The Herfindahl-Hirschman Index (HHI) is an essential metric for assessing market concentration and competitiveness. Frequently employed in the context of mergers and acquisitions (M&A), the HHI provides a quantitative measure of how market share is distributed among firms within an industry.
The HHI is calculated by squaring the market share of each firm and then summing these squared values. This approach amplifies the significance of larger firms, making the HHI particularly useful for pinpointing potential monopolies or oligopolies. The index ranges from close to zero to 10,000, where lower values signify less concentration and higher values suggest potential monopolistic scenarios.
Key Takeaways
- The Herfindahl-Hirschman Index (HHI) evaluates market competitiveness.
- Markets with an HHI less than 1,500 are deemed competitive, 1,500 to 2,500 are moderately concentrated, and above 2,500 are highly concentrated.
- The HHI simplifies market concentration assessment but may miss complexities of specific markets.
Formula and Calculation of the Herfindahl-Hirschman Index (HHI)
The HHI formula is straightforward and can be expressed as:
[HHI = s_1^2 + s_2^2 + s_3^2 + … + s_n^2]
where:
- (s_n) = market share percentage of firm (n) expressed as a whole number
For example, if the market has four firms with market shares as 40%, 30%, 15%, and 15% respectively, the HHI would be calculated as follows:
[HHI = 40^2 + 30^2 + 15^2 + 15^2 = 1,600 + 900 + 225 + 225 = 2,950]
This value indicates a highly concentrated market.
What the Herfindahl-Hirschman Index (HHI) Indicates
The HHI reflects the level of competition within a market. A monopoly will approach an HHI of 10,000, while a highly competitive market will have an HHI nearing zero. U.S. regulatory bodies, such as the Department of Justice, consider different thresholds when examining mergers:
- Competitive Marketplace: HHI below 1,500
- Moderately Concentrated: HHI between 1,500 and 2,500
- Highly Concentrated: HHI above 2,500
Mergers that boost the HHI by more than 200 points in a highly concentrated market often trigger antitrust scrutiny.
Example of the Herfindahl-Hirschman Index (HHI)
Consider an industry with the following market shares:
- Firm A: 40%
- Firm B: 30%
- Firm C: 15%
- Firm D: 15%
The HHI would be calculated as:
[HHI = 40^2 + 30^2 + 15^2 + 15^2 = 1,600 + 900 + 225 + 225 = 2,950]
In another scenario, for an industry with Firm 1 having 48.59% market share and 19 firms each having 2.71%, the HHI would be 2,500. This scenario reflects a highly concentrated market despite the larger number of companies.
Limitations of the Herfindahl-Hirschman Index (HHI)
The simplicity of the HHI is both its strength and its limitation:
- Market Definition: Accurately defining the market is crucial. The index may oversimplify complex competitive dynamics.
- Geographical Considerations: If firms operate exclusively in different regions, the HHI might fail to reflect local monopolies.
- Segment-Specific Dominance: A firm might dominate a specific product or service segment, which isn’t captured well by the general market share approach.
Creators of the Herfindahl-Hirschman Index (HHI)
The HHI’s roots date back to the work of German economist Albert O. Hirschman in 1945, detailed in National Power and the Structure of Foreign Trade. Hirschman’s method emphasized larger firms more heavily, recognizing their significant impact on market dynamics. American economist Orris C. Herfindahl further developed the concept in his 1950 dissertation, repurposing it to analyze market concentration in the U.S. steel industry.
The Bottom Line
The Herfindahl-Hirschman Index (HHI) is an invaluable tool for determining market competitiveness by evaluating the concentration of market share among firms. While regulations mainly guide its application, understanding its potential limitations is crucial for a nuanced market analysis. With the HHI, regulators and businesses can make informed decisions about potential market monopolies and the need for antitrust actions.
Related Terms: Monopoly, Market Share, Federal Trade Commission, Antitrust, Concentration Ratio.
References
- U.S. Department of Justice. “Herfindahl-Hirschman Index”.
- U.S. Justice Department. “Horizontal Merger Guidelines”, Select 5.3 Market Concentration.
- Free Press. “In the Matter of Applications of T-Mobile US, Inc. and Sprint Corporation for Consent to Transfer Control of Licenses and Authorizations”, Page 24.
- Conversable Economist. “The Herfindahl-Hirschman Index: Story, Primer, Alternatives”.
