Market concentration: definition, types and formulas


There are growing fears that markets around the world are becoming less competitive. Low competition means that the major companies hold more market power – they can raise prices and make it difficult for small businesses and startups to enter the market. Another problem with rising prices and profit margins is wage suppression. Workers and consumers suffer from high market concentration (low competition) while big players get richer.

A recent US Market Concentration Study found that more than 75% of U.S. industries have experienced an increase in concentration since the late 1990s. Whether you want to enter a particular market in the U.S. or elsewhere, whether you need market share information of your main competitors or whether you are considering a specific merger, market concentration data can help you make informed decisions.

What is the market concentration?

Market concentration shows the competitive intensity in a particular industry or economy. It shows the extent of production dominance in a specific market by measuring the combined market share of leading companies in that industry. This market share can refer to the percentage of total sales, the number of customers or points of sale, employment statistics and other relevant indicators.

For example, if the top five companies in an industry have more market share than the others combined, that industry is highly concentrated. It may indicate a monopoly or an oligopoly (more on those in a moment), where there is insufficient competition. Low concentration means that larger firms do not have greater market power. They do not influence the total market output in their industry, which makes it very competitive.

Frustrated with market data - Angry in the office
Image: Sergei Nivens / Depositphotos

You can use market concentration data to quantify a market structure to determine whether entering that industry or economy is profitable or to identify the impact of a potential merger. It is also a crucial indicator for calculating a location quotient to discover successful local industries.

Location quotient data can help you determine the concentration of employment in a specific region, but you will need firmographic data on employment and annual revenues. The most cost effective and fastest way to get it is to buy it from a data provider like Coresignal.

Determine a market structure

Market concentration data helps you determine a particular market structure in an industry or economy. Understanding their characteristics will improve your decision making.

perfect competition

Perfect or atomistic competition indicates a structure in which several small firms compete for market share, but none have significant market power. None influences the prices because the return is optimal. Supply equals demand, ensuring allocative and productive efficiency. This market structure means that all companies sell identical products or services and earn maximum profits. However, you won’t find it in the real world.

Monopolistic competition

Monopolistic competition occurs when many firms compete for market share but sell slightly different products that are not perfect substitutes. This structure does not have an optimal return and companies can raise prices to some extent.

Monopoly

A monopoly indicates the absence of competition. A business is the sole provider of a particular product or service; it dominates the market and has the power to set high prices because no other company can compete with it.

Oligopoly

An oligopoly refers to a structure where a tiny fraction of the market dominates the entire industry. A few large players hold more than 60% of the total market share. They compete or collaborate to control the market, leading to higher prices and lower wages.

How to Calculate Market Concentration

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You can calculate market concentration using the concentration ratio or the Herfindahl-Hirschman Index (HHI).

Concentration ratio

You typically consider the top four to eight companies in a sector or economy to calculate the concentration ratio (CR), a sum of the percentage market share of those companies. The lower the ratio, the stronger the competition. A ratio of 50% or less indicates weak competition, while a ratio above 60% indicates oligopoly. A ratio close to or equal to 100% implies a monopoly.

Herfindahl-Hirschman index

You calculate the HHI by squaring each company’s market share percentage and adding the numbers together to get a figure as high as 10,000. An index above 2,000 indicates a highly concentrated market. The HHI is more accurate because it weights leading companies by size. Here is an example of three different markets, each with a four-company concentration ratio of 85%:

1. Market A (low competition)

RC = 40% + 20% + 20% + 5%

HHI = 2440

2. Market B (highly competitive)

RC = 25% + 20% + 20% + 20%

HHI = 1840

3. Market C (monopoly)

RC = 75% + 5% + 3% + 2%

HHI = 5678

Conclusion

Market concentration is an imperfect indicator because market structure and competitive intensity have an ambiguous relationship. Higher concentration does not necessarily indicate a decline in competitiveness – it can also mean competition at work. Don’t just look at market concentration data. Consider other indicators of competitive intensity, such as production, prices, profits, profit margins, and churn rates.

Photo credit: The photos (1, 2, 3) presented were taken by Sergey Nivens.

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