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A concentration ratio is an economic tool used to determine the amount of competition in an economic market. The Herfindahl index and four-firm or eight-firm concentration ratio is the most common formula for this economic tool. The concentration ratio will measure the total production output for a specific number of firms in a business industry or sector. The purpose of this ratio is to discover the amount of market control the major companies have in an industry. Industries or sectors dominated by a few major firms are seen as an oligopoly, which indicates few suppliers for consumer goods or services. Each company may base its business decisions on the other actions of companies in an oligopolistic industry.
The Herfindahl index is the sum of the squares for each market shares from major companies in an industry, with the total companies measured no higher than 50. This index provides an indicator range from 0 to 1, with higher numbers generally indicating a decrease in competition and an increase in market share for the largest companies in an industry. Economists typically use .18 as the point in the Herfindahl index in which an industry has a high concentration of dominant firms. One company who consistently dominates the market will have a monopoly, which usually represents an unfavorable position for consumer prices.
As an example, five companies have market shares of 30%, 30%, 20%, 15%, and 5%, respectively. The Herfindahl index is calculated as 30^2, 30^2, 20^2, 15^2, 5^2, which leads to an index of .245. This indicates an industry with a high concentration of dominant firms.
A four-firm or eight-firm concentration ratio is much easier to calculate than the Herfindahl index. Each of these ratios takes the top four or eight companies in an industry and sums the total market share for each company. The four- or eight-firm concentration ratio will range from 0 to 100%. An industry with 0% as the total market share has no market concentration and represents an industry where no one company dominates the market. This is often seen as perfect competition. Industries with a total of 100% as the sum of market shares equal total concentration in a market. This is the classic example of an oligopoly because four or eight firms dominate the market. Low market concentration is seen as 0 to 50%, medium concentration with 50 to 80% and high market concentrations with 80 to 100%.