Herfindahl–hirschman index

What Is the Herfindahl–Hirschman Index?

The Herfindahl–Hirschman Index (HHI) is a widely used measure of Market Concentration within a specific industry. It calculates the degree of competition by summing the squares of the market share of each firm operating in the market. Th²⁶e Herfindahl–Hirschman Index serves as a key indicator of market competitiveness, helping to identify industries that might be approaching a monopoly or those that exhibit characteristics closer to perfect competition.

History and Origin

The concept behind the Herfindahl–Hirschman Index originated from the independent work of two economists in the mid-20th century. Albert O. Hirschman first proposed a similar index in his 1945 book, National Power and the Structure of Foreign Trade, where he applied the idea to the concentration of imports and exports. Later,²⁵ in 1950, Orris C. Herfindahl utilized a version of the index that is consistent with its modern form in his doctoral dissertation, focusing on concentration within the steel industry. Althou²⁴gh both economists contributed to its development, the index gained its dual name and widespread recognition over time. It was²³ formally adopted by U.S. Antitrust law authorities, specifically the Department of Justice (DOJ) and the Federal Trade Commission (FTC), in the 1980s as a primary tool for assessing market concentration in merger reviews.

Ke²²y Takeaways

• The Herfindahl–Hirschman Index (HHI) quantifies market concentration by summing the squares of the individual market shares of all firms in an industry.
• It is a core tool used by antitrust authorities, particularly the U.S. Department of Justice and Federal Trade Commission, to evaluate the competitive impact of proposed mergers and acquisitions.
• A higher HHI value indicates greater market concentration and less competition, while a lower value suggests a more competitive market.
• The ²¹HHI gives proportionally more weight to firms with larger market shares, reflecting their greater influence on market dynamics.
• Whil²⁰e widely used, the HHI has limitations, including its sensitivity to market definition and its inability to fully capture complex market realities.

Formula and Calculation

The Herfindahl–Hirschman Index is calculated by squaring the market share (expressed as whole numbers, not decimals) of each firm in an industry and then summing those squared values.

The formula is expressed as:

Where:

• (s_i) = the market share of firm i (expressed as a whole number, e.g., 30 for 30%)
• (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 calculation would be:
(\text{HHI} = 40^2 + 30^2 + 30^2 = 1600 + 900 + 900 = 3400).

Interpreting the Herfindahl–Hirschman Index

The Herfindahl–Hirschman Index ranges from close to zero (indicating a highly competitive market with numerous small firms) to 10,000 (representing a pure monopoly with one firm holding 100% of the market share).

U.S. antitrus¹⁹t authorities, such as the Department of Justice and the Federal Trade Commission, use specific thresholds to interpret HHI values and assess market structure and the potential impact of mergers and acquisitions:

• HHI below 1,500: Considered an unconcentrated, competitive market.
• HHI between 1,500 and 2,500: Considered a moderately concentrated market.
• HHI above 2,500: Considered a highly concentrated market.

Additionally, regulators examine the change in HHI resulting from a merger. An increase in HHI of more than 100 points in already highly concentrated markets (post-merger HHI above 1,800 or 2,500 depending on the specific guidelines) often raises significant competitive concerns and triggers further scrutiny. This framework¹⁷, ¹⁸ provides a benchmark for evaluating whether a proposed merger might create or enhance market power to an anticompetitive degree.

Hypothetical Example

Consider the market for online streaming services with the following firms and their respective market shares:

• StreamFlix: 45%
• WatchPrime: 25%
• CineNow: 15%
• TVGo: 10%
• Other smaller services (combined): 5%

To calculate the Herfindahl–Hirschman Index for this market:

1. Square each firm's market share:

   • StreamFlix: (45^2 = 2025)
   • WatchPrime: (25^2 = 625)
   • CineNow: (15^2 = 225)
   • TVGo: (10^2 = 100)
   • Other smaller services: (5^2 = 25)

2. Sum the squared values:

   • HHI = (2025 + 625 + 225 + 100 + 25 = 3000)

In this hypothetical example, the Herfindahl–Hirschman Index is 3000. According to the general thresholds, this market would be considered highly concentrated. If StreamFlix were to acquire CineNow, their combined market share would be 60% (45% + 15%). The new HHI would then be calculated as: (60^{2 + 25}2 + 10^{2 + 5}2 = 3600 + 625 + 100 + 25 = 4350). The increase of 1350 points (4350 - 3000) would likely trigger significant regulation and antitrust review by authorities.

Practical Applications

The Herfindahl–Hirschman Index is a cornerstone of economic theory and practical regulation, primarily used in the realm of antitrust law. Its most prominent application is by government agencies like the U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) to evaluate the competitive effects of proposed mergers and acquisitions.

Regulators use the ¹⁶HHI to gauge pre- and post-merger market concentration. By analyzing how a merger would change the Herfindahl–Hirschman Index, they can determine if the transaction is likely to create or enhance market power and thereby reduce competition. For instance, the DOJ ¹⁴, ¹⁵provides detailed guidance on how it uses the HHI to assess mergers and potential antitrust violations. Companies themselves a¹³lso use the Herfindahl–Hirschman Index in their strategic planning and in presenting merger proposals to regulators to demonstrate that the proposed consolidation will not lead to an anticompetitive outcome.

Limitations and Crit¹²icisms

Despite its widespread use, the Herfindahl–Hirschman Index has several limitations and has faced criticism. One primary drawback is its sensitivity to the definition of the relevant market. A narrow market definition can artificially inflate the HHI, suggesting higher concentration than truly exists, while an overly broad definition can underestimate it. For example, defining the market for "soft drinks" versus "all beverages" would yield vastly different HHI values.

Critics also point out that the Herfindahl–Hirschman Index is a static measure that may not fully capture the dynamic nature of markets, especially in rapidly evolving sectors like technology. It primarily focuses on curr¹¹ent market share and doesn't explicitly account for factors such as potential new entrants, innovation, or the ease of supply substitution. For instance, an industry mi¹⁰ght appear concentrated based on HHI, but low barriers to entry could mean that potential competition keeps existing firms' pricing in check, a nuance the HHI alone might miss. Some academic critiques argue that the HHI may provide little useful information about a merger's effect on consumer welfare, particularly in network industries where "bigger" can sometimes lead to greater benefits.

Herfindahl–Hirschman Ind⁹ex vs. Concentration Ratio

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

The Concentration Ratio typically measures the combined market share of the largest N firms in an industry, commonly expressed as CR4 (the sum of the market shares of the top four firms). While simple to calculate and un⁸derstand, the Concentration Ratio does not account for the distribution of market shares among those top firms, nor does it consider the market shares of firms outside the top N. For example, two industries could have the same CR4, but one might have a dominant firm and three small ones, while the other has four equally sized large firms.

In contrast, the Herfindahl–Hirschman Index sums the squares of all firms' market shares within the industry, providing a more comprehensive view. By squaring the market shares, the HHI gives proportionally greater weight to larger firms. This makes the Herfindahl–Hirschman Index more sensitive to changes in the market shares of leading firms and provides a more nuanced picture of market monopoly or dispersion. Regulators generally prefer the HHI because it offers a more granular assessment of market power than the simpler Concentration Ratio.

FAQs

What does a high Herfi⁶, ⁷ndahl–Hirschman Index indicate?

A high Herfindahl–Hirschman Index (HHI) indicates a highly concentrated market with limited competition. This suggests that a few large firms hold a significant portion of the market share, potentially giving them substantial market power over pricing and market dynamics.

How is the Herfindahl–Hirschman Index used in antitrust cases?

In antitrust cases, the Herfindahl–Hirschman Index is a primary tool used by government bodies like the U.S. Department of Justice and the Federal Trade Commission. They calculate the HHI before and after proposed mergers and acquisitions to assess whether the merger would significantly increase market concentration and potentially harm competition.

Can the Herfindahl–Hirschman Index pred⁴, ⁵ict future market behavior?

The Herfindahl–Hirschman Index is a snapshot of current market structure and concentration. While it helps in understanding existing competitive conditions, it is not designed to predict future market behavior or the specific actions of firms. Its utility lies in providing a quantitative measure for antitrust authorities to evaluate the immediate impact of proposed changes in market structure.

What is the maximum value of the Herfindahl³–Hirschman Index?

The maximum value of the Herfindahl–Hirschman Index is 10,000. This occurs in a theoretical monopoly where a single firm holds 100% of the market share ((100^2 = 10,000)). The minimum value approaches zero in a market with a²n extremely large number of very small firms, approaching perfect competition.

Is the Herfindahl–Hirschman Index the only measure of market concentration?

No, the Herfindahl–Hirschman Index is not the only measure of market concentration, though it is widely used. Other measures include Concentration Ratios (e.g., CR4 or CR8), which sum the market shares of the largest N firms. Economists also consider other qualitative factors, such¹ as barriers to entry, product differentiation, and buyer power, when analyzing market competitiveness.