The most common concentration ratios are the CR4 and the CR8, which means the market share of the four and the eight largest firms. Concentration ratios are usually used to show the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is oligopolistic. The standard tools of competition economists and competition authorities to measure market concentration are the Herfindahl-Hirschman index and the concentration ratios. These two are known as the traditional structural measures of market concentration. The concentration of firms in an industry is of interest to economists, business strategists and government agencies.
Two common ratios
The Four-Firm Concentration Ratio measures the total market share of the four largest firms in an industry.
The Eight-Firm Concentration Ratio measures the total market share of the eight largest firms in an industry.
Usually, these two common ratios are comparable from industry to industry, while concentration ratios for other numbers of firms can be also calculated.
Measurement
N-firm concentration ratio is a common measure of market structure and shows the combined market share of the N largest firms in the market. For example, the 5-firm concentration ratio in the UK pesticide industry is 0.75, which indicates that the combined market share of the five largest pesticide sellers in the UK is about 75%. N-firm concentration ratio does not reflect changes in the size of the largest firms. The Herfindahl index avoids this problem.
Concentration levels
Concentration ratios range from 0 to 100 percent. The levels reach from no, low or medium to high to "total" concentration.
;Perfect competition: If there are N firms in an industry and we are looking at the top n of them, equal market share for all of them means that CRn = n/N. All other possible values will be greater than this. ;No concentration: If CRn is close to 0%, this means perfect competition or at the very least monopolistic competition. If for example CR4=0 %, the four largest firm in the industry would not have any significant market share. ;Low concentration: 0% to 40%. This category ranges from perfect competition to an oligopoly. ;Medium concentration: 40% to 70%. An industry in this range is likely an oligopoly. ;High concentration: 70% to 100%. This category ranges from an oligopoly to monopoly. ;Total concentration:100% means there is a monopoly.
Problems
The definition of the concentration ratio does not use the market shares of all the firms in the industry and does not provide the distribution of firm size. It also does not provide a lot of detail about competitiveness of the industry. The concentration ratios just provide a sign of the oligopolistic nature of an industry and indicate the degree of competition. The Herfindahl index provides a more complete picture of industry concentration than does the concentration ratio.
Standard concentration ratios have performed poorly in explaining margins in certain markets, especially electricity markets, where supply and demand must be balanced in real time. As to account for the specificities of electricity markets the specific structural measures such as the Pivotal Supplier Index and Residual Supplier Index have been proposed. The Herfindahl index and the concentration ratios focus on the market shares of companies, but measures such as the PSI and the RSI identify the "pivotalness" of companies to meeting the demand on the system. A company that is very pivotal can be said to have a potential for high market power. Empirical estimates in electricity markets have related the RSI to price cost margins.
Pivotal Supplier Index (PSI)
The Pivotal Supplier Index considers the demand in addition to the supply side. At the most basic level, the PSI answers the question if a particular supplier, the "pivotal supplier", is needed to supply the demand: would it be possible to supply the prevalent demand also without this supplier or is he mandatory? The Pivotal Supplier Index is expressed as the following: PSI = I
where Cx is the capacity of the potential pivotal supplier and the sum of Ci the capacity of all suppliers. The function I is the indicator function, which takes the value 1 if the expression "." contained in it is true. An equivalent expression is the following: PSI = I
where the sum of capacities is taken over all suppliers apart from x. The PSI is a binary indicator that can be calculated hourly. If the supplier Cx is needed to supply the demand, it is pivotal and the index takes the value "1". If he is not pivotal, it takes the value "0".
Residual Supply Index (RSI)
The Residual Supply Index is a simple and effective tool in monitoring market power. It is the non-binary alternative to the PSI.
The Residual Supply Index is expressed as: RSI = /D
where Cx is the capacity of the analysed supplier and the sum of Ci the capacity of all suppliers, and D is demand. As the estimated RSI exceeds 100%, the RSI gives an indication that the supplier x's potential to impact price is falling. With a RSI smaller than 100%, the supplier being analyzed begins to become more 'pivotal' and thus could potentially practise market power. The RSI has the advantage over the PSI to be not binary and for this reason it can better indicate the existence of structural market power.
