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.
- 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.
Pros and Cons of the HHI
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 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 HHI 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.
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.
Example of HHI Risk
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.
For these reasons, for the HHI to be properly used, other factors must be taken into consideration, and markets must be very clearly defined.