The concentration index measures the amount of competition in an economic market and determines the market control of top companies. The Herfindahl index and the four- or eight-company concentration index are common formulas used. High concentration indicates an oligopoly, while low concentration represents perfect competition.
A concentration index is an economic tool used to determine the amount of competition in an economic market. The Herfindahl index and the four- or eight-company concentration index are the most common formula for this economic tool. The concentration index will measure the total output produced for a specific number of companies in a sector or business sector. The purpose of this index is to find out the amount of market control the top companies have in an industry. Industries or sectors dominated by a few large companies are seen as an oligopoly, which means few suppliers of consumer goods or services. Each firm can base its business decisions on other firms’ actions in an oligopolistic sector.
The Herfindahl Index is the sum of squares of each market share of the top companies in an industry, with the measured total of no more than 50 companies. This index provides a range of indicators 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 often use 0.18 as the point in the Herfindahl index at which an industry has a high concentration of dominant firms. A company that consistently dominates the market will have a monopoly, which generally 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 0.245. This indicates an industry with a high concentration of dominant firms.
A concentration index of four or eight companies is much easier to calculate than the Herfindahl index. Each of these indexes takes the top four or eight companies in an industry and adds up each company’s total market share. The concentration rate of four or eight companies ranges from 0 to 100%. An industry with 0% of the total market share has no market concentration and represents an industry in which no single company dominates the market. This is generally seen as perfect competition. Industries with a total of 100% as the sum of market shares equals the total concentration in a market. This is the classic example of an oligopoly, because four or eight companies dominate the market. Low market concentration is seen from 0 to 50%, medium concentration from 50 to 80%, and high market concentrations from 80 to 100%.
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