What Is Concentration Ratio?
The concentration ratio, in economics, is a ratio that indicates the size of firms in relation to their industry as a whole. Low concentration ratio in an industry would indicate greater competition among the firms in that industry, compared to one with a ratio nearing 100%, which would be evident in an industry characterized by a true monopoly.
Understanding Concentration Ratio
The concentration ratio indicates whether an industry is comprised of a few large firms or many small firms. The four-firm concentration ratio, which consists of the market share of the four largest firms in an industry, expressed as a percentage, is a commonly used concentration ratio. Similar to the four-firm concentration ratio, the eight-firm concentration ratio is calculated for the market share of the eight largest firms in an industry. The three-firm and five-firm are two more concentration ratios that can be used.
- The concentration ratio compares the size of firms in relation to their industry as a whole.
- Low concentration ratio indicates greater competition in an industry, compared to one with a ratio nearing 100%, which would be a monopoly.
- An oligopoly is apparent when the top five firms in the market account for more than 60% of total market sales, according to concentration ratio.
Concentration Ratio Formula and Interpretation
The concentration ratio is calculated as the sum of the market share percentage held by the largest specified number of firms in an industry. The concentration ratio ranges from 0% to 100%, and an industry's concentration ratio indicates the degree of competition in the industry. A concentration ratio that ranges from 0% to 50% may indicate that the industry is perfectly competitive and is considered low concentration.
A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales. If the concentration ratio of one company is equal to 100%, this indicates that the industry is a monopoly.
Assume that ABC Inc., XYZ Corp., GHI Inc., and JKL Corp. are the four largest companies in the biotechnology industry, and an economist aims to calculate the degree of competition. For the most recent fiscal year, ABC Inc., XYZ Corp., GHI Inc. and JKL Corp. have market shares of 10%, 15%, 26% and 33%, respectively. Consequently, the biotech industry's four-firm concentration ratio is 84%. Therefore, the ratio indicates that the biotech industry is an oligopoly. The same could be calculated for more or less than four of the top companies in the industry. The concentration ratio only indicates the competitiveness of an industry and whether an industry follows an oligopolistic market structure.
The Herfindahl-Herschman Index (HHI) is an alternative indicator of firm size, calculated by squaring the percentage share (stated as a whole number) of each firm in an industry, then summing these squared market shares to derive a HHI. The HHI has a fair amount of correlation to the concentration ratio and may be a better measure of market concentration.