-firm concentration ratio is a commonly used ratio that considers the market share of the four largest firms in an industry. An similar approach is also used in three, five, and eight-firm models.
Interpreting concentration ratio percentages
Concentration ratio percentages can yield important insights into market competitiveness, including:
- The degree of competition – if concentration ratios under the five-firm model rise from 40% to 60%, this may be an indication of lower competitive pressure and higher prices for consumers.
- Monopolies – concentration ratio percentages also identify companies likely to operate a monopoly in their respective market. In some cases, the approach can also identify the companies likely to hold a monopoly in the future.Â
- Regulatory oversight – a value of 80% or more under the three-firm model means there is greater scope for collusion between each firm. These markets are characterized by oligopolies, where a small number of firms work to restrict output and/or fix prices to achieve superior market returns. For this reason, many governments have regulatory bodies in place for vulnerable industries such as gas, electricity, oil, and air transportation.
Limitations of concentration ratios
Concentration ratios can provide inaccurate results due to the scope the market evaluated, particularly if local, national, and global markets are involved. For example, two organizations may dominate the local market while having little to no presence in the national market. Estimating market size is also highly subject in some cases. If regulatory bodies were trying to identify the size of the market Facebook operates in, would it incorporate phone apps, photo-sharing websites, or a mixture of both?
What’s more, there are situations where concentration ratios cannot quantify monopoly power. Consider the example of a national market where only one sugar company exists. Though the company may appear to have a monopoly at first glance, it is actually in direct competition with large food wholesalers who choose to import sugar alongside various other products. The wholesaler operates in a different sector but is nonetheless in direct competition with the sugar company that must then adjust its prices accordingly.
Key takeaways:
- The concentration ratio indicates the size of organizations in relation to their industry as a whole. Markets comprised of more numerous smaller firms tend to have low concentration ratios, while markets comprised of a few larger firms tend to have high concentration ratios.
- Concentration ratios yield important insights into market competitiveness, including the degree of competition and the presence of monopolies, oligopolies, and potential regulatory oversight.
- The concentration ratio is not suited to situations where the scope of a market or the extent of monopoly power is difficult to define.
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