Concentration ratio (CR) measures the market dominance of the largest companies. We calculate this by adding up the market share of the largest N-companies.
In general, this ratio tells us the market concentration on big companies. Although the ratio is useful to help us determine the market structure, it does not become an absolute measure of market power.
Why does concentration ratio matter
The concentration ratio is one of the quantitative indicators of the level of competition or monopoly power in an industry. The higher the ratio, the greater the degree of concentration.
The ratio will be equal to 0%, indicating perfect competition and 100% for monopolies. A low ratio of around 0% to 40% suggests the market ranges from perfect competition to oligopoly. Furthermore, a ratio of more than 40% to less than 100% leads to oligopoly.
An increase in the ratio over time indicates that the market is increasingly concentrated. Large companies increasingly dominate the industry.
How we calculate the concentration ratio
The ratio commonly used is the concentration ratio of four companies (CR4). The ratio is the sum of the market share (S) of the four largest companies in an industry.
In addition to CR4, the CR8 ratio is also commonly used to measure market concentration in the eight largest companies.
In general, we calculate the concentration ratio using the following formula:
CRn = S1 + S2 + …+ Sn
Where, S is the nth largest company market share. While for, CR4 and CR8, we calculate it using the formula:
CR4 = S1 + S2 + S3 + S4
CR8 = S1 + S2 + S3 + S4 +S5 + S6 + S7 + S8
From this data, for CR4, we need to add up the market share of the four largest companies, which is equivalent to 82% = 33% + 22% + 15% + 12%. The figure shows that four companies control a substantial market share. Therefore, we suspect the market operates on oligopoly.
How to measure market share
Market share measures the market dominance of a company. We usually measure it by dividing the company’s sales to total market sales in a certain period, expressed as a percentage. Sales figures can be in terms of quantity or money (revenue). In addition to sales, we may use total output or total assets, depending on the needs and relevance of our analysis.
Mathematically, the market share formula is:
Market share = (Company sales / Total market sales) x 100%
Pros and cons
The concentration ratio is relatively easy to calculate. We can use it to detect the market structure of an industry, even if it does not provide an absolute clue.
However, you should pay attention to some weaknesses associated with it. First, the concentration ratio does not measure market power.
A value of 100% does indicate a monopoly. You might conclude that the company enjoys absolute market power. Companies can charge high prices or reduce quality to maximize profits.
However, such initial conclusions can be misleading. Why?
Even though the company enjoys a 100% market share, if the barriers to entry are insignificant, the monopolist will not have the power of pricing. Chances are, the company will behave like a company in perfect competition and must remain competitive.
Second, the concentration ratio is also not an absolute measure because it depends on the definition of the market you are examining. Markets can be local, national, and even global, which can shift the range of results.
Furthermore, when each company has several product lines, calculating the concentration ratio of the company’s total revenue can also be misleading. The company may be superior and have the power of pricing in certain product lines, but not for other segments. Therefore, we should calculate the company’s market share in each line to draw conclusions, but, of course, it will take more time.
Third, when there is a merger at the top level, the ratio is unaffected. In fact, when the two companies join, the combined entity will have increased strength. However, the ratio will not change significantly.
To overcome these weaknesses, we can use the Herfindahl-Hirschman index (HHI). HHI sums up the square of the market share of each company. The maximum value will range from 0 to 10,000 (or 100%).
In the previous example, assume, the biggest and second-largest companies are merged. Their combined market share is 55%.
The C4 ratio changes from 82% to 90% = 55% + 15% + 12% + 8%. The difference between before and after the merger is only about 8%.
Next, let’s calculate the HHI before and after the merger. Before the merger of industrial HHI was 20.64% = 33%2 + 22%2 + 15%2 + 12%2 + 8%2 + 7%2 + 3%2. After the merger, the number of companies reduced to 6 from the previous 7 companies. After the merger, the value of HHI is 35.16% = 55%2 + 15%2 + 12%2 + 8%2 + 7%2 + 3%2. The difference in HHI before and after the merger was 14.52%, more significant than using CR4 (8%).