The four-firm concentration ratio is an analytic tool that helps industry experts and government regulators to assess the state of competition in a market. By measuring the combined market shares of the top four companies in a specific industry or market, we can tell whether an improper imbalance in market competition exists or may be created by company mergers.
Monopolies and Oligopolies
In order to understand the concentration ratio, it’s important to first understand the terms “monopoly” and “oligopoly.”
In a healthy market – that is, an industry in which companies offer the same or similar goods or services in roughly equal shares – a balanced state of competition exists. This idealized state of competition can be “thrown off” or out of balance in a few ways.
For example, a monopoly exists where one firm dominates the market, above all others. If there are other competitors, they are vastly outperformed by the dominant company. In the United States as well as other countries, government agencies enforce antitrust laws and regulations to prevent monopolies from occurring.
Another type of imbalanced market is the oligopoly. An oligopoly exists when a market is dominated by just a handful of firms. In an oligopoly, it’s entirely possible that other firms also do business, but their market shares are usually a small slice of the total sales for that market.
These smaller firms may also compete only in a limited way with the dominant firms. For example, they may offer only a part of the goods or services offered by the dominant companies.
Types of Concentration Ratios
Government and industry analysts utilize a number of tools and calculations in order to grasp fully the “big picture” of a particular market and the state of competition in that market.
Most commonly used are the four-firm and eight-firm concentration ratios. Sometimes called CR4 and CR8, respectively, these ratios are designed to evaluate and analyze markets to spot existing or developing oligopolies and other unbalanced market conditions.
This analysis can take place after the fact – that is, after an oligopoly or monopoly already exists – but more commonly, the evaluation takes place before the market is thrown out of balance. Antitrust regulators will evaluate a proposed merger, for example. If the combining of the two companies in question will create an oligopolistic or monopolistic market, the merger may be more closely scrutinized or even prohibited.
Together with the Herfindahl Index (HI, or HHI, for Herfindahl Hirschman Index), the concentration ratios help illuminate the combined market share of the largest companies operating in a particular market or niche.
How to Calculate the Four-Firm Concentration Ratio
The formula for determining the 4-firm concentration ratio is:
CR4 = (X1 + X2 + X3 + X4) / T
In this equation:
- X is the total sales of an individual company (sales figures for the four largest firms are used in the four-firm concentration ratio)
- T is the total sales of the industry or market in question.
Add together the total sales for each of the four largest firms in your selected industry. Then divide that sum by the total sales of the industry. Convert that result to a percentage, and that percentage value is the four-firm concentration ratio.
It isn’t necessary to use accurate sales figures on a company or industry basis in order to calculate the four-firm concentration ratio. The key is to locate and use the most current and most reliable data you can find.
Evaluating the Result
The resulting percentage must be assessed against a range of possible norms to determine the state of the market.
For example, a ratio of 40 percent or less means that no single company or group of companies dominates that market. However, if the result is greater than 40 percent, an oligopoly is deemed to exist. Results close or equal to 100 percent indicate a monopoly in which one company controls the industry.
Other Methods of Evaluating a Market’s Level of Competition
Concentration rules are only one method of evaluating the condition of a market. Both the four-and-eight-firm concentration ratios provide merely an estimate, rather than a concrete measure of actual market dominance. Another tool, the Herfindahl Index, can illuminate the bigger picture by providing another benchmark for comparison purposes.