In the broadest terms, a concentration ratio is the amount of the total output of an industry generated by a given number of firms. This is important in Microeconomic theory, as competition between firms, or lack thereof, defines how a given firm will operate within a market. In the abstract, perfect competition allows for freedom for many firms to enter a market, which in turn means all firms become price takers. In reality, this is rarely the case, and markets typically resemble monopolistic or oligopolistic structures. Since Microeconomic theory states that firms will act differently depending on their relationship to the market, knowing how much a firm constitutes a market is vital for many economic analyses.

How is it measured

Generally, two common measurements of firm concentration are the 4-firm and 8-firm concentration ratios. These are useful when comparing industry to industry or sector to sector, as many details get lost when aggregating firm outputs across specific services and goods. However, there are issues with simplifying concentration down to such a basic statistic. In the hypothetical industry below, note how the four-firm concentration ration is equivalent between scenarios, despite firms having drastically different market shares.

 

Firm 1 20% 55%
Firm 2 20% 15%
Firm 3 20% 5%
Firm 4 20% 5%
Total Market Share 80% 80%

More accurate approaches to measure true concentration do exist, with The Herfindahl index being one of the most common. This type of measurement is useful for competition law and anti-trust action, because it more accurately accounts for larger firms having disproportional market impact. The key to this index being more accurate is that it weighs the average market share (of all firms) against the observed market share, resulting in a more representative proportion.

Current Trends

Almost without exception, concentration ratios within industries have been rising in recent decades. The domestic airline industry is a great example of this, and the concentration ratio is increasing for two reasons that transcend airline-industry-specific trends; Firms are able to merge relatively easily to create larger carriers, and laws exist preventing foreign competition from entering the domestic air travel market. In the case of airlines, the most recent large merger was between American and US Airways in 2013. Ostensibly, those arguing on behalf of the merger asserted “The combination of American Airlines and US Airways creates a better network than either carrier could build on its own,” …. “American’s substantial operations throughout the central United States provide critical coverage where US Airways is underdeveloped.” There is also good reason to prevent foreign competition in the domestic market as foreign government subsidies or tax structures can allow foreign competitors to artificially out-compete domestic airlines. Neither dynamic is unique to the airline industry; many mergers can be spun in a manner in which it appears both firms have capabilities the other firm doesn’t, or that foreign competition can undercut domestic markets. However, this concentration in the airline industry has not been great for consumers. Travel fees that are not included with the price of a ticket (cost of luggage for example) have been steadily increasing regardless of short-term market fluctuations. For example, the cost of fuel (one of the largest airline expenses) has plummeted in recent years, but none of that lower cost has been passed onto passengers in terms of cheaper fares or reduced fees.

Concentration Ratio of Firms Within an Industry