Updated for the 2026-2027 CFA® Level I curriculum.
Market structure describes how competitive an industry is, based on the number of firms, their relative size, and how easily new firms can enter. Analysts use a concentration ratio and the Herfindahl-Hirschman Index (HHI) to measure how concentrated a market is. CFA Level I tests whether you can calculate these measures correctly and explain why a single number never fully proves the presence or absence of market power.
Quick Answer
A concentration ratio (CRN) adds the market shares of the largest N firms in an industry. The HHI squares and sums every firm's market share, giving extra weight to the largest players. Higher values on either measure suggest greater concentration, but neither one proves market power by itself. Analysts still need to check the relevant market definition, substitute products, entry barriers, demand elasticity, and potential competition before drawing conclusions.
Key Takeaways
CRN equals the sum of the market shares of the top N firms, commonly CR4.
HHI equals the sum of squared market shares across all firms in the market.
HHI reacts more strongly than CRN to mergers between large firms because squaring amplifies size differences.
A high concentration ratio or HHI is evidence of concentration, not proof of monopoly pricing power.
Market definition, potential entrants, and demand elasticity all affect how much weight to give a concentration measure.
Qualitative traits, such as differentiation and barriers to entry, help confirm what the numbers suggest.
Consistent units matter. Mixing percentage and decimal shares in HHI produces meaningless results.
What You Need to Know for CFA Level I
Identify market structure using seller count and size, product differentiation, pricing power, entry barriers, and non-price competition.
Calculate directly from given market shares or from sales data when shares are not provided.
Calculate using either decimal or percentage shares, but stay consistent within a single calculation.
Explain why rises more sharply than when two large firms merge.
Treat concentration measures as supporting evidence, not a final conclusion about competitiveness.
Recognize the limitations tied to market definition, potential entry, demand elasticity, and outdated data.
Compare qualitative classification of market structure with quantitative concentration measures.
How Do You Identify a Market Structure?
Start by defining the relevant product and geographic market. A market defined too narrowly or too broadly changes every conclusion that follows.
Once the market is defined, assess five factors:
Number and relative size of firms
Degree of product differentiation
Extent of pricing power held by individual firms
Height of barriers to entry and exit
Amount of non-price competition, such as advertising or service quality
Concentration measures support this assessment but do not replace it. A market with only a few firms can still behave competitively if entry is easy and potential competitors constrain pricing. For a full comparison of the four classic structures, see the related note on the four types of market structures.
What Is a Concentration Ratio?
A concentration ratio measures the combined market share held by the largest firms in an industry. CR4, which uses the top four firms, is the most common version, but N can be any number the question specifies.
Values range from near zero in a highly fragmented market to 100% in a pure monopoly. A high concentration ratio economics analysts observe signals that a small number of firms control most of the market. It does not automatically mean those firms hold durable pricing power.
Concentration Ratio Formula and Calculation
Where:
= concentration ratio for the largest N firms
= market shares of the largest firms, ranked from largest to smallest
= number of firms included, set by the question (commonly 4)
If the question gives sales figures instead of shares, divide each firm's sales by total market sales first. Keep every share in the same format, either percentage or decimal, throughout the calculation.
What Is the Herfindahl-Hirschman Index?
The HHI sums the squared market shares of every firm in the market, not just the largest few. Squaring each share gives much more weight to large firms than to small ones. A firm with a 40% share contributes far more to HHI than four firms with 10% shares each, even though their combined share is the same.
If shares are entered as decimals, HHI ranges from near 0 to 1. If shares are entered as percentages, HHI ranges from near 0 to 10,000. This note uses decimal shares throughout. Pick one convention and apply it consistently.
HHI Formula and Calculation
Where:
= Herfindahl-Hirschman Index for the market
= market shares of all n firms in the market, expressed consistently as decimals or percentages
= total number of firms in the market
Because squares each share, a merger between two large firms raises more sharply than a simple calculation would suggest. The worked example below shows this effect directly.
Concentration Ratio vs HHI
Feature | CRN | HHI |
|---|---|---|
Calculation | Sum of the top N market shares | Sum of squared shares across all firms |
Data required | Top N firms only | Every firm in the market |
Sensitivity to size distribution | Low; ignores gaps among top firms and all firms outside the top N | High; weights the largest firms heavily |
Merger sensitivity | May barely move if both firms are already inside the top N | Usually rises sharply for large-firm mergers |
Simplicity | Easy with limited data | Needs complete market share data |
ignores how shares are distributed within the top N and says nothing about the firms left out. captures the size distribution more fully, but it still says nothing about entry threats or demand elasticity.
Limitations of Concentration Measures
Market definition drives the result. A narrower product or geographic market produces a higher concentration figure than a broader one, even with the same firms.
Potential entrants matter. High incumbent concentration does not prevent competition if new firms can enter quickly and cheaply.
Neither measure estimates demand elasticity or observed pricing behavior. A concentrated market with elastic demand may not support higher prices.
Data can go stale. Older figures may miss new technology, recent mergers, imports, or new substitute products.
Comparisons can mislead. Comparing concentration across markets or time periods is only valid if the market definition stays consistent.
How Mergers Affect CRN and HHI
When two firms already inside the top merge, often changes only slightly, since their shares were already counted. typically rises more, because the combined share gets squared instead of the two original shares being squared separately.
This difference matters for identifying market structure. A regulator or analyst who looks only at might understate how much a merger between two large competitors increases concentration.
Worked Market-Share Example
Suppose a regional beverage market has six firms with the following market shares:
Firm | Market Share |
|---|---|
Firm 1 | 32% |
Firm 2 | 24% |
Firm 3 | 18% |
Firm 4 | 12% |
Firm 5 | 8% |
Firm 6 | 6% |
Step 1: Calculate CR4 before the merger.
Step 2: Calculate HHI before the merger.
Step 3: Merge Firm 1 and Firm 2.
Their combined share is 32% + 24% = 56%. The new market has five firms: 56%, 18%, 12%, 8%, and 6%.
Step 4: Recalculate CR4 after the merger.
Step 5: Recalculate HHI after the merger.
Interpretation. CR4 rose by 8 percentage points, from 86% to 94%. HHI rose by roughly 0.154, from 0.2168 to 0.3704, a much larger proportional jump. Squaring the merged firm's 56% share drives most of that increase. This confirms that HHI reacts more strongly to large-firm mergers than CRN does.
Even so, neither number proves the merged firm can raise prices. That conclusion depends on whether new entrants can respond, whether substitute beverages exist, and how price-sensitive buyers are in this market.
Common Exam Traps
Dividing by total market sales twice. If a question already gives market share percentages, do not divide by total sales again. Use the shares as given.
Mixing decimal and percentage conventions in HHI. Squaring a mix of formats produces a number that means nothing. Convert every share to the same format first.
Calculating HHI using only the top firms. HHI requires every firm's share, not just the largest few used for CRN.
Assuming a high CRN or HHI proves monopoly power. Concentration measures are evidence. They do not confirm pricing power without checking entry conditions and demand elasticity.
Ignoring the relevant market. A concentration figure calculated for the wrong product or geographic market misrepresents the actual competitive environment.
Forgetting potential entry. Easy entry can constrain even a highly concentrated incumbent group.
Assuming CRN always reflects a merger's full impact. If both merging firms were already inside the top N, CRN may barely move even though the market grew more concentrated.
Practice Question
An analyst reviews annual sales for five firms in a regional cement market:
Firm A: $450 million
Firm B: $300 million
Firm C: $150 million
Firm D: $100 million
Firm E: $100 million
Total market sales are $1,100 million. What is the four-firm concentration ratio (CR4), and what is the strongest limitation of using this result alone to conclude the market lacks competition?
CR4 is approximately 91%, and the result does not account for potential entrants that could constrain pricing.
CR4 is approximately 68%, and the result assumes all firms share identical cost structures.
CR4 is approximately 91%, and the result cannot be calculated because market shares must come from units sold rather than revenue.
Correct Answer: A
CR4 = (450 + 300 + 150 + 100) / 1,100 = 1,000 / 1,100 = 0.909, or approximately 91%. This concentration level is high, but it says nothing about whether new firms could enter the cement market or how price-sensitive buyers are. Those factors determine whether the incumbents can actually exercise pricing power.
Option B. Uses the wrong firm total (leaves out Firm D) and cites a limitation, cost structure assumptions, that concentration ratios do not actually make.
Option C. Correct calculation but a false claim. Revenue-based market shares are a standard and valid method for measuring concentration.
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FAQs About Market Structure Identification and Concentration
What is the concentration ratio formula?
The concentration ratio formula, CRN, adds the market shares of the largest N firms in an industry. For example, CR4 sums the shares of the four largest firms. Shares must be expressed consistently, either as percentages or decimals, before adding them together.
How do you calculate a four-firm concentration ratio?
Rank all firms by market share, then add the shares of the top four. If only sales figures are given, divide each of the top four firms' sales by total market sales first, then sum the results.
What is the difference between concentration ratio and HHI?
CRN sums the shares of the top N firms only. HHI sums the squared shares of every firm in the market. HHI weights large firms more heavily and reacts more strongly to mergers among the biggest competitors.
Why can a high concentration ratio be misleading?
A high ratio shows that few firms hold most of the market, but it does not confirm pricing power. Easy entry, elastic demand, or a narrowly defined market can all make the ratio overstate actual market power.