Concentration ratio of an industry is used as an indicator the relative size of the industry as a whole. In most cases it is calculated using four largest firms in the industry and the method is known as the four-firm concentration ratio. Concentration ratio may also be used as a market share indicator in an industry since it represents the market output compared to the number of firms in the industry. Further, using the Herfindahl index which is a correlation of the concentration ratio it is easy to rank the firm size in any industry, for instance we can easily use this particular method to determine which firm in an industry has the largest market share. With that we can use the size of concentration ratio to determine market forms of any industry (O’Sullivan, Sheffrin, Perez, 2006, p. 24).
Concentration ratio defines market forms which include a perfect competition, monopolistic competition, oligopoly and monopoly competition. Perfect competition is a market where demand and supply powers are all quite strong meaning that there are several firms supplying similar products and also there are several customers for those products. This kind of market tends to have a very low concentration ratio and this is the kind of industry described of having a concentration ratio of 20%. Having stated that the industry has 20 firms and the CR is 20% it means that all these firms have a reasonable competitive advantage hence can have power to win adequate demand of their products (Young, Philip and John, 2007, p.5).
Further, the concentration ratio of a perfect competition industry which has a concentration ratio of 205 can be altered by demand and price forces. For instance, increase in demand which further results to increase in price for the good will also affects supply in the long run. Since the firms in a perfect competitive environment has almost equal power to capture demand, its increase will mean that shortage in supply will occur in the short run hence price increase. But in the long run price will then decrease since supply will increase. However, in the long run concentration ratio will not actually change since the number of large firms and their market share which are very essential when calculating CR will not be altered.
On the other hand, an industry may have a concentration ratio that is as high as 80% instead of 20%, this means that the industry operates in a monopoly competition where the number of large firms in it is very low at times as low as one. In this industry the large firm will tend to dictate supply and consequently price. The high concentration ratio is caused by the scarcity of large firms since it tends to dictate market forces. A large firm owns all competitive advantage and it makes it very difficult to maintain equilibrium with the smaller firms. Monopolistic environments in the market are brought about by scarcity of resources, skilled work force and government rules (O’Sullivan, et al., 2006).
High concentration ratio means that the large firm’s dictates profits for the smaller firms; it even makes it difficult for the small firms to exist. Actually in most cases where high concentration ratio exist there are no small firms since the highest supply in the market is made by the large firms and the small firms are not in a position to compete with it. In monopoly competition price is quite elastic since the large firm which is basically the sole supply dictates when price fluctuates, in this kind of industry customer satisfaction is not a key concern and demand also is hardly affected by price changes in the long run.
O’Sullivan, Sheffrin, Perez. (2006). Principles, Applications and Tools. New York: Prentice Hall.
Young, Philip, K., John, J. (2007). Industry Concentration. London: Business Administration, Inc.