CalculatingConcentration Ratio: Definition, Mathematical Representation, Method, Advantages, Disadvantages
The concentration of a market is an essential factor in understanding its dynamics. Two common measures used to assess market concentration and infer market power are the concentration ratio (CR) and the Herfindahl-Hirschman Index (HHI).
Advantages of Concentration Ratio (CR)
The concentration ratio offers several advantages, primarily due to its simplicity and transparency. CRs, such as CR4 or CR5, measure the combined market share of the top 4 or 5 firms, making them easy to calculate and interpret for policymakers and analysts. By focusing on the largest firms only, CRs quickly highlight market dominance by the key players, which can be useful when the largest firms inherently drive market outcomes. CRs are also commonly used in empirical research and policy assessment, especially for preliminary screening of market structures.
Disadvantages of Concentration Ratio (CR)
However, CRs have their drawbacks. They do not account for the distribution of market shares outside the top firms, potentially missing important nuances in competition among smaller players. Changes in market shares below the threshold firms do not affect the CR, making it less sensitive to shifts in competition or market structure than HHI. Furthermore, CR provides a partial snapshot which might overlook how fragmented or competitive the rest of the market is beyond the leaders.
Advantages of Herfindahl-Hirschman Index (HHI)
On the other hand, the Herfindahl-Hirschman Index (HHI) offers several advantages. HHI sums the squares of all firms' market shares, reflecting both the size and distribution of firms across the entire market, giving a more nuanced picture of concentration. Because HHI weights larger firms more heavily due to squaring of market shares, it is more sensitive to changes in the market structure, especially increases in dominance. HHI is the preferred tool for regulatory authorities like the U.S. DOJ and FTC when analyzing mergers and assessing market power because of its robustness and sensitivity.
Disadvantages of Herfindahl-Hirschman Index (HHI)
Despite its advantages, HHI also has drawbacks. Unlike CR, HHI requires detailed data on all firms and calculations, which might be harder to explain to stakeholders unfamiliar with it. Additionally, HHI is data-intensive, requiring comprehensive market share data for all firms, which might not always be available or reliable in some markets.
In summary, concentration ratios offer a straightforward, quick snapshot focused on the largest firms but can overlook the competitive dynamics of smaller firms, whereas the HHI provides a fuller, more sensitive measure of market concentration but is more data-demanding and complex to interpret. This difference guides their use in different analytical or regulatory contexts.
The concentration ratio is calculated by adding up the market share of the largest N-companies. The Herfindahl-Hirschman index (HHI), on the other hand, sums up the square of the market share of each company, providing a more accurate measure than the concentration ratio. Market share is measured by dividing a company's sales by total market sales in a certain period, expressed as a percentage. It's important to note that calculating the concentration ratio of a company's total revenue can be misleading if the company has several product lines.
A ratio of more than 40% to less than 100% leads to oligopoly, indicating a market structure where a few large firms dominate. The CR4 ratio is calculated as the sum of the market share of the four largest companies in an industry. Understanding these measures can help in making informed decisions about market competition and potential interventions.
[1] E.C. (2020). Guidelines on the assessment of horizontal mergers under the EU Merger Regulation. European Commission. [2] U.S. Department of Justice & Federal Trade Commission (2020). Horizontal Merger Guidelines. U.S. Department of Justice & Federal Trade Commission.
*In the context of assessing market concentration, the efficiency and transparency of the concentration ratio (CR) make it useful for policymakers and analysts to quickly identify market dominance by key players.
*On the other hand, the Herfindahl-Hirschman Index (HHI) provides a more nuanced picture of market concentration by considering the size and distribution of firms across the entire market, which offers a more accurate measure than the concentration ratio.
