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Herfindahl hirschman index hhi

What Is Herfindahl-Hirschman Index (HHI)?

The Herfindahl-Hirschman Index (HHI) is a widely recognized measure of market concentration used within the field of market analysis. It assesses the size of firms in relation to the industry they are in, providing an indicator of the level of competition among them. The HHI is particularly significant for regulatory bodies and economists when evaluating potential impacts of mergers and acquisitions on an industry's competitive landscape. A higher HHI value generally suggests a more concentrated market, potentially indicating less competition and a closer resemblance to a monopoly.

History and Origin

The concept behind what is now known as the Herfindahl-Hirschman Index emerged independently from two economists. Albert O. Hirschman, a German economist, introduced a similar idea in his 1945 book, National Power and the Structure of Foreign Trade, applying it to the concentration of imports and exports. Five years later, in 1950, American economist Orris C. Herfindahl developed the concept further in his doctoral dissertation, using it to analyze the competitiveness of the U.S. steel industry.18, His work provided a framework for measuring market concentration by summing the squares of individual market share percentages. The combined contributions of these two scholars led to the index being formally named the Herfindahl-Hirschman Index.

Key Takeaways

  • The Herfindahl-Hirschman Index (HHI) quantifies market concentration by summing the squares of the market shares of all firms in an industry.
  • It is a key tool used by antitrust authorities to assess the competitive impact of proposed mergers and acquisitions.
  • HHI values range from near zero (highly competitive) to 10,000 (pure monopoly).
  • Higher HHI values indicate greater market concentration and potentially less competition.
  • The HHI helps identify industries that may be prone to anticompetitive behavior.

Formula and Calculation

The Herfindahl-Hirschman Index (HHI) is calculated by squaring the percentage of each firm's market share within an industry and then summing these squared values. This approach gives greater weight to firms with larger market shares, reflecting their disproportionate impact on market competition.

The formula for the HHI is:

HHI=s12+s22+s32+⋯+sn2HHI = s_1^2 + s_2^2 + s_3^2 + \dots + s_n^2

Where:

  • (s_i) = the market share percentage of firm (i)
  • (n) = the total number of firms in the market

For example, if a market has three firms with market shares of 40%, 30%, and 30%, the HHI would be calculated as:
HHI=402+302+302HHI = 40^2 + 30^2 + 30^2
HHI=1600+900+900HHI = 1600 + 900 + 900
HHI=3400HHI = 3400

It is important to note that when calculating HHI, the market shares are typically expressed as whole numbers (e.g., 40 for 40%) rather than decimals (e.g., 0.40).17 This results in HHI values ranging from approximately 1/N (for markets with many small firms, approaching perfect competition) to 10,000 (for a single firm with 100% market share, representing a monopoly).

Interpreting the HHI

The interpretation of the Herfindahl-Hirschman Index provides a clear framework for assessing market concentration and potential competitive concerns. The U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) use specific thresholds for interpreting HHI values in their guidelines for evaluating mergers.16

Generally, the interpretation of HHI is as follows:

  • HHI below 1,500: Indicates an unconcentrated market, suggesting a competitive environment.15,
  • HHI between 1,500 and 2,500: Indicates a moderately concentrated market.14,
  • HHI above 2,500: Indicates a highly concentrated market, suggesting potential for reduced competition and increased market power for dominant firms.13,

When assessing mergers, regulatory bodies also consider the change in HHI (often referred to as delta HHI). For instance, an increase in HHI of more than 100 points in a moderately concentrated market (post-merger HHI between 1,500 and 2,500) or an increase of more than 50 points in a highly concentrated market (post-merger HHI above 2,500) can raise significant competitive concerns and trigger further scrutiny.12,11,10 The HHI provides a quantitative measure to help identify markets that might be trending towards an oligopoly or even a monopoly.

Hypothetical Example

Consider the market for online streaming services in a specific region. Let's assume there are five major players:

  • StreamFlix: 40% market share
  • CineNow: 25% market share
  • TVGo: 20% market share
  • WatchIt: 10% market share
  • PlayOn: 5% market share

To calculate the Herfindahl-Hirschman Index (HHI) for this market:

  1. Square each firm's market share:

    • StreamFlix: (40^2 = 1600)
    • CineNow: (25^2 = 625)
    • TVGo: (20^2 = 400)
    • WatchIt: (10^2 = 100)
    • PlayOn: (5^2 = 25)

  2. Sum the squared market shares:

    • (HHI = 1600 + 625 + 400 + 100 + 25 = 2750)

In this hypothetical example, the HHI for the online streaming market is 2750. According to the U.S. Department of Justice guidelines, an HHI above 2,500 indicates a highly concentrated market. This suggests that the online streaming market in this region is quite concentrated, with a few dominant players, and a merger between two of the larger services would likely face significant scrutiny from regulatory bodies.

Practical Applications

The Herfindahl-Hirschman Index (HHI) is a versatile tool with several practical applications across various financial and economic domains. Its primary use is in antitrust laws and policy, where government agencies like the U.S. Department of Justice and the Federal Trade Commission use it to evaluate the potential competitive impact of proposed mergers and acquisitions. If a merger significantly increases the HHI of a market, it may be challenged to prevent the creation or enhancement of market power.9

Beyond antitrust enforcement, the HHI can also be applied in:

  • Financial Portfolio Analysis: While primarily for market concentration, the HHI can be adapted to measure the concentration within an investment portfolio. By squaring the percentage weight of each asset and summing them, investors can gauge their portfolio's concentration and identify areas where greater portfolio diversification might be beneficial for risk management.
  • Industry and Sector Analysis: Analysts use the HHI to gauge the level of competition within specific industries or sectors. A rising HHI might signal a trend towards consolidation, which could have implications for pricing power, innovation, and barriers to entry for new firms.
  • Credit Risk Assessment: Financial institutions sometimes use a variation of the HHI to measure credit concentration risk within their loan portfolios. A higher HHI in this context suggests that a bank's loan book is heavily reliant on a few large borrowers or sectors, increasing its vulnerability to defaults from those concentrated exposures.8

The Corporate Finance Institute notes that companies themselves may use the HHI in their merger proposals to demonstrate that a transaction would not lead to an overly concentrated or monopolistic market, indicating that consumers would still retain power in that industry.7

Limitations and Criticisms

Despite its widespread use, the Herfindahl-Hirschman Index (HHI) has several limitations that can affect its accuracy and applicability. One significant critique is its sensitivity to the definition of the "market" being analyzed.6 Defining the precise geographic scope and product boundaries of a market can be challenging, and an inaccurate definition can lead to misleading HHI values. For instance, a broad market definition might make a concentrated industry appear competitive, while a narrow definition could make a competitive industry seem concentrated.

Another limitation is the HHI's static nature; it provides a snapshot of market concentration at a specific point in time but does not fully account for market dynamics.5 This means it may not capture factors such as potential new entrants, technological innovation, or rapid shifts in consumer preferences that could quickly alter an industry's competitive landscape. The HHI also does not directly consider non-price competition, product differentiation, or the elasticity of demand, which are crucial aspects of real-world competition.4

Furthermore, the HHI does not inherently reflect factors like barriers to entry or the presence of substitute goods, which can influence a market's true competitiveness even with a high concentration. Some critics argue that relying solely on the HHI for antitrust decisions might overlook potential economic efficiency gains from mergers, especially in industries where scale or network effects are beneficial to consumers.3 The use of the HHI in network industries, for example, has been critiqued for potentially generating limited useful information about a merger's effect on consumer welfare.2 While useful for initial screening, a comprehensive antitrust review typically involves more in-depth qualitative analysis beyond just the HHI.1

Herfindahl-Hirschman Index vs. Concentration Ratio

The Herfindahl-Hirschman Index (HHI) and the Concentration Ratio (CR) are both measures of market concentration, but they differ in their calculation and the insights they provide.

The Concentration Ratio (CR) typically sums the market share percentages of a fixed number of the largest firms in an industry, such as the top four (CR4) or top eight (CR8). For example, a CR4 of 70% means the four largest firms collectively control 70% of the market. This measure is straightforward and easy to calculate, offering a quick indication of the dominance of the biggest players.

However, the Herfindahl-Hirschman Index (HHI) offers a more nuanced view. Instead of just summing the market shares of the top few firms, the HHI squares the market share of every firm in the market and then sums these squared values. This squaring process gives disproportionately more weight to larger firms. As a result, the HHI provides a more comprehensive picture of market concentration by reflecting both the number of firms and their relative sizes. For instance, two industries might have the same CR4, but if one industry has a single, much larger dominant firm among the top four, its HHI would be significantly higher, accurately reflecting its greater concentration and potentially lower competition. While the CR is simpler, the HHI is generally considered a more sensitive and accurate indicator of overall market structure, especially for discerning between different distributions of market power among leading firms.

FAQs

What is a "highly concentrated" market according to the HHI?

A market is considered "highly concentrated" when its Herfindahl-Hirschman Index (HHI) is above 2,500. This level suggests that a small number of firms hold a dominant position, potentially leading to less competition and increased market power.

Why does the HHI square the market shares?

Squaring the market share percentages in the HHI calculation gives greater weight to larger firms. This emphasizes the impact of dominant players on market concentration and ensures that industries with a few very large companies yield higher HHI values than those with many small or medium-sized firms, even if the total number of firms is the same.

Is a higher HHI good or bad?

A higher HHI is generally viewed as "bad" from a consumer or public policy perspective because it indicates a more concentrated market with less competition. This can lead to higher prices, reduced innovation, and fewer choices for consumers. However, from a firm's perspective, a higher concentration might mean greater profitability and stability due to less intense competitive pressures.

How is the HHI used by regulators?

Regulatory bodies like the U.S. Department of Justice and Federal Trade Commission use the HHI to assess the competitive effects of proposed mergers and acquisitions. They compare the HHI before and after a merger to determine if the transaction would significantly increase market concentration and potentially violate antitrust laws.

Can the HHI be used for investment decisions?

While the HHI is primarily an economic tool for industry analysis and antitrust regulation, investors can conceptually apply its underlying principles. Understanding market concentration in an industry can offer insights into its competitive intensity and potential profitability, which might indirectly influence investment decisions. However, it's not a direct tool for selecting individual stocks or constructing an investment portfolio.