{"id":801,"date":"2019-10-10T20:04:00","date_gmt":"2019-10-10T20:04:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=801"},"modified":"2026-01-13T10:09:38","modified_gmt":"2026-01-13T10:09:38","slug":"describe-the-use-and-limitations-of-concentration-measures-in-identifying-market-structure","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/economics\/describe-the-use-and-limitations-of-concentration-measures-in-identifying-market-structure\/","title":{"rendered":"Use and Limitations of Concentration Measures in Identifying Market Structure"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n  \"name\": \"The Firm and Market Structures (2022 Level I CFA\u00ae Exam \u2013 Reading 9)\",\n  \"description\": \"This video lesson covers the firm and market structures, exploring monopoly, monopolistic competition, oligopoly, and perfect competition. It explains profit maximization, supply functions, demand elasticity, and long-run equilibrium. Additionally, it discusses concentration measures like the HHI and strategies firms adopt under different market structures to compete effectively.\",\n  \"uploadDate\": \"2019-06-11T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/img.youtube.com\/vi\/PBMOxv2e3QU\/default.jpg\",\n  \"contentUrl\": \"https:\/\/youtu.be\/PBMOxv2e3QU\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/PBMOxv2e3QU\",\n  \"duration\": \"PT21M26S\"\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"If a market has five suppliers and each of the top two suppliers holds 20 percent of the market share, which of the following best represents the concentration ratio for the top two suppliers and their respective HHI?\",\n    \"text\": \"If a market has five suppliers and each of the top two suppliers holds 20 percent of the market share, which of the following best represents the concentration ratio for the top two suppliers and their respective HHI?\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"Concentration ratio = 40%; HHI = 0.08.\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"Concentration ratio = 4%; HHI = 40.\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"Concentration ratio = 40%; HHI = 0.4.\"\n      }\n    ]\n  }\n}\n<\/script>\n\n\n\n<iframe loading=\"lazy\"\n  width=\"611\"\n  height=\"344\"\n  src=\"https:\/\/www.youtube.com\/embed\/PBMOxv2e3QU?rel=0&#038;modestbranding=1&#038;playsinline=1&#038;vq=hd1080\"\n  title=\"YouTube video player\"\n  frameborder=\"0\"\n  allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\"\n  allowfullscreen>\n<\/iframe>\n\n\n\n<h2><strong>Concentration Ratio<\/strong><\/h2>\n<p>The concentration ratio is the sum of market shares covered by the largest N firms. It is determined by finding the sum of sales value for the largest firms and dividing it by the total market sales. Therefore, the resulting figure lies between zero (for perfect competition) and 100 (for monopolies).<\/p>\n<p>The main advantage of this concentration measure is the simplicity of its calculation. However, there are some limitations to the usage of this method.<\/p>\n<h3><strong>Example of Concentration Ratio<\/strong><\/h3>\n<p>Suppose there are 10 producing companies in a market. The production percentages for the top three companies are 35%, 20%, and 10%. Calculate the concentration ratio for these three companies.<\/p>\n<h4>Solution<\/h4>\n<p>The concentration ratio is the sum of market shares covered by the largest\u00a0<em><strong>N<\/strong><\/em><em>\u00a0<\/em>firms. So the concentration ratio for the first 3 companies are:<\/p>\n<p>$$ \\text{Concentration ratio} = \\frac{35\\%+20\\%+10\\%}{100%}=65%$$<\/p>\n<h3><strong>Limitations of the Concentration Ratio<\/strong><\/h3>\n<p>This method cannot quantify market power directly. The big question should be whether high concentration levels can be interpreted as an indication of monopoly power. An example is the case of only one sugar company in a country. This company enjoys monopoly power. However, the problem comes in when there exist large wholesalers in, say, the food sector. These wholesalers may decide to import sugar alongside their range of products. As a result, this will most likely compel the sugar company to adjust its prices as if it\u2019s in perfect competition.<\/p>\n<p>The concentration ratio tends not to be affected by mergers among the top market incumbents. If there exists a merger between the largest and second-largest companies, their combined pricing power is most likely to be larger than that of the two pre-existing companies, which the concentration ratio will not accurately represent.<\/p>\n<h2>The Herfindahl\u2013Hirschman Index (HHI)<\/h2>\n<p>Economists O.C. Herfindahl and A.O. Hirschman came up with an index that first squares the market shares of top <em><strong>N\u00a0<\/strong><\/em>companies. These squares are then summed up. For a monopoly firm, the Herfindahl-Hirschman Index (HHI) should be equal to 1.<\/p>\n<p>Consequently, in the case of\u00a0<em><strong>M\u00a0<\/strong><\/em>firms with equal market shares, the HHI should be equal to \\(\\frac{1}{M}\\). This is a very useful gauge for interpreting the HHI. This measure was developed to try and overcome some issues associated with the concentration ratio.<\/p>\n<h3>Example of the Herfindahl\u2013Hirschman Index (HHI)<\/h3>\n<p>Using the same example as above, the HHI for the top three companies can be calculated as:<\/p>\n<p>$$ \\text{HHI} = 0.35^2+0.20^2+0.10^2=0.1725$$<\/p>\n<h3><strong>Limitations of the HHI<\/strong><\/h3>\n<p>The HHI does not consider the elasticity of demand, and thus it cannot approximate the potential profitability of a single company or a group of companies.<\/p>\n<blockquote>\n<h2><strong>Question 1<\/strong><\/h2>\n<p>If a market has 5 suppliers and each of the top two suppliers holds 20 percent of the market share, which of the following best represents the concentration ratio for the top 2 suppliers and their respective HHI?<\/p>\n<p>A. \u00a0Concentration ratio = 4%; HHI = 40<\/p>\n<p>B. \u00a0Concentration ratio = 40%; HHI = 0.08<\/p>\n<p>C. \u00a0Concentration ratio = 40%; HHI = 0.4<\/p>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is B.<\/p>\n<p>The concentration ratio is the sum of the two suppliers\u2019 market share.<\/p>\n<p>Therefore, 20% + 20% = 40%.<\/p>\n<p>For the HHI, we take 0.20<sup>2<\/sup> \u00d7 2 = 0.04.<\/p>\n<h2><strong>Question 2<\/strong><\/h2>\n<p>Which one of the following is <em>least likely<\/em> a characteristic of the concentration ratio measure?<\/p>\n<p>A. It is simple to compute<\/p>\n<p>B. It does not directly quantify market power<\/p>\n<p>C. It cannot be used to estimate elasticity<\/p>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is C.<\/p>\n<p>As a matter of fact, analysts use the simpler concentration to estimate elasticity. On the other hand, the HHI does not consider the elasticity of demand and as such, cannot be used to approximate the potential profitability of a single company or a group of companies.<\/p>\n<\/blockquote>\n<div class=\"notes_inv\"><hr \/>\n<p><a href=\"https:\/\/analystprep.com\/cfa-level-1-exam\/economics\/learning-sessions-curriculum-economics\/\"><em>Economics &#8211; Learning Sessions<\/em><\/a><\/p>\n<\/div>","protected":false},"excerpt":{"rendered":"<p>Concentration Ratio The concentration ratio is the sum of market shares covered by the largest N firms. It is determined by finding the sum of sales value for the largest firms and dividing it by the total market sales. Therefore,&#8230;<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4],"tags":[],"class_list":["post-801","post","type-post","status-publish","format-standard","hentry","category-economics","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Concentration Measures in Market Structure<\/title>\n<meta name=\"description\" content=\"Concentration ratios and the Herfindahl-Hirschman Index (HHI) measure market dominance. 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