Market structures and Concentration ratio (Market structures and Contestability)

The 3-firm concentration ratio is the combined market share of the largest three firms (A, B and C):

$40\% + 20\% + 12\% = 72\%$

The 3-firm concentration ratio is 72% (1 mark for correct method — summing the largest three shares; 1 mark for the correct answer).

A barrier to entry is an obstacle that makes it difficult or costly for new firms to enter a market and compete with existing firms (1). Barriers can be structural — such as economies of scale, where large incumbents produce at a low average cost a small entrant cannot match (1) — or strategic, such as limit pricing, where an incumbent sets a low price to make entry unprofitable (1). Because barriers deter entrants, they allow existing firms to keep their market power and long-run abnormal profit, so the market stays concentrated (1).

An oligopoly is a market dominated by a few large firms, whereas perfect competition has many small firms; two characteristics clearly distinguish them.

Characteristic 1 — barriers to entry. In perfect competition there are no barriers, so new firms enter freely and any abnormal profit is competed away, keeping firms small. In an oligopoly, high barriers — such as economies of scale and brand loyalty — block entry, which is exactly what allows a few firms to remain dominant and earn long-run abnormal profit.

Characteristic 2 — price-setting power and interdependence. A perfectly competitive firm is a price-taker: with many sellers of a homogeneous product and perfect information, it must accept the market price. Oligopolists have price-making power but are interdependent — each must consider rivals' likely reactions before changing price, so they may avoid price competition and compete in other ways.

Both differences stem from the same root: the high barriers in an oligopoly prevent the free entry that keeps perfectly competitive firms small and powerless over price.

In a concentrated market, barriers to entry keep out potential rivals, so incumbents can sustain prices above the competitive level and earn long-run abnormal profit.

Barrier 1 — economies of scale. Large incumbents produce at high volume, spreading fixed costs so their average cost is low. A small entrant, starting at low output, faces higher unit costs and cannot match the incumbents' prices; where scale economies are large relative to demand, the market can even become a natural monopoly. Unable to compete on cost, entrants are deterred, and the incumbents retain the market power to keep prices — and profits — high.

Barrier 2 — patents and brand loyalty. A patent gives one firm the exclusive legal right to a product, directly blocking imitation. Even without a patent, years of advertising build brand loyalty, so a newcomer must spend heavily just to be noticed — and much of that spend is an unrecoverable sunk cost that makes entry risky. Both effects mean existing firms face little threat of new competition, protecting their abnormal profit.

Because each barrier reduces the threat of entry, the few firms in the market can maintain prices above cost in the long run — the essence of sustained market power.

A rise in the concentration ratio means the largest few firms now hold a greater combined market share, so the market has become more concentrated — a shift along the spectrum towards oligopoly or monopoly.

Analysis — why prices might rise (KAA). Greater concentration usually means greater market power. With fewer effective competitors, each large firm has more price-setting ability and less need to fear that a rival will undercut it. Firms may avoid price competition and instead hold prices above the competitive level, restricting output to do so; in an oligopoly they might even tacitly coordinate. If barriers to entry are high, no new firms can enter to compete the price back down, so the higher prices persist in the long run — leaving consumers paying more and enjoying less choice. This is the standard case that rising concentration harms consumers.

Evaluation (AO4). However, higher prices are not automatic. First, it depends on contestability: if barriers to entry remain low, the mere threat of new entrants can discipline the large firms into keeping prices near the competitive level despite the high ratio. Second, greater concentration may bring economies of scale — as firms grow, average costs fall, and competition between the remaining large firms can pass some of these savings on as lower prices. Third, larger firms may earn the profit needed to fund innovation and R&D, improving products and, over time, cutting costs. Fourth, the outcome depends on firm conduct: concentration describes structure, not behaviour, and regulators may prevent price collusion.

Judgement. A rise in the concentration ratio increases the risk of higher prices, and this is likely when barriers to entry are high and the market is not contestable, so incumbents can exploit their power. But it is not inevitable: where barriers are low, scale economies are large, or firms still compete hard on price, consumers may pay the same or even less. The effect on prices is therefore conditional on barriers, contestability and conduct — not a direct result of the ratio itself.

The concentration ratio measures the combined market share of the largest n firms; a high ratio means a few firms dominate, indicating an oligopoly or monopoly tendency. The claim is that such concentration always harms consumers. Whether it holds depends on barriers to entry, firm conduct and the offsetting benefits of scale.

The case that high concentration harms consumers (KAA + AO4). Concentration is closely linked to market power. With few effective rivals, dominant firms become price-makers: they can restrict output and set prices above the competitive level, transferring surplus from consumers to producers. Where barriers to entry are high — patents, economies of scale, brand loyalty, control of resources — no new firms can enter to compete the price down, so the harm persists in the long run. Reduced competition can also mean less choice, weaker incentives to improve quality, and, in oligopoly, the risk of tacit collusion that keeps prices high. On these grounds a high concentration ratio does look bad for consumers, and it is why competition authorities scrutinise concentrated markets.

The case against 'always' (AO4). Yet 'always' is too strong. First, contestability matters more than the ratio: if barriers are low, the threat of entry can force even a highly concentrated market to price competitively — the ratio measures structure, not behaviour. Second, large firms exploit economies of scale, producing at lower average cost; competition among the remaining large firms can pass these savings on as lower prices, and a concentrated market may deliver cheaper goods than many small, high-cost firms could. Third, the abnormal profit that concentration allows can fund research and innovation (dynamic efficiency), giving consumers better products over time — a key defence of large pharmaceutical or technology firms. Fourth, regulation (price caps, competition law) can curb any abuse, so the potential harm need not materialise. In each case consumers may be no worse off, or better off, despite a high ratio.

Evaluation and judgement. The decisive point is that a high concentration ratio signals the potential for consumer harm, not its certainty. It measures structure; whether consumers actually lose depends on conduct (do firms compete or collude?) and performance (are scale savings and innovation passed on?). The outcome therefore turns on: the height of barriers to entry and the contestability of the market; the size of scale economies and whether they are passed on; the strength of regulation; and whether firms use market power to exploit or to invest. On balance, a high concentration ratio raises the risk of consumer harm and often does harm consumers where barriers are high and the market is not contestable — but it does not always do so, because contestability, economies of scale, innovation and regulation can offset or even reverse the effect. The word 'always' cannot be defended: the honest verdict is that high concentration is a warning sign, not a guarantee, of consumer harm.