fbpixel Concept 21: Concentration Measures | IFT World
101 Concepts for the Level I Exam

Concept 21: Concentration Measures


The two concentration ratios used to measure the market power of the firm.

N-Firm Concentration Ratio

  • Sum of the market shares of the N largest firms in an industry.
  • Market share = firm revenue / total market revenue.
  • Advantage: Simple to calculate and understand.
  • Disadvantages: Ignores barriers to entry, does not directly measure market power or elasticity of demand.

Herfindahl-Hirschman Index (HHI)

  • HHI = sum of squared market shares of N largest firms in a market.
  • Ranges from 0 to 1: where 0 indicates perfect competition and 1 indicates a perfect monopoly.

Consider the market share of the following firms:

Firm Revenue/Total market revenue
Bruce 30%
Clark 20%
Flash 15%
Peter 10%
Xavier 10%
James 5%

Compute the following 4-firm concentration ratio and the HHI.

  1. 4-firm concentration ratio prior to and post the merger of Bruce and Clark.
  2. HHI prior to and post the merger of Bruce and Clark.

Solution:

\noindent Solution:

1.Prior to the merger,
Four-firm\ concentration\ ratio=30+20+15+10=75\%
Post the merger, Bruce and Clark become one entity having a market share of 50\%.
Four-firm\ concentration\ ratio=50+15+10+10=85\%
Four-firm concentration ratio fails to capture the large increase in market share of the most dominant firm which has gone up from 30\% to 50\%, while the measure has only gone up by 10\%.

2. Prior to the merger,
HHI={0.30}^2+{0.20}^2+{0.15}^2+{0.10}^2=0.1625
Post the merger,
HHI={0.50}^2+{0.15}^2+{0.10}^2+{0.10}^2=0.2925
HHI shows a larger increase, better reflecting the increase in the market share of the new large firm.


Crash Courses for November CFA Level I, II exams are coming soon!
This is default text for notification bar