Economists and government officials have an interest in maintaining a competitive marketplace. They want the consumer to receive the best quality products, the most choices and the best prices. The common belief is that companies who have a monopoly do not have an incentive to meet these standards. As a result, economists have created several metrics to measure the degree to which a market is competitive and fair to the consumer.
The Four-Firm Concentration Ratio
One way to measure the competitiveness of a specific market is to calculate the percentage of the total market controlled by the top four companies. The four-firm concentration ratio is determined by adding up the percentage market share of each of the top four firms in the industry.
The theory is that the higher percentage of the market controlled by these four firms, the less competitive the market is. A ratio in the range of 0 percent to 50 percent is considered to have a low concentration and be competitive. Ratios in the range from 50 percent to 80 percent are moderately competitive, and anything above 80 percent is approaching a monopoly.
While the four-firm concentration ratio is easy to calculate, it has several disadvantages. It does not consider that the largest of the top four companies could be substantially bigger than the smallest firms in the top four. Nike, for example, has 62 percent of its market, and the other firms all have 5 percent or less.
The concentration ratio often does not consider revenues from foreign subsidiaries. This omission overstates the extent of domestic concentration. As a result, the inability to precisely define a company's diverse product lines could lead to inaccurate comparisons to other firms in the same industry.
The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is a slightly more advanced measure of market concentration than the four-firm concentration ratio. It is calculated taking the market share of each firm in the market, squaring each one and adding up the sum. The total ranges from zero, meaning perfect competition, to 10,000, indicating a monopoly. The U.S. Department of Justice uses the HHI to evaluate the effects of proposed mergers.
The DOJ considers an HHI above 2,500 as a highly concentrated and less competitive market, between 1,500 to 2,500 as moderately competitive, and less than 1,500 as a competitive market
Examples of Market Concentration
When taken together, the four-firm concentration ratio and the HHI reveal much about the competitiveness of a marketplace.
Consider auto manufacturing. The market shares of the top four companies are General Motors with 17.7 percent, Ford with 15.1 percent, Toyota with 14.4 percent and Chrysler with 12.8 percent. All total, the top four firms have 60 percent of the market.
The HHI of the top four firms is calculated as follows: (17.7 x 17.7) + (15.1 x 15.1) + (14.4 x 14.4) + (12.8 x 12.8) = 912
Although the top four auto firms have 60 percent of total revenues, the low HHI of 912 indicates that the market is competitive.
Competition in the Beer Industry
Take a look at the beer industry. The top four producers are Anheuser-Busch with 43.5 percent, MillerCoors with 25.1 percent, Constellation/Crown with 7.4 percent and Heineken with 3.9 percent. Their share of the total market adds up to 79.9 percent.
The HHI for these four beer producers: (43.5 x 43.5) + (25.1 x 25.1) + (7.4 x 7.4) + (3.9 x 3.9) = 2,592
With nearly 80 percent of the market for the top four companies and an HHI of 2,592, the beer industry is a highly concentrated market. Anheuser-Busch dominates the market for beer producers.
Concentration in the Sneakers Market
The market for sneakers is an even more glaring example of a concentrated market. The market leaders are Nike at 62 percent, Skechers at 5 percent, Adidas at 5 percent and Asics at 4 percent. The four firms together control 76 percent of the market.
The HHI for top sneaker manufacturers: (62 x 62) + (5 x 5) + (5 x 5) + (4 x 4) = 3,898
In this case, the 76 percent market share of the top four sneaker firms is less than the 79.9 percent of the top four beer producers. This would appear to be a good sign, but the HHI tells a much different story. The HHI of 3,898 is well beyond the 2,500 threshold considered as a noncompetitive market. This is the result of one firm, Nike, dominating the market and being far ahead of the other competitors.
The four-firm concentration ratio and the Herfindahl-Hirschman Index are useful tools for economists, investors and government officials to analyze the competitiveness of a marketplace. These metrics do not provide a detailed picture of the competitiveness among firms in an industry, but they do serve as a good starting indicator.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.