## Thursday, October 27, 2011

### The Concentration Ratio and the Herfindahl Index

CFA Level 1 - Equity Investments

The concentration ratio is the measure of the percentage market share in an industry held by the largest firms within that industry. For example, suppose 3 firms dominate a specific industry, such as beverages, holding 80% market share of the beverage industry. The concentration ratio of the beverage industry would thus be 80%.
Example: Concentration ratio

The beverage industry is composed of 5 firms with market shares as follows:

Co A has 30% market share
Co B has 30% market share
Co C has 20% market share
Co D has 15% market share
Co E has 5% market share.

Calculate the concentration ratio for the beverage industry.

Answer: The three-firm concentration ratio fro the beverage industry is 80% (30% + 30% + 20%).

Herfindahl Index

Another measure of concentration in an industry can be expressed using the Herfindahl index. The Herfindahl index is simply the sum of the squares of the market shares for each firm within the industry and is always less than one.

Formula 13.12

Example: Calculate the Herfindahl Index

The beverage industry comprises 5 firms with market shares as follows:

Co A has 30% market share
Co B has 30% market share
Co C has 20% market share
Co D has 15% market share
Co E has 5% market share.

Calculate the Herfindahl Index for the beverage industry.

The Hefindahl Index is calculated as follows:

(0.30)2 + (0.30)2 + (0.20)2 + (0.15)2 + (0.05)2 = 0.245

The Herfindahl index for the beverage industry is 0.245.

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