Herfindahl index

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This article is about the economic measure. For the index of scientific prolificacy, see H-index.
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The Herfindahl index (also known as HerfindahlHirschman Index, or HHI) is a measure of

the size of firms in relation to the industry and an indicator of the amount of competition among
them. Named after economists Orris C. Herfindahl and Albert O. Hirschman, it is
an economic concept widely applied in competition law, antitrust[1] and also technology
management.[2] It is defined as the sum of the squares of the market shares of the 50 largest firms
(or summed over all the firms if there are fewer than 50)[3] within the industry, where the market
shares are expressed as fractions. The result is proportional to the average market share,
weighted by market share. As such, it can range from 0 to 1.0, moving from a huge number of
very small firms to a single monopolistic producer. Increases in the Herfindahl index generally
indicate a decrease in competition and an increase ofmarket power, whereas decreases indicate
the opposite.
The major benefit of the Herfindahl index in relationship to such measures as the concentration
ratio is that it gives more weight to larger firms.
The measure is essentially equivalent to the Simpson diversity index used in ecology.

Contents
1 Example
2 Formula
3 Problems
4 Intuition
5 Decomposit
ion
6 See also
7 References
8 Further
reading
9 External
links

[edit] Example

For instance, two cases in which the six largest firms produce 90 % of the goods in a market:
Case 1: All six firms produce 15% each, and
Case 2: One firm produces 80 % while the five others produce 2 % each.
We will assume that the remaining 10% of output is divided among 10 equally sized producers.

The six-firm concentration ratio would equal 90 % for both case 1 and case 2. But the first case
would promote significant competition, where the second case approaches monopoly. The
Herfindahl index for these two situations makes the lack of competition in the second case
strikingly clear:
Case 1: Herfindahl index = 6 * 0.152 + 10 * 0.012 = 0.136 (13.6%)
Case 2: Herfindahl index = 0.802 + 5 * 0.022 + 10 * 0.012 = 0.643 (64.3%)
This behavior rests in the fact that the market shares are squared prior to being summed, giving
additional weight to firms with larger size.
The index involves taking the market share of the respective market competitors, squaring it, and
adding them together (e.g. in the market for X, company A has 30%, B, C, D, E and F have 10%
each and G through to Z have 1% each). If the resulting figure is above a certain threshold then
economists consider the market to have a high concentration (e.g. market X's concentration is
0.142 or 14.2%). This threshold is considered to be 0.18 in the US,[4] while the EU prefers to
focus on the level of change, for instance that concern is raised if there's a 0.025 change when the
index already shows a concentration of 0.1.[5] So to take the example, if in market X company B
(with 10% market share) suddenly bought out the shares of company C (with 10% also) then this
new market concentration would make the index jump to 0.162. Here it can be seen that it would
not be relevant for merger law in the U.S. (being under 0.18) or in the EU (because there is not a
change over 0.025).

[edit] Formula

where si is the market share of firm i in the market, and N is the number of firms. Thus, in a
market with two firms that each have 50 percent market share, the Herfindahl index
equals0.502 + 0.502 = 1 / 2.
The Herfindahl Index (H) ranges from 1 / N to one, where N is the number of firms in the
market. Equivalently, if percents are used as whole numbers, as in 75 instead of 0.75, the index
can range up to 1002, or 10,000.
A HHI index below 0.01 (or 100) indicates a highly competitive index.
A HHI index below 0.1 (or 1,000) indicates an unconcentrated index.
A HHI index between 0.1 to 0.18 (or 1,000 to 1,800) indicates moderate concentration.
A HHI index above 0.18 (above 1,800) indicates high concentration[1].
A small index indicates a competitive industry with no dominant players. If all firms have an
equal share the reciprocal of the index shows the number of firms in the industry. When firms
have unequal shares, the reciprocal of the index indicates the "equivalent" number of firms in the
industry. Using case 2, we find that the market structure is equivalent to having 1.55521 firms of
the same size.
There is also a normalised Herfindahl index. Whereas the Herfindahl index ranges from 1/N to
one, the normalized Herfindahl index ranges from 0 to 1. It is computed as:
where again, N is the number of firms in the market, and H is the usual Herfindahl Index, as
above.

[edit] Problems

The usefulness of this statistic to detect and stop harmful monopolies however is directly
dependent on a proper definition of a particular market (which hinges primarily on the notion of
substitutability).
For example, if the statistic were to look at a hypothetical financial services industry as a
whole, and found that it contained 6 main firms with 15 % market share apiece, then the industry
would look non-monopolistic. However, one of those firms handles 90 % of the checking and
savings accounts and physical branches (and overcharges for them because of its monopoly), and
the others primarily do commercial banking and investments. In this scenario, people would be
suffering due to a market dominance by one firm; the market is not properly defined because
checking accounts are not substitutable with commercial and investment banking. The problems
of defining a market work the other way as well. To take another example, one cinema may have
90% of the movie market, but if movie theatres compete against video stores, pubs and
nightclubs then people are less likely to be suffering due to market dominance.
Another typical problem in defining the market is choosing a geographic scope. For
example, firms may have 20% market share each, but may occupy five areas of the country in
which they are monopoly providers and thus do not compete against each other. A service
provider or manufacturer in one city is not necessarily substitutable with a service provider or
manufacturer in another city, depending on the importance of being loc