Oligopoly and Measures of Concentration
One method to gauge the extent of market power is the concentration ratio.
Concentration ratios give the portion of industry sales held by the 4, 8 or 20 largest firms in the industry. The table below presents the 4, 8 and 20-firm concentration ratios for selected domestic industries in the US for 1982.
Industry Number of
Companies
282
4-firm ratio
(%)
28
8-firm ratio
(%)
48
20-firm ratio
(%)
76 Petroleum refining
Motor vehicles and car bodies
284 92 97 99
Electronic computing equipment
Radio and TV equipment
Aircraft
1520
2083
139
42
22
64
64
35
81
82
57
98
Newspapers 7520
Pharmaceutical 584 preparations
22
26
34
42
49
60
Concentration ratios give some idea about market concentration but they say little about the extent of competition or geographical factors. For example, even though the
4-firm concentration ratio for newspapers is 22%, many towns in the US have only one paper. So many local newspapers have virtual monopoly status. Another problem with concentration ratios is that they say nothing about potential competition. Some industries with very high concentration ratios behave much like competitive industries because of the threat of entry into the industry – prices are kept low to discourage entry. Finally, the information in the table only represents domestic production. This explains why the 4-firm concentration ratio in motor vehicles is 92% even though imported automobiles would make up approximately 33% of domestic sales.
A more serious problem with concentration ratios is that they do not distinguish between an industry in which one firm dominates and one where a small number of large firms share the market. For example, if one firm had 57% of the market and the other 43 firms in the industry each had 1%, the 4-firm concentration ratio would be
60%. This is the same concentration ratio as an industry with 4 firms having 15% of the market apiece. Industry behaviour might be similar in both cases, but it is also possible that the large firm would dominate the industry in the first case, but it is also possible that the large firm would dominate the industry in the first case, while the four firms in the second case would resort to cutthroat competition.
This problem can be eliminated by using a different measure of market concentration, the Herfindahl Index. The Herfindahl Index is calculated by squaring the percentage share of each firm. This puts extra weight on firms with a larger market share.

The formula for computing a Herfindahl Index is: where Si is the market share of the ith firm. The Herfindahl Index can run from 100 for an industry composed of identically sized firms to 10000 for a pure monopoly. For the two examples above, the index would be:
H = 57² + 1² …….. + 1² = 3249 + 43 = 3292
H = 15² + 15² +15² +15² +1² …….. + 1² = 900 + 40 = 940
The Herfindahl Index is widely considered to be a superior measure of market concentration because it can isolate the presence of a single or few dominant firms.
However, the Herfindahl Index suffers from some of the same problems as concentration ratios: it says nothing about potential competition or geographical concentration.