What’s it: Herfindahl-Hirschman Index (HHI) is a measure of market concentration. You compute it by summing the squares of each firm’s market share in the industry. This is an alternative to the n-firm concentration ratio.
This index is important for many purposes. Industry analysts use it to determine market structure and competition. Regulators use it to measure market concentration and evaluate mergers? For example, when two companies merge, it is to determine whether the merger will result in monopoly power in violation of antitrust laws or not.
How to calculate the Herfindahl-Hirschman index
Calculating the Herfindahl-Hirschman index is relatively easy. If market share data is available, you simply square each company’s market share, and then the results you add up.
The following is the Herfindahl-Hirschman index formula:
The Herfindahl-Hirschman index ranges from 0 to 10,000 points (or 100%). It depends on the number of companies and the market share of each company.
The Herfindahl-Hirschman index figure is equal to 10,000, representing a monopoly. There is only one company with a market share, of course, 100%.
Meanwhile, if the Herfindahl-Hirschman index value approaches 0, the market leads to perfect competition. It shows that no company dominates the market.
Let’s calculate the Herfindahl-Hirschman index for the data in the table above. There are seven companies in the industry. Take the market share of each company, square each market share, and then add the results. The result should be something like below:
HHI = 33%2 + 22%2 + 15%2 + 12%2 + 8%2 + 7%2 + 3%2 = 20,64% atau 2064
Herfindahl-Hirschman Index for measuring competition,
The high Herfindahl-Hirschman index shows that some players tend to dominate the market. Still, of course, you must look at the distribution of each company’s market share.
Furthermore, an increase in the Herfindahl index generally indicates a decrease in competition and increased market power. Several companies have succeeded in increasing their market share by capturing the market share of competitors. Meanwhile, if it decreases, the level of competition is lower.
An increase in market power also occurs when two companies merge (horizontal merger). Typically, regulators will oversee such a merger if it increases Herfindahl-Hirschman by more than 100 points in a concentrated market.
Typically, a Herfindahl-Hirschman index of more than 1,500 will be considered a concentrated market. Specifically:
- An index of less than 1,500 is considered a competitive market
- An index between 1,500 and 2,500 is considered a moderately concentrated market
- An index of more than 2,500 or greater is considered a highly concentrated market.
A concentrated market means that few players have monopoly power. A more concentrated market means higher the monopoly power and the lower the level of competition.
Herfindahl-Hirschman Index advantages and disadvantages
The Herfindahl-Hirschman Index measures competition in a particular industry by examining the proportion of all existing players’ market share. The index reflects the distribution of market share and gives weight to the largest players proportionately. So, it’s a better measure than the concentration ratio.
However, the Herfindahl-Hirschman index also contains several drawbacks, including:
- The index doesn’t take into account the possibility of entering new companies. Just like the n-firms concentration ratio, it only tells you the market power of the existing companies. Market power is less relevant when barriers to entry are low. A new player brings in new capacity and erodes the incumbent’s market share, reducing their market power.
- It is challenging to collect market share data for the entire company. Say, you didn’t find the market share of several companies. Then, you categorize them as “other.” In that case, you may come to inaccurate conclusions, particularly if the “other” category, cumulatively, has a significant share of the market. Another problem is when the supply comes from imports. You may find it challenging to track down each foreign company.
- Sensitive to market definitions. Say, you calculated the company’s market share for the food industry. You may find the market is less concentrated. However, if you dig deeper into a subsegment, for example, the bakery market, you may come to a different conclusion.
- It says nothing about differentiation. Suppose you calculate market share based on production volume. In that case, it will produce a different number when you use the revenue value. Revenue is sensitive to an individual firm’s pricing strategy. Differentiation allows the company to get market power and set a high price, enabling it to achieve target revenue even with low volume.
Market definition problems
The Herfindahl-Hirschman index value depends on the definition of market share you use. Say, there are ten companies in the industry, each of which has a 10% market share. By using the calculation formula above, the industry will appear very competitive.
However, if you look deeper, one company may have several product segments. In a specific segment, the company may have a dominant market share, say 90%. So, the company will have the monopoly power of the product.
Not only product segments but other problems also arise when each company targets different geographies. Say, in an extreme case, there are two companies in the food industry and have a 50% market share based on their output volume. It seems that, from that percentage, the competition is a little loose.
But, if the two are targeting two different markets, that percentage will say something else. Say, one company is targeting the foreign market, while the other is the domestic market. Isn’t it the monopolist in the domestic market? Thus, market share by volume of output is irrelevant.