Herfindahl-Hirschman Index (HHI) Definition, Formula, and Example

What Is the Herfindahl-Hirschman Index (HHI)?

The Herfindahl-Hirschman Index (HHI) is a typical measure of market focus and is used to find out market competitiveness, usually pre- and post-merger and acquisition (M&A) transactions.

The index measures the scale of firms relative to the scale of the trade they’re in and the quantity of competitiveness. The HHI is calculated by squaring the market share of every agency competing in a market after which summing the ensuing numbers. It might vary from near 0 to 10,000, with decrease values indicating a much less concentrated market.

Components and Calculation of the Herfindahl-Hirschman Index (HHI)

The HHI is a generally accepted measure of market focus. It’s calculated by squaring the market share of every agency competing in a market after which summing the ensuing numbers. It might vary from near 0 to 10,000. The U.S. Division of Justice makes use of the HHI for evaluating potential merger antitrust points.

​HHI=s12​+s22​+s32​+…sn2​the place:sn​=the market share proportion of agency n expressed as a entire quantity, not a decimal​

What the Herfindahl-Hirschman Index (HHI) Signifies

The nearer a market is to a monopoly, the upper the market’s focus (and the decrease its competitors). If, for instance, there have been just one agency in an trade, that agency would have 100% market share, and the HHI would equal 10,000, indicating a monopoly. If there have been 1000’s of companies competing, every would have roughly 0% market share, and the HHI could be near 0, indicating practically good competitors.

The U.S. Division of Justice considers a market with an HHI of lower than 1,500 to be a aggressive market, an HHI of 1,500 to 2,500 to be a reasonably concentrated market, and an HHI of two,500 or larger to be a extremely concentrated market. As a normal rule, mergers that improve the HHI by greater than 200 factors in extremely concentrated markets increase antitrust considerations, as they’re assumed to boost market energy underneath Part 5.3 of the Horizontal Merger Tips collectively issued by the Justice Division and the Federal Commerce Fee (FTC).

The first benefit of the HHI is the simplicity of the calculation wanted to find out it and the small quantity of information required for the calculation. The first drawback of the HHI stems from the truth that it’s such a easy measure that it fails to have in mind the complexities of assorted markets in a manner that permits for a genuinely correct evaluation of aggressive or monopolistic market circumstances.

Instance of the Herfindahl-Hirschman Index (HHI)

The HHI is calculated by taking the market share of every agency within the trade, squaring them, and summing the outcome, as depicted within the equation above. Think about the next hypothetical trade with 4 complete companies:

1. Agency 1 market share = 40%
2. Agency 2 market share = 30%
3. Agency 3 market share = 15%
4. Agency 4 market share = 15%

The HHI is calculated as:

HHI​=42+32+152+152=1,600+900+225+225=2,950​

This HHI worth is taken into account a extremely concentrated trade, as anticipated as a result of there are solely 4 companies. Nevertheless, the variety of companies in an trade doesn’t essentially point out something about market focus, which is why calculating the HHI is vital.

For instance, assume an trade has 20 companies. Agency 1 has a market share of 48.59%, and every of the 19 remaining companies has a market share of two.71% every. The HHI could be precisely 2,500, indicating a considerably extremely concentrated market. If Agency 1 had a market share of 35.82% and every of the remaining companies had a 3.38% market share, the HHI could be precisely 1,500, indicating a aggressive market.

Limitations of the Herfindahl-Hirschman Index (HHI)

The essential simplicity of the HHI carries some inherent disadvantages, primarily by way of failing to outline the precise market that’s being examined in a correct, real looking method. For instance, contemplate a state of affairs through which the HHI is used to judge an trade decided to have 10 energetic firms, and every firm has a couple of 10% market share. Utilizing the fundamental HHI calculation, the trade would seem extremely aggressive.

Nevertheless, inside the market, one firm may need as a lot as 80% to 90% of the enterprise for a particular phase of the market, such because the sale of 1 particular merchandise. That agency would thus have practically a complete monopoly for the manufacturing and sale of that product.

One other downside in defining a market and contemplating market share can come up from geographic components. This downside can happen when firms inside an trade have roughly equal market share, however they every function solely in particular areas of the nation, so that every agency, in impact, has a monopoly inside the particular market through which it does enterprise.

For instance, whereas the merger of mobile phone suppliers Dash and T-Cell elevated the HHI worth for the whole nation by a number of hundred factors as a result of market share is concentrated in sure geographical areas, the index worth elevated by greater than 1,000 factors in lots of markets. For these causes, for the HHI to be correctly used, different components have to be considered, and markets have to be very clearly outlined.

Creators of the Herfindahl-Hirschman Index (HHI)

The idea behind the HHI initially emerged in a 1945 e book by German economist Albert O. Hirschman titled Nationwide Energy and the Construction of Overseas Commerce. The tactic proposed by Hirschman differed from current measures of focus by inserting a extra vital weighting on bigger companies whose larger market share has a larger impression on the extent of competitiveness out there.

A number of years after Hirschman outlined this method for measuring market focus, American economist Orris C. Herfindahl repurposed the thought in his 1950 doctoral dissertation, Focus within the U.S. Metal Business. Whereas Hirschman had utilized the thought to the focus of imports and exports on a national foundation, Herfindahl makes use of the framework to research on the competitiveness of the metal trade. Herfindahl refers to Hirschman’s work in a footnote.

The Backside Line

The Herfindahl-Hirschman Index (HHI) is used to find out market competitiveness. It measures the diploma of focus inside a particular market. A market with an HHI of lower than 1,500 is taken into account a aggressive market, an HHI of 1,500 to 2,500 is reasonably concentrated, and an HHI of two,500 or larger is extremely concentrated.