A concentration ratio is the combined market share of the largest companies in an industry.
Suppose you’re looking to open a coffee shop in your neighborhood but are concerned about the competition due to limited financial resources. In that case, you can use a concentration ratio to assess the situation. The concentration ratio measures the combined market share of the leading companies in an industry, providing valuable insights into market power. It helps answer questions such as: How much of the local business do the four largest companies control? Is there one dominant shop, or are there many smaller companies that you could compete against?
Economists calculate the concentration ratio by adding up the market shares of the largest companies, typically the four companies with the highest total sales (CR4). There’s also CR8, which includes the market shares of the eight companies with the largest market shares. For example, assume there are ten coffee shops in your neighborhood. The table below provides the names and market shares of all ten shops. CR4 equals 59 percent, and CR8 is 89.25 percent.
A high concentration ratio indicates that entering a market would be challenging due to the presence of a few powerful companies. On the other hand, a low concentration ratio is typical in industries with numerous companies, like monopolistically competitive or perfectly competitive industries. It’s generally less risky to enter these markets because there are fewer or no dominant companies that could put pressure on a start-up.
Oligopolies typically have a concentration ratio (C4) exceeding 40 percent. Monopolies have a concentration ratio of 100 percent, as one company controls the entire market. Perfectly competitive industries have concentration ratios close to zero because there are many small companies, and no single company dominates the market. Monopolistically competitive industries have concentration ratios of less than 40 percent, which is not high enough to be considered an oligopoly but not low enough to be considered a perfectly competitive industry. Based on the high concentration ratio, you can conclude that there are already enough coffee shops in your neighborhood, and establishing a profitable one is difficult.
Economists typically calculate a concentration ratio for a specific region or country. The table below shows the concentration ratios for various industries in the financial sector of the United States in 2012. The credit card issuing industry is a powerful oligopoly with high barriers to entry, as the largest four companies control approximately 78 percent of the market. In contrast, credit unions operate in a monopolistically competitive industry due to their large numbers and relatively little market power among the largest credit unions. You can find concentration ratios for other industries on the Census Bureau website. 
Economists prefer using the Herfindahl-Hirschman Index (HHI) over the concentration ratio to measure the market power of individual companies in an industry. The HHI takes into account all the companies in an industry and assigns more weight to those with the largest market shares. Like the concentration ratio, the HHI index uses market shares, but it considers the market shares of all companies rather than just the top four or eight. (Sometimes, the HHI is calculated for only 50 companies due to the difficulty of collecting data for all companies in an industry.) The next step in calculating the HHI involves squaring each company’s market share and then summing the squares to obtain the industry’s HHI. The table below illustrates how to calculate the HHI for the coffee shops in your neighborhood.
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, while perfectly competitive industries with many companies have HHIs of less than 1,500. Moderately competitive industries fall within the range of between 1,501 and 3,000. Most monopolistically competitive and some oligopolies would have scores in this range.
Economists also prefer the HHI as it provides a more accurate measure of market concentration than a concentration ratio. For instance, two industries with different market structures may have the same concentration ratio, as illustrated in the table below. Let’s consider Industry ABC and Industry XYZ, each consisting of 15 different companies labeled 1 – 15 and A – O, respectively. The table shows each company’s market share. Despite both industries having a C4 of 73 percent, they have different HHIs. Industry ABC’s HHI is 1,560, while Industry XYZ’s HHI is 3,488. The higher HHI for Industry XYZ indicates that the larger companies in Industry XYZ have more market power than those in Industry ABC. 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. Economists consider the HHI to be more reliable because it includes all the companies in an industry.
Frequently, two companies may join forces through a merger or acquisition. The main goal is usually to improve production or distribution efficiency. However, this combination can impact the level of competition and market power within the industry. Due to this, the government must approve large mergers and acquisitions. The Federal Trade Commission and the Justice Department use the HHI to evaluate proposed mergers and acquisitions in the United States. Regulators examine the index before and after the merger to determine the potential impact on industry competition. A significant increase in the HHI indicates that the merger could harm competition in the industry, potentially leading to the denial of the proposed merger or acquisition.
Market Structure Part II – Monopolistic Competition and Oligopoly
Market Structure Part I – Perfect Competition and Monopoly
Output and Profit Maximization
