Analyzing Market Concentration with the Herfindahl-Hirschman Index (HHI): An Overview of the Methodology
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Summary:
The Herfindahl-Hirschman Index (HHI) is a commonly used measure of market concentration that assesses the level of competition in a given market. Market competitiveness is evaluated using the HHI, with a market being considered competitive if its HHI is less than 1,500, moderately concentrated if it is between 1,500 and 2,500, and highly concentrated if it is 2,500 or higher. However, the HHI’s main drawback is that it is such a straightforward indicator that it ignores the complexity of different marketplaces. To calculate the HHI, the squares of the market shares of all firms within a market are added, with higher values indicating a higher degree of market concentration. The HHI ranges from 0 to 10,000, with a score of 0 indicating perfect competition and a score of 10,000 indicating a monopoly.
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What is Herfindahl-Hirschman Index (HHI)?
This (HHI) is a measure of market concentration that is commonly used in antitrust and competition law to assess the level of competition in a given market.;
It is calculated by summing the squares of the market shares of all firms within a market, with higher values indicating a higher degree of market concentration.
The HHI ranges from 0 to 10,000, with a score of 0 indicating perfect competition (i.e., a large number of small firms each with a small market share) and a score of 10,000 indicating a monopoly (i.e., a single firm with 100% market share).
In general, an HHI score of less than 1,500 is considered to represent a competitive market, while a score above 2,500 suggests a highly concentrated market.
The HHI is often used by regulatory agencies to evaluate proposed mergers and acquisitions, with higher HHI scores indicating a greater risk of reduced competition and increased market power.
The HHI can also be used to assess the competitive effects of other types of conduct, such as exclusive dealing or price fixing.
Formula for herfindahl-hirschman index (HHI)
The formula for calculating the Herfindahl-Hirschman Index (HHI) is:
HHI = ∑(Si)2
Where:
HHI: Herfindahl-Hirschman Index
∑: Summation of
Si: Market share of firm i, expressed as a percentage (for example, if firm i has a market share of 20%, then Si = 0.20)
To calculate the HHI, you first need to identify all the firms that operate in a particular market and determine their individual market shares.
You then square each firm’s market share (expressed as a decimal) and add up these squared market shares for all firms in the market. The resulting number is the HHI for that market.
For example, if a market has three firms with market shares of 30%, 20%, and 10%, respectively, the HHI would be calculated as follows:
HHI = (0.30)2 + (0.20)2 + (0.10)2
HHI = 0.09 + 0.04 + 0.01
HHI = 0.14
So in this example, the HHI for the market would be 0.14, indicating a relatively low level of market concentration.
Detailed example of herfindahl-hirschman index
Let’s consider an example of a hypothetical market for smartphones in a particular country. Assume that there are four major firms operating in this market: A, B, C, and D.
Their market shares and the resulting HHI score for this market can be calculated as follows:
Firm A: Market share = 40%
Firm B: Market share = 30%
Firm C: Market share = 20%
Firm D: Market share = 10%
To calculate the HHI for this market, we need to square the market share of each firm and add them up:
HHI = (0.40)2 + (0.30)2 + (0.20)2 + (0.10)2
HHI = 0.16 + 0.09 + 0.04 + 0.01
HHI = 0.30
The resulting HHI score for this market is 0.30, which is relatively low and suggests that this market is somewhat competitive.
Now let’s consider a scenario where Firm A acquires Firm C, and their combined market share increases to 60%. The new HHI score for this market would be:
HHI = (0.60)2 + (0.30)2 + (0.10)2
HHI = 0.36 + 0.09 + 0.01
HHI = 0.46
The resulting HHI score of 0.46 is significantly higher than the previous score of 0.30, indicating that the market has become more concentrated as a result of the merger.
This increase in the HHI score would likely be a cause for concern for regulators, as it suggests that the merged entity could have increased market power and potentially limit competition in the market.
An HHI score below 1,500 indicates a competitive market, while a score ranging from 1,500 to 2,500 represents a moderately concentrated market.
A market is considered highly concentrated when the HHI is 2,500 or above. Generally, if a merger leads to an increase of more than 200 points in HHI in a highly concentrated market, it raises antitrust concerns since it is believed to enhance market power.
Limitations of the herfindahl-hirschman index (HHI)
While the Herfindahl-Hirschman Index (HHI) can be a useful tool for assessing market concentration and competition, it also has several limitations that should be taken into account:
- It only considers market shares
The HHI only takes into account the market shares of firms in a given market, without considering other factors that may affect competition, such as barriers to entry, product differentiation, or innovation. This means that the HHI may not fully capture the competitive dynamics of a market.
- It does not distinguish between different types of market concentration
The HHI treats all forms of market concentration the same way, even though it is the result of a natural monopoly, a cartel, or a merger. This means that it may not provide a complete picture of the competitive effects of different types of market concentration.
- It does not take into account cross-market effects
The HHI only considers market concentration within a single market, without considering the potential effects of concentration in related markets.
For example, the HHI may not capture the competitive effects of a merger between two firms that operate in different markets but that are closely related, such as a merger between a supplier and a buyer.
- It can be sensitive to the number of firms in a market
The HHI can be affected by the number of firms in a market, with smaller markets potentially having higher HHI scores even if they are competitive.
This means that the HHI should be used in conjunction with other measures of the market concentration and competition.
- While the HHI can be a useful tool for assessing market concentration, it should be used in conjunction with other measures and should be interpreted with caution, taking into account the specific characteristics of each market.
The HHI is advantageous due to its simplicity and low data requirement. Additionally, it considers the firm size, making it a superior measure to the concentration ratio.
As a result, it is a widely used tool for evaluating market concentration and antitrust policy.
Creators of the herfindahl-hirschman index (HHI)
The Herfindahl-Hirschman Index (HHI) is named after two economists, Orris C. Herfindahl and Albert O. Hirschman, who independently developed the index in the 1950s.
Orris C. Herfindahl was an economist who worked for the US Department of Agriculture and is known for his research on agricultural economics.
He first proposed the index in 1950 as a measure of market concentration in the agricultural sector.
Albert O. Hirschman was an economist who worked for the World Bank and was known for his contributions to development economics, industrial organization, and political science.
He independently proposed a similar measure of market concentration in his book “The Strategy of Economic Development,” published in 1958.
Their work on market concentration and the development of the HHI has since become a widely used tool for antitrust regulators, economists, and policymakers to measure the degree of competition and market power in different industries.
Conclusion
In conclusion, the Herfindahl-Hirschman Index (HHI) is a useful tool for measuring market concentration and competitiveness. The formula for calculating HHI is relatively simple and involves squaring the market shares of all firms in the market and adding them together. A higher HHI score indicates greater market concentration and potentially less competition.
An example of HHI calculation was given to illustrate its application in the real world. Overall, understanding HHI and its implications can provide valuable insights for businesses, policymakers, and investors alike.
Key takeaways
- Market competitiveness is assessed using the Herfindahl-Hirschman Index (HHI).
- A market is regarded to be competitive if its HHI is less than 1,500, moderately concentrated if it is between 1,500 and 2,500, and highly concentrated if it is 2,500 or higher.
- The HHI’s main drawback is that it is such a straightforward indicator that it ignores the complexity of different marketplaces.
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