To understand the significance of concentrated liquidity, we must first examine the limitations of Uniswap V2's approach. In V2, liquidity providers deposited their tokens into pools where liquidity was distributed uniformly across the entire price curve from zero to infinity.

Inefficiency Challenge

Infinite price curve approach created several critical problems:

• Capital Inefficiency: Liquidity in V2 pools was distributed infinitely that allowing trades at any price from 0 to infinity. This made capital extremely inefficient. For example, the historical price range of ETH spans from $0.75 to $4,800, yet V2 provided liquidity for scenarios where ETH might trade at $50,000 or $0.01 price ranges that would never realistically be reached.
• Poor Stablecoin Trading: Pegged tokens like USDC and USDT require high liquidity to maintain their 1:1 peg, regardless of trade size. V2's general AMM algorithm wasn't well-suited for stablecoin trading, which is why alternative AMMs like Curve dominated this market.
• Wasted Liquidity: Most of the liquidity sat unused in price ranges far from current market prices. If ETH was trading at $2,000, providing liquidity for ETH at $10,000 was essentially pointless yet that's exactly what V2 forced LPs to do.
• Higher Slippage for Traders: With liquidity spread thinly across all price ranges, traders experienced higher slippage, especially for larger swaps. The lack of concentrated liquidity around current market prices meant that even moderate-sized trades could move prices significantly.

How Concentrated Liquidity Works

Instead of spreading liquidity uniformly, V3 and V4 enable LPs to:

• Select Custom Price Ranges: LPs can choose specific price boundaries (between points 'a' and 'b') where they want their liquidity to be active
• Concentrate Capital Strategically: Multiple LPs can overlap their ranges, creating deep liquidity pools around expected trading ranges
• Activate and Deactivate Automatically: When prices move outside an LP's range, their liquidity becomes inactive until prices return

In v3/v4, however, the liquidity is spread around more like this:

LPs choose a "price range" where they add their liquidity. These "liquidity buckets" can overlap with each other, increasing the total amount of liquidity available with a subsection of their price ranges - and can be non-overlapping as well.