The Four Firm Concentration Ratio
- Pages: 3
- Word count: 664
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One of the cornerstones of Adam Smith’s economic system has been the mantra of perfect competition. Ideally, each firm in the market should be of equal size to each other with no single firm dominating the field. This absence of a dominant player forces the firms to continuously compete with each other through price, product offerings and promotions which is a beneficial situation for the consumer. If there were a dominating player, that firm could influence the market through its sheer size. It can dictate the price through price gouging or simply kill off its competition through undercutting. Or it may set standards and practices which other firms will be pressed to follow.
One way to get a picture of competition in a given market is through the four-firm concentration ratio. The four firm concentration ratio is defined as the ratio of the product output of the four largest firms to the total output of the industry. A high concentration ratio indicates an oligopoly while a low number indicates an industry closer to perfect competition.
In an industry with 20 firms, I would say that a concentration ratio of 30% is indicative of near perfect competition. In the case of perfect competition – all firms would be of the same size and the concentration ratio would be or 20%. We can see that 30% is not far from the perfect case of perfect competition and we can infer that the largest firms do not deviate far in size from the smaller players. Without additional knowledge of the product type, we can consider the industry to be operating in a state of near perfect competition.
A price increase will tend to benefit all firms equally in our example market. Since there are no dominating firms, all firms will still tend to sell at the same rate as before the price increase. Also, since the firms are the same size, no firm is in the position to dictate the price through price gouging since the customers will simply transfer to the other firms or undercut their competition through loss leadership since they are just of equal size as the competition.
Another market with a four firm concentration ratio of 80%, could already be described as an oligopoly. Only a small part of the market (4 firms out of 20 – ) is responsible for 80% of prodcution. Put another way, the other 16 firms account for 80% of the players yet account for only 20% of production. The contribution of the other 16 firms is very insignificant compared to the contribution of the top 20% of firms.
One possible reason for the creation of oligopolies might be high barriers to entry which prohibit newer, smaller firms from entering the market. A particular example is OPEC. Other nations cannot simply produce oil if they don’t have oil fields in the first place. The limited supply of oil puts OPEC in a leadership position where it can influence prices by manipulating production output. Compare this to the world supply of manual labor. Due to the universal supply of manual labor, companies have many options regarding their manufacturing operations and as such they always enjoy the lowest possible labor costs by operating plants in places like China, India or in Latin America.
While competing as a smaller firm in an oligopoly type setting might seem impossible given the size of the main competitors, it is possible for smaller firms to exist in an oligopoly.
A possible way for firms to co-exist with oligopolies is by providing offerings for niche markets. One particular example is Facebook. Facebook was originally exclusive for College students. Thus it had a much smaller presence than industry leader MySpace. However, due to its differentiated offerings and marketing, it was able to survive and grow and become an equal to MySpace.
Mankiw, Gregory. Principles of Economics. 12th . Mason, OH: Thomson Higher Education, 2007.