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Concentration Ratio

Updated on April 18, 2024
Article byPrakhar Gajendrakar
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Concentration Ratio?

The concentration ratio in economics compares the sales of a specified number of largest firms in the industry with the industry’s total sales. It is a method used to evaluate the market concentration.

The concept is simple if the market share details are easily available and accurate. It explains the level of competition in the industry and the performance of the companies operating in an industry. For example, if this ratio of a company equals 100%, there is no competition in the industry, which points to the existence of a monopoly.

Key Takeaways

  • The concentration ratio (CR) in economics compares the sales of a specified number of largest firms in the industry with the industry’s total sales.
  • In other words, it calculates the total percentage market shares of the specific number of largest firms in the industry.
  • It is a method used to evaluate the market concentration.
  • The CR value and industry competition level exhibit a negative correlation.  If the concentration is high, the level of competition is low, and vice versa.

Concentration Ratio Explained

Concentration ratios falling between 0% and100% provide information about the industry. If the value of the ratio is equal to 0%, perfect competition exists, and the value of 100% points to monopoly and zero competition. If the value is below 40%, then the concentration is low. It also points to monopolistic competition exhibiting many producers engaged in healthy competition by selling differentiated products. A value greater than 40% points to the medium concentration scenario pointing to the presence of oligopoly where the industry is dominated by few numbers of significant and large players. Finally, if the CR is greater than 70%, the concentration is high, and competition is very low, pointing to oligopoly or monopoly.

The understanding of the concept help economists study different industries and major players in the industry and compare different companies in an industry. The economists can choose to go for three-firm, four-firm, and five-firm CR. It helps to understand the industry’s market share distribution and concentration level. Greater market concentration means larger firm size. Furthermore, a high concentration level is not always attractive since it features a monopoly or oligopoly, causing adverse effects like high barriers to entry and reducing innovation.

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Formula

The concentration ratio formula is as follows:

Concentration ratio formula

The calculation divides the total sales contributed by the industry’s largest firms by the overall sales made by the industry.

Or

CRn = C1 + C2 + … + Cn

  • n: Number of firms or companies included.
  • C1 + C2 + … + Cn: Sum of the percentage of market share of the specified number of largest firms. Market share is the ratio of total sales of the company and total industry sales.

Example

Martha wants to open a furniture company with the required capital and other resources. Still, before starting the business, she wants to know the level of competition in the furniture industry. So Martha collected the details of firms operating in the sector; five major firms have strong goodwill, brand, sales, and market share.

FirmSales ($, Million)Market share (Cn) in %
12016.66
23025
32520.83
41512.5
5108.33
654.16
732.5
832.5
943.33
1054.16

CRn = C1 + C2 + … + Cn

CR5 = C1 + C2 + … + C5

=C1 + C2 + C3 + C4 + C5

= 16.66 + 25 + 20.83 + 12.5 + 8.33

= 83.3%

Or

Concentration ratio = ($100 million)/($120 million) ×100

= 83.3%

The largest five firms share more than 60% market share, 83.32%, and contribute to more than half of the total industry sales. The small firms operating in the same industry contribute the rest of the market sales. This detailed information helped Martha understand the risk, competition, and growth prospects and make better business decisions.

Four Firm Concentration Ratio

It is the total sales of the four largest firms of any given industry compared to the entire industry sales. The four firm concentration ratio will be as follows:

Concentration Ratio Formula 1

Or

CR4 = C1 + C2 + C3 + C4

Here,

C1 + C2 + C3 + C4:   Sum of the percentage of market share or industry sales of the four largest firms specified.

A common example is the UK supermarket or grocery industry, where the top four firms, Tesco, Sainsbury’s, Asda, and Morrisons, account for more than 60% of the supermarket industry. It explains how competitive all the four firms are and how challenging it is for new firms to enter the market.

Frequently Asked Questions (FAQs)

How to calculate concentration ratios?

It involves calculating the ratio of sales made by the specified number of largest firms in the industry and the industry’s total sales. Another easy approach is totaling the percentage market share held by the specified number of largest firms in the industry.

What is a high concentration ratio?

A high concentration ratio suggests that a few companies control a considerable portion of the market, indicating strong market dominance and low competition. If the ratio is 100% or very close to it, then the presence of a monopoly is certain. Generally, if the ratio is greater than 70%, the industry’s concentration level is high and hints at oligopoly or monopoly.

Why do experts study the concentration ratio in economics?

The ratio helps in determining important aspects like:
– Total sales contribution by the largest firms in the industry
– Explains the market share held by the big firms.
– Useful in evaluating the level of competition and presence of monopoly or oligopoly established in the market.

This has been a Guide to What is Concentration Ratio. We explain its examples, how to calculate it using formulas, and the four-firm concentration ratio. You may learn more from the following articles –

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