QuickMBA / Economics / Industry Concentration

Industry Concentration

The concentration of firms in an industry is of interest to economists, business strategists, and government agencies. Here, we discuss two commonly-used methods of measuring industry concentration: the Concentration Ratio and the Herfindahl-Hirschman Index.

Concentration Ratio (CR)

The concentration ratio is the percentage of market share owned by the largest m firms in an industry, where m is a specified number of firms, often 4, but sometimes a larger or smaller number. The concentration ratio often is expressed as CRm, for example, CR4.

The concentration ratio can be expressed as:

CRm  =  s1  +  s2  +  s3  +  ... ... +  sm

where  si  =  market share of the ith firm.

If the CR4 were close to zero, this value would indicate an extremely competitive industry since the four largest firms would not have any significant market share.

In general, if the CR4 measure is less than about 40 (indicating that the four largest firms own less than 40% of the market), then the industry is considered to be very competitive, with a number of other firms competing, but none owning a very large chunk of the market. On the other extreme, if the CR1 measure is more than about 90, that one firm that controls more than 90% of the market is effectively a monopoly.

While useful, the concentration ratio presents an incomplete picture of the concentration of firms in an industy because by definition it does not use the market shares of all the firms in the industry. It also does not provide information about the distribution of firm size. For example, if there were a significant change in the market shares among the firms included in the ratio, the value of the concentration ratio would not change.

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index provides a more complete picture of industry concentration than does the concentration ratio. The HHI uses the market shares of all the firms in the industry, and these market shares are squared in the calculation to place more weight on the larger firms. If there are n firms in the industry, the HHI can be expressed as:

HHI  =  s12  +  s22  +  s32  +  ... ... +  sn2

where si is the market share of the ith firm.

Unlike the concentration ratio, the HHI will change if there is a shift in market share among the larger firms.

The Herfindahl-Hirschman Index is calculated by taking the sum of the squares of the market shares of every firm in the industry. For example, if there were only one firm in the industry, that firm would have 100% market share and the HHI would be equal to 10,000  -- the maximum possible value of the Herfindahl-Hirschman Index. On the other extreme, if there were a very large number of firms competing, each of which having nearly zero market share, then the HHI would be close to zero, indicating nearly perfect competition.

The U.S. Department of Justice uses the HHI in guidelines for evaluating mergers. An HHI of less than 1000 represents a relatively unconcentrated market, and the DOJ likely would not challenge a merger that would leave the industry with an HHI in that range. An HHI between 1000 and 1800 represents a moderately concentrated market, and the DOJ likely would closely evaluate the competitive impact of a merger that would result in an HHI in that range. Markets having an HHI greater than 1800 are considered to be highly concentrated; there would be serious anti-trust concerns over a proposed transaction that would increase the HHI by more than 100 or 200 points in a highly concentrated market.

Other Considerations in Using Industry Concentration Measures

One should be aware that these measures are influenced by the definition of the relevant market. For example, the automotive industry is not the same as the market for sport utility vehicles. One also must consider the geographic scope of the market, for example, national markets versus local markets.

Recommended Reading

Young, Philip K. Y., McAuley, John J., Portable MBA in Economics

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