Understanding Competition Through Industry Concentration

There are many methodical lenses through which we look at industries to get a better grasp of how they are going to do in the near future.

For example, through location quotient, we can look at how the size of the industry stands out in particular regions as compared to a broader regional context.

While high industry concentration when applied to compare the market share of particular firms within the industry informs us about the competitive conditions within the industry.

Combining these and other ways to look at the industries allows us to know better how the economic value is distributed within them and possibly points to ways to profit from it.

What Does Industry Concentration Mean?

First things first, how do we determine whether we have a low or high industry concentration?

The basic answer lies within how much the industry is dominated by one or a few top companies.

Industry or industrial concentration, sometimes used synonymously with market concentration, refers to the ratio of the entire production in the industry attributable to a particular firm or small group of firms.

Thus, for example, if we have an industry in which 2 or 3 major companies are responsible for 60% of production, that is a highly concentrated industry.

Alternatively, if there are no firms in the industry that stand out so much and the majority of the production is distributed among many companies, we have a fragmented industry.

High industry concentration is taken to mean that the industry might be moving towards a monopoly, that is approaching 100% concentration.

However, such a situation would be very rare, as in many countries there are legal mechanisms developed to prevent monopolization.

A more frequent situation might be an oligopoly when the industry is dominated by a few firms, usually meaning less than five. In fact, the standard for determining high industry concentration is the C4 ratio, which is described as the top 4 companies in the industry accounting for at least 80% of the market share.

However, at least in the USA, this is rarely the case, as recent studies show that only 4% of the industries have lately been over the fence and in the high concentration territory.

This indicates that the competitive conditions are generally not as alarming as they are sometimes taken to be due to big company mergers. This brings us to what more can we tell about competition from industry concentration rates.

What does high industry concentration tell us?

Analyzing industries through concentration rates has many important use cases.

First of all, the competitive situation within the industry is one of the initial concerns for those who consider entering into it.

Here one can tell a lot from concentration rates, as high industry concentration would indicate that it is much harder to get started in this field. New companies would have to be prepared to have more initial expenditure and wait longer for the profit.

A standard example of high industry concentration is the search engine market, dominated by Google with over 92% globally.

This indicates that technology firms that are capable of establishing themselves in the field early have the greatest chance of dominating the market for years.

Great or nearly perfect competitive conditions, on the other hand, are those where the C4 ratio is below 50%.

In such an industry the entry requirements would be much lower, and all the companies had a good opportunity to get their fair share of the market.

Competitive conditions in the industry are, of course, also very important to investors.

Depending on how near to the monopoly or oligopoly the industry is, hedge fund managers might decide whether it is worth investing in a smaller firm within the industry.

The stock of the dominant firm might be a safe long-term investment here. Meanwhile, there may be many attractive stocks with reasonable safety margins in industries with low concentration ratios.

Additionally, investors and market researchers might go further with analyzing competition and comparing industry concentration in different regions.

Here is where location quotient might come into play, helping to compare industry concentration in different regions.

High industry concentration in one region as opposed to national levels might indicate better production conditions there, but tougher competition as well.

Different metrics to determine industry concentration

A final thought that is important to consider when talking about industry concentration is that it might be useful to calculate it using other metrics.

For example, revenue instead of production could be taken as the basic metric.

Or the size of the firm by their employment rates could be calculated, thus making it immediately commensurable with the location quotient.

In all these cases, what matters the most is to get reliable data that allows for various calculations and comparisons.

When enough information about the various aspects of the industries is collected, it is possible to determine many features of regional, national, and global competitive conditions.

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