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 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 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.
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.