Concentration ratio

            In economics, the four-firm concentration ratio indicates the relative size and market share of firms in relation to the whole industry - Concentration ratio introduction. It consists of the percentage of the four largest firms’ market share. This measure also helps determine the form and structure of an industry, thus one with a 30% concentration ratio can be classified as having monopolistic competition.

            In monopolistic competition, there occurs a high degree of competition among many firms which sell similar, but not perfectly substitutable products or services. It differs from perfect competition in that firms are profit maximizers. This means that they produce the quantity that will yield maximum economic profit. Production does not happen at the lowest possible cost, so an excess in production capacity usually develops. Price-taking does not occur in monopolistic competition since the large number of firms gives everyone a certain degree of market power.

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            When barriers are low and firms are able to easily break into an industry, a rise in a product’s demand and price will give other firms incentive to enter. As new firms enter, each firm’s demand and marginal revenue decreases. In the long run, since each firm has some market power, they will produce up to the point where the price equals to the average cost, translating to zero profits for all.

            In order to maximize profit, each firm must set the price in such a way that it higher than the marginal cost. One way to do this is though product differentiation. Monopolistically competitive markets are largely inefficient because prices are usually charged below the average cost and ease of entry (and exit) limits profits in the long run. If  firms are making profits, the entry of more firms limits those profits. On the same token, if firms are incurring losses, the exit of some firms wipes out those losses.

            Now if the four-firm concentration ratio of an industry with 20 firms is 80% instead of 30%, its market structure will become oligopolistic. An oligopoly is a market where there is a limited number of competitors that produce or control most of the market supply—each one with considerable market power. Since there are few market players, each firm is aware of others’ actions, often resulting in interactivity. Changes in pricing and marketing of one influences the decisions of other firms. Strategic planning by oligopolistic firms always takes explicit account of the possible response of other market players.

            Industries with high concentration ratios are often characterized by strong barriers for entry. Some of these barriers include patents, significant capital costs, and control over distribution systems. For instance, the wireless communication industries have high concentration ratios since governments usually regulates distribution by giving license to only two or three companies.

            Smaller firms can attempt to thrive and profit in an oligopolistic market by stifling competition through product differentiation. Product differentiation is the process wherein a product is made to appear superior or different by highlighting features apart from those of other competitors. Another way of thriving in the market is basing the firm regionally where it does not directly compete with its rivals.

            Oligopolistic competition can give rise to different market outcomes which include price leadership and contestable market models. In price leadership, one firm (usually the market leader), informally establishes market prices to which other firms respond. This will eventually lead to a situation wherein price changes among all firms are relatively the same. It can stabilize unstable markets by reducing inherent risks such as those concerning investments and product development. However, price leadership can also cause unstable sales and prices, thus making it inefficient. In addition to that, if the price leader ends up much better off than its competitors, a price war could occur wherein the competition is driven out of the market by repeatedly driving down prices.

            A contestable market model leads to a more efficient outcome. Here, market entry and exit is costless, thus other firms are willing to enter if profit is possible. Because of this, existing firms behave as if competition exists, producing closer to the competitive price and output to restrict other firms from entering the industry. When the competition between firms in an oligopoly is fierce, it usually results to lower prices and higher production, approaching that of a perfect competition.

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