what the herfindahl hirschman index hhi can tell you
the closer a market is to a monopoly the higher the market s concentration and the lower its competition if for example there was only one firm in an industry that firm would have 100 market share and the hhi would equal 10 000 indicating a monopoly if there were thousands of firms competing each would have roughly 0 market share and the hhi would be close to zero indicating nearly perfect competition the u s department of justice considers a market with an hhi of less than 1 500 to be a competitive marketplace an hhi of 1 500 to 2 500 to be a moderately concentrated marketplace and an hhi of 2 500 or greater to be a highly concentrated marketplace 2as a general rule mergers that increase the hhi by more than 200 points in highly concentrated markets raise antitrust concerns as they are assumed to enhance market power under section 5 3 of the horizontal merger guidelines jointly issued by the justice department and the federal trade commission ftc 2the primary advantage of the hhi is the simplicity of the calculation needed to determine it and the small amount of data required for the calculation the primary disadvantage of the hhi stems 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 regulators use the hhi index to measure the largest companies in a particular industry to determine if that industry should be considered competitive or close to being a monopoly 2example of the herfindahl hirschman index hhi the hhi is calculated by taking the market share of each firm in the industry squaring them and summing the result as depicted in the equation above consider the following hypothetical industry with four total firms the hhi is calculated as h h i 4 0 2 3 0 2 1 5 2 1 5 2 1 600 900 225 225 2 950 begin aligned hhi 40 2 30 2 15 2 15 2 1 600 900 225 225 2 950 end aligned hhi 402 302 152 152 1 600 900 225 225 2 950 this hhi value is considered a highly concentrated industry as expected because there are only four firms however the number of firms in an industry does not necessarily indicate anything about market concentration which is why calculating the hhi is important for example assume an industry has 20 firms firm 1 has a market share of 48 59 and each of the 19 remaining firms has a market share of 2 71 each the hhi would be exactly 2 500 indicating a substantially highly concentrated market if firm 1 had a market share of 35 82 and each of the remaining firms had a 3 38 market share the hhi would be exactly 1 500 indicating a competitive marketplace 2limitations of the herfindahl hirschman index hhi 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 companies within an industry 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 for these reasons for the hhi to be properly used other factors must be taken into consideration and markets must be very clearly defined history of the herfindahl hirschman index hhi the concept behind the hhi initially emerged in a 1945 book by german economist albert o hirschman titled national power and the structure of foreign trade the method proposed by hirschman differed from existing measures of concentration by placing a more significant weighting on larger firms whose greater market share has a greater impact on the level of competitiveness in the market 3a few years after hirschman outlined this system for measuring market concentration american economist orris c herfindahl repurposed the idea in his 1950 doctoral dissertation concentration in the u s steel industry 3whereas hirschman applied the idea to the concentration of imports and exports on a countrywide basis herfindahl used the framework to analyze the competitiveness of the steel industry herfindahl refers to hirschman s work in a footnote 3