What Are the Benefits and Shortfalls of the Herfindahl-Hirschman Index?

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration in an industry. It measures the market concentration of the 50 largest companies in a particular industry to determine if that industry should be considered competitive or as close to being a monopoly.

Market concentration in an industry is determined by examining the number of companies that manufacture or market a particular product or line of products, along with the relative distribution of market share in terms of sales for each company within the industry. Economists consider the concentration of market share to be an important determinant in the viability of market competition and consumer choice.

Key Takeaways

• The Herfindahl-Hirschman Index, or HHI, looks at the market concentration in an industry to determine if the industry provides healthy competition or is veering close to being a monopoly.
• Federal regulators consider the HHI when they are debating whether to approve a corporate merger, as they want to promote healthy competition and avoid the creation of monopolies.
• The HHI is calculated by taking the sum of the squared market shares of the 50 biggest companies in an industry.
• The simplicity of the calculation is both its biggest advantage and disadvantage—it’s easy to calculate but so basic that it doesn’t account for the nuances and complexities of certain markets.

Advantages and Disadvantages of the Herfindahl-Hirschman Index

The primary advantages of the Herfindahl-Hirschman Index (HHI) are the simplicity of the calculation necessary to determine it and the small amount of data required for the calculation. The primary disadvantages of the HHI stem from the fact that it is such a simple measure that it fails to take into account the complexities of various markets in a way that allows for a genuinely accurate assessment of competitive or monopolistic market conditions.

The basic simplicity of the HHI carries some inherent disadvantages, primarily in terms of failing to define the specific market that is being examined in a proper, realistic manner. For example, consider a situation in which the HHI is used to evaluate an industry determined to have 10 active companies, and each company has about a 10% market share. Using the basic HHI calculation, the industry would appear highly competitive. However, within the marketplace, one company might have as much as 80% to 90% of the business for a specific segment of the market, such as the sale of one specific item. That firm would thus have nearly a total monopoly for the production and sale of that product.

Another problem in defining a market and considering market share can arise from geographic factors. This problem can occur when there are companies within an industry that have roughly equal market share, but they each operate only in specific areas of the country, so that each firm, in effect, has a monopoly within the specific marketplace in which it does business.

Pros

• Provides a simple calculation for the level of competitiveness in an industry.

• Does not require extensive data, aside from market shares.

Cons

• Does not account for the complexities of various markets.

• Does not account for situations where a single company has market dominance over specific geography or p

Note

The HHI does not account for nuances, such as the fact that while there may be a number of companies active in an industry, implying healthy competition, one company might control the majority of the business for the sale of one specific product, which suggests a potential monopoly.

How the Herfindahl-Hirschman Index Is Calculated

The calculation for the HHI is the sum of the squared market shares of the 50 largest companies in an industry. The calculation for the HHI is simple and straightforward, requiring only basic market data, which is the primary advantage of using the HHI.

The HHI value can range anywhere from near 0 up to 10,000. A higher index value means that the industry is considered to be closer to monopoly conditions. Generally, a market with an HHI value of under 1,000 is considered to be competitive.

The U.S. Justice Department and the Federal Trade Commission (FTC) are wary of any mergers that would result in an HHI value over 1,000 and are likely to disapprove any merger that would result in an HHI value over 1,800.

Example of HHI Risk

Imagine a hypothetical industry of fifty companies, each with about 2% market share nationwide. Using only the formula and the available data, the Herfindahl-Hirschman index for that industry is 50*2²=200, suggesting a highly competitive market.

However, the Herfindahl-Hirschman index does not account for regional variations of market dominance. It is possible (however unlikely) that each of the fifty companies each have monopolistic market dominance in one of the fifty U.S. states. In that case, the healthy-seeming market would be much less competitive than the index calculation suggests.

Important

A market with an HHI of less than 1,000 is seen as competitive, while one with an HHI of over 1,000 is seen as being at risk for veering toward a monopoly; regulators are likely to shoot down any merger requests that result in an HHI value above 1,800.

How Do You Calculate the Herfindahl-Hirschman Index?

The Herfindahl-Hirschman index is calculated by adding up the squared market shares of the top fifty companies in a given industry. For example, imagine an industry where two market leaders control 26% of the market each, and 48 smaller companies have a market share of 1% each. The Herfindahl-Hirschman Index for that industry is 26²+26²+48*(1²)=1,400.

Because it is significantly higher than 1,000, this would be considered a highly concentrated industry.

What Does the Herfindahl-Hirschman Index Tell You?

The Herfindahl-Hirschman index is a measure of the amount of competition in an industry. A high Herfindahl-Hirschman index indicates a near-monopolistic level of control by a handful of companies, while a low index indicates a more competitive playing field.

Who Uses the Herfindahl-Hirschman Index?

The Herfindahl-Hirschman index is used by regulators to predict how policy changes would affect the level of competition in an industry. If a proposed merger or acquisition would result in an unacceptably high index level, regulators would be likely to reject the proposed corporate action.

The Bottom Line

The Herfindahl-Hirschman index is a convenient way to measure the competitiveness in an industry or market sector. Although it is computationally simple, it does not always account for all of the differences between companies and products.