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How to measure competition?

Aug 26, 2011

Often when we read on companies we come across a common word. Competition. Webster defines competition as 'the effort of two or more parties acting independently to secure the business of a third party by offering the most favourable terms'. Competition tends to limit the prices that the company can charge for its goods or services. As competition increases, companies have to offer innovative deals to the customers to try and woo them into buying their goods and services.

While the literature on competition can go on, one does wonder is there a way to measure competition?

The answer to this is yes. The field of economics has proposed two measures that can be used to measure competition to some extent. Obviously, there are limitations to using these measures, which we will discuss later, but nevertheless they do provide a good reference point.

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The first measure that can be used to measure competition is called the four firm concentration ratio. This ratio measures what percentage of the total sales of an industry is accounted for by the four largest firms in that industry. Let us try and understand this with the help of an example. For our example, we will consider 2 industries - software and auto ancillaries.

Software Auto-ancillaries
Company Name Sales (Rs m) Company Name Sales (Rs m)
TCS 373,245 Motherson Sumi Systems 81,756
Wipro 311,392 Sundaram-Clayton 80,857
Infosys 275,010 Amtek Auto 36,908
HCL Tech 157,304 Tata Autocomp Systems 23,700
 
Largest 4 1,116,951 Largest 4 223,222
Total Industry 1,784,776 Total Industry 906,165
4 firm concentration ratio 63% 4 firm concentration ratio 25%
Source: AceEquity

The Four firm concentration ratio for Software is 63%. This suggests that the 4 largest firms hold nearly 63% of the total revenues of the industry. This in itself suggests lower levels of competition. The case is completely different for the auto-ancillaries where the largest four firms hold only 25% of the total revenues of the industry, thus suggesting high levels of competition.

As a general principle, lower ratio indicates higher competition and vice versa. Generally, a ratio below 60% is regarded as an indicator of a competitive market.

While this ratio can help us understand the levels of competition to some extent, unfortunately it does suffer from a major drawback. What if the top 4 firms control the largest portion of the sales but still compete intensively amongst each other? What if each of them has other products and services in addition to the main product that helps them diversify their product base. This in turn would reduce the effect of competition on them. What about market shares and market leadership? The four firm concentration ratio falls short of answering these questions.

This is where the second measure of competition comes in. This is the Herfindahl-Hirschman Index (HHI). This index calculates the sum of the percentage market share of all the firms in the industry. Confused? Let's simplify with the help of an example. Suppose there are 5 firms in an industry. Their market shares look something like this:

  Market Share (%) Square of market share
Company A 20 400
Company B 15 225
Company C 10 100
Company D 10 100
Company E 5 25
HHI   850

The HHI for the industry would be = 202 + 152 + 102 + 102 + 52 = 850. As per the general principles, a lower HHI number suggests higher levels of competition and vice versa. Generally an HHI of less than 1,000 is considered to be highly competitive. HHI in the range of 1,000 to 1,800 is considered to be moderately competitive and that over 1,800 is considered to have low levels of competition.

While the HHI number does address issues like market shares and competition amongst the large firms, but even then it has its own set of limitations. It fails to address issues like product diversification. It also fails to address things like barriers to entry which are equally important when one is discussing the subject of competition. Maybe the level of competition is low but if the barriers to entry are low then competition could go up.

Competition is an important thing to study when it comes to analyzing a company. A company's ability to price its products is a direct function of the level of competition in the industry. This in turn has a direct impact on the company's margins. If a company has high pricing power, then it is able to pass on increase in input prices to its customers. This helps it to protect its margins. If on the other hand, it lacks this power, then margins do come under pressure during times when input prices go up. As a result, understanding competition is necessary when it comes to making an investment decision. Despite all of their limitations, the two measures still provide a good starting point for the discussion on competition. They may be used as a reference to at least understand whether or not competition exists in a particular industry.

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