Skip to content

CFA Level I Exam · The Firm and Market Structures

Identifying Market Structures and Concentration Measures

Updated 7 October 2026 · Fact-checked

Market structure is classified by the number of firms, product differentiation, barriers to entry, pricing power and non-price competition. The four types are perfect competition, monopolistic competition, oligopoly and monopoly. Measure concentration with the N-firm ratio (sum of top N market shares) or the HHI (sum of squared shares of all firms).

Understand Identifying Market Structures and Concentration

Economists sort industries into four market structures. The sorting uses five features: how many sellers there are, whether products are identical or differentiated, how hard it is for new firms to enter, how much control a firm has over price, and whether firms compete on things other than price, such as advertising.

At one end is perfect competition: many sellers, identical products, no barriers to entry, and no pricing power. Firms are price takers. At the other end is monopoly: one seller, no close substitutes, high barriers, and large pricing power. In between sit monopolistic competition (many sellers, differentiated products, low barriers, some pricing power, heavy advertising and product differentiation) and oligopoly (few sellers, products identical or differentiated, high barriers, pricing power that depends on how rivals react).

The exam also asks you to measure market power. Pricing power is hard to observe directly, so analysts use concentration measures. They show how much of the market a few firms control. A high measure suggests less competition. It is a signal, not proof.

The N-firm concentration ratio adds the market shares of the largest N firms. It is simple, but it ignores how shares are split among those N firms and ignores all the other firms. It also can barely move when mergers happen among the top firms.

The Herfindahl-Hirschman Index (HHI) squares each firm's market share and adds the results. Squaring gives large firms more weight, so the HHI reflects the distribution of shares. Note that both measures depend on how the market is defined, and neither measures barriers to entry directly. A market with high concentration can still be competitive if entry is easy (a contestable market).

Key formulas to remember

N-firm concentration ratio
CRN = s1 + s2 + … + sN (the N largest market shares)
Shares can be of sales or output. Common versions are the 4-firm and 8-firm ratios. Ignores the other firms and the split inside the top N.
Herfindahl-Hirschman Index
HHI = Σ (si)² over all firms in the market
Use shares in whole percentages (HHI up to 10,000) or decimals (up to 1). Say which you use. A monopoly is 10,000 in percentage form; N equal firms give 10,000 ÷ N.
HHI with equal shares
HHI = 1 ÷ N (decimal form) or 10,000 ÷ N (percentage form)
Gives the minimum HHI for N firms; any unequal split gives a higher value.
Market structure features
Perfect competition: many firms, identical product, no barriers. Monopolistic competition: many firms, differentiated, low barriers. Oligopoly: few firms, high barriers. Monopoly: one firm, high barriers.
Pricing power: none, some, considerable (interdependent), considerable (possibly regulated).

How to solve Identifying Market Structures and Concentration questions

Use this method for both classification questions and concentration calculations.

  1. 1Read the stem for clue words: number of sellers, identical or differentiated product, ease of entry, and who sets price.
  2. 2If it is a classification question, match the clues to the four structures. Start with the extremes (one seller, price takers) and eliminate them first.
  3. 3Watch for advertising and product differentiation with many sellers and easy entry. That points to monopolistic competition.
  4. 4For an N-firm ratio, sort the shares from largest to smallest and add the top N only.
  5. 5For the HHI, square every firm's share and add all of them. Keep units consistent (percent or decimal).
  6. 6Check reasonableness: in percentage form, the HHI is at least the square of the largest share, at least 10,000 ÷ N for N firms, and at most 10,000.
  7. 7For a merger question, recompute the HHI after combining the two firms' shares, then compare before and after.
  8. 8Choose the option that matches your result and its unit.

Quickest way: Square, add, sanity-check

When to use it: Use for HHI and concentration ratio questions when you have about 90 seconds.

  1. Write shares as whole percentages.
  2. Square each in your head or on the calculator and add.
  3. For a merger of firms with shares a and b, the HHI rises by 2 × a × b. You do not need to recompute everything.
  4. Eliminate options that are below the equal-share minimum or above 10,000.
  5. For classification, eliminate the two options that contradict the number of sellers or entry barriers.

Common mistakes in Identifying Market Structures and Concentration

  • Adding shares for all firms in the HHI without squaring

    Students mix up the HHI with the N-firm ratio.

    Fix: HHI always squares each share. The N-firm ratio never squares.

  • Leaving out small firms in the HHI

    Students copy the N-firm ratio habit of using only the top firms.

    Fix: Include every firm that is listed. Tiny firms add little but are part of the formula.

  • Mixing units, such as squaring 0.30 and reporting it as 900

    Shares are given as percentages in one place and decimals in another.

    Fix: Pick one form. In percentage form 30² = 900. In decimal form 0.30² = 0.09.

  • Calling any market with advertising an oligopoly

    Students link branding with big firms.

    Fix: Count the sellers and check entry. Many sellers with differentiated products and easy entry is monopolistic competition.

  • Treating a high concentration ratio as proof of pricing power

    Students forget that the ratios say nothing about entry barriers or the market definition.

    Fix: Treat concentration as a rough indicator. Easy entry can keep a concentrated market competitive.

  • Thinking a monopoly never faces any constraint

    The word suggests unlimited power.

    Fix: Monopolies may be limited by regulation, demand elasticity or the threat of entry.

Worked examples

Example 1

An industry has five firms with market shares of 35%, 25%, 20%, 15% and 5%. What is the HHI (in percentage form)? Options: A) 2,000 B) 2,500 C) 3,000

Show the solution
  1. Square each share: 35² = 1,225; 25² = 625; 20² = 400; 15² = 225; 5² = 25.
  2. Add: 1,225 + 625 = 1,850; + 400 = 2,250; + 225 = 2,475; + 25 = 2,500.
  3. HHI = 2,500, which is option B.
  4. Separate step: the 3-firm concentration ratio is 35 + 25 + 20 = 80%. It is a different measure and is not one of the options.

Answer: B) 2,500

Example 2

A market has five firms with shares of 30%, 20%, 20%, 20% and 10%. The firm with 30% plans to merge with one of the 20% firms. The HHI is in percentage form. What is the HHI after the merger? Options: A) 2,200 B) 2,800 C) 3,400

Show the solution
  1. Before the merger: 30² + 20² + 20² + 20² + 10² = 900 + 400 + 400 + 400 + 100 = 2,200.
  2. After the merger the combined firm has 50%. The other firms keep 20%, 20% and 10%.
  3. After the merger: 50² + 20² + 20² + 10² = 2,500 + 400 + 400 + 100 = 3,400.
  4. Check with the shortcut: the HHI rises by 2 × 30 × 20 = 1,200, and 2,200 + 1,200 = 3,400.

Answer: C) 3,400

Exam tips

  • Questions often give a short description and ask you to name the structure. Count sellers and check entry before reading the options.
  • Know the contrast: monopolistic competition has many sellers and differentiated products; oligopoly has few sellers and interdependence.
  • For HHI, say whether the exam gives shares as percentages or decimals. Options are in ascending order, so a wrong unit usually shows up as an option far off the scale.
  • Remember the limits of concentration measures: the N-firm ratio ignores the distribution among the top firms, and neither measure captures entry barriers.
  • Use the 2 × a × b shortcut for merger questions to save time.

Practice questions from The Firm and Market Structures

Identifying Market Structures and Concentration: frequently asked questions

What is the difference between perfect competition, monopolistic competition, oligopoly and monopoly?

They differ in the number of sellers, product differentiation, barriers to entry and pricing power. Perfect competition has many sellers and identical products. Monopolistic competition has many sellers with differentiated products. Oligopoly has few sellers, and monopoly has one.

How do you calculate the Herfindahl-Hirschman Index?

Square each firm's market share and add the results for all firms. With shares in percent, the index ranges up to 10,000. With decimals, it ranges up to 1.

What does the N-firm concentration ratio tell you?

It gives the combined market share of the N largest firms. A higher value suggests less competition. It ignores the split among those firms and the firms outside the top N.

Why is the HHI better than the N-firm ratio?

It uses every firm and gives larger firms more weight through squaring. So it responds to changes in share distribution and to mergers, which the N-firm ratio can miss.