Concentration Measures in Economics

N-firm concentration is the sales of top n firms divided by the total sales in the industry, i.e., the percentage of sales held by the n largest firms in an industry. For example, 4-firm concentration ratio will be the percentage of sales held by the four largest firms in an industry.

In a market with perfect competition, this ratio would be zero. It will be 100 in a highly concentrated market. In general, a ratio of more than 60% is indicative of a high degree of concentration (oligopoly), and less than 40% indicates a competitive market.

Herfindahl-Hirschman Index (HHI)

HHI measures market concentration and is a metric used by government oversight bodies in the U.S. to determine if a merger should be allowed or blocked.

HHI calculates the sum of squared market shares for competing companies.

For an individual firm, HHI is calculated once; for a merger of two companies the HHI of the combined entity will be the sum of their individual market share HHI values.

This number is small in competitive markets. When HHI crosses a certain threshold, the government may legally challenge the proposed merger. An HHI greater than 1,800 indicates an uncompetitive market, and mergers which result in HHIs greater than 1,800 are more likely to be challenged by the Justice Department antitrust division.

Note that a small change to HHI in a heavily concentrated industry may be more scrutinized than a large change to HHI in a highly competitive industry. In the U.S., the Justice Department will consider other factors than just the HHI, when determining whether or not to attempt to block a merger.

Suppose there are five firms in a market, with the following market shares:

Firm 1: 30%, Firms 2, 3, and 4: 20% each, Firm 5: 10%. The HHI for this industry is 302 + 202 + 202 + 202 + 102 = 2,200. A market with an HHI this high is considered to be uncompetitive.

In addition to the above concentration measures, concentration can be gauged by:

• Barriers to entry - Low barriers to entry, even in concentrated industries can lead to greater competition in the future.
• Number of firms in the industry
• Product type - Is the product a commodity or can it be easily differentiated?
• Price control - Does the firm control price? Is price subject to regulation or market forces beyond the control of the firm?

Limitations of concentration measures include:

• Scope of the market - Is there a small, domestic market for a product or is there a global market? For example, there is limited worldwide demand for a local newspaper, but there is a wider market for clothing, worldwide.
• Entry barriers - Do firms enter and exit the industry easily or often?
• Market and industry definitions - Markets and industries may not correspond. Companies may compete in multiple product markets, some competitive and others less competitive. Companies may also switch from industry to industry depending on market demands. There may be smaller, sub-markets within an industry that are more or less competitive than the overall market.

Most U.S. markets are competitive. In addition to domestic competition, U.S. companies face competition from international companies as well.