What is the Herfindahl-Hirschman Index?
Herfindahl-Hirschman Index or HHI score refers to a measure of market concentration and is an indicator of the amount of competition in a particular industry. HHI Index formula helps in analyzing and observing, if a particular industry is highly concentrated or close to monopoly or if there is some level of competition around it. It is calculated by first squaring and then summing the individual market share of each firm in a particular industry or market.
HHI Index can range from 0 to 10,000 if whole percentage numbers are used. Similarly, it can range from 0 to 1, where market shares are used as fractions. E.g. if there’s only one firm operating in an industry, holding 100% market share, it’s respective HHI would be exactly 10,000 or 1 and would indicate a monopoly.
Examples of Highly Concentrated Industries:
- Soda Production – Coca-Cola and PepsiCo combined, holds more than 70% of the market share.
- Lighting and Bulb – General Electric, Philips and Siemens together hold around 90% of the market share.
Herfindahl-Hirschman Index Formula
The formula for Herfindahl-Hirschman Index is:
sn is the market share of firm n.
How Herfindahl-Hirschman Index (HHI) Works Anyways?
HHI score is directly proportional to the concentration in a particular market. That means, a higher HHI value or score reflects a higher concentration in industry and thus reflects lesser competition. Similarly, a lower HHI score would entail the presence of good competition around firms in an industry. A value closer to 10,000 or 1 would indicate the presence of monopoly and a value closer to 0 would indicate healthy competition and almost null concentration among firms.
U.S Department of justice along with many regulatory bodies around the world utilizes HHI to assess the concentration level in their respective markets, especially for M&A transactions. For simplicity, agencies generally consider following HHI slab, to assess the concentration:
- HHI less than 1,500 = Competitive Market
- HHI between 1,500 and 2,500 = Moderately Concentrated Market
- HHI equal to or greater than 2,500 = Highly Concentrated Market
In addition, merger transactions that increase the HHI by more than 200 points in highly concentrated markets are presumed to likely enhance market share under the horizontal merger guidelines, issued by U.S department of justice and federal trade commission.
Example of Herfindahl Index
Let’s understand the example of the Herfindahl index.
Suppose we have only four firms in the toy-making industry and below are the respective market shares of these four firms:
- Market Share of Firm A = 25%
- Market Share of Firm B = 35%
- Market Share of Firm C = 12%
- Market Share of Firm D = 28%
Calculation of the Herfindahl-Hirschman Index will be –
Herfindahl-Hirschman Index (HHI) Formula = (25)2 + (35)2 + (12)2 + (28)2
Herfindahl-Hirschman Index (HHI) Formula = 625 + 1,225 + 144 + 784
Herfindahl-Hirschman Index (HHI) = 2,778
Since the score is higher than 2,500, this would represent that our toy industry is highly concentrated in nature and healthy competition is not visible.
You can refer the above given excel template for the detailed calculation of the Herfindahl index.
Why Use the Herfindahl-Hirschman Index and Why Not?
The primary advantage of HHI is its simple calculation and less dependency on huge data sources. Rather, HHI calculation only requires a handful of data to assess the viability and provides good direction and starting point for further analysis.
A major disadvantage of HHI is also its simplistic nature. Since the formula is simple; it fails to undertake various market adversaries and complexities that are present in today’s market structure, especially around M&A transactions.
Limitations of Herfindahl-Hirschman Index
Generally speaking, in addition to the disadvantage of simplicity, HHI also suffers from various limitations which would emphasize a careful consideration of all the persistent factors before its application. That means, HHI can’t be implemented for all the industries directly and can be effective only when all the relevant factors are considered.
For instance, firms may appear to have less market share in a particular industry and that industry could appear as competitive, but these firms could hold dominant positions in a particular geographic area or country, which would not be indicative out of HHI score. So there is a limitation of defining the scope and market, which makes the analysis and observation less effective. For e.g. the U.S automaker industry might seem to be competitive with less concentration but a particular firm, let’s say ford might have a dominant position in a specific country, let’s say, South Africa.
Also, the limitation of defining a market persists in a scenario where intra-industry competition is present in a specific market. For e.g. a specific market might appear to be competitive with the analysis of low HHI score. However, a particular firm might hold a dominant position in a specific segment of the market or product which the firm deals with. For e.g. in the tech industry, HHI score might be low due to the availability of many players and with decent market shares.
But a particular firm, let’s say Google might hold a dominant position in a specific market segment, let’s say search engine. Alternatively, if we just define our scope and focus on search engine market only, instead of the generalized tech world, we would find that Google holds a significant market position and dominates the industry.
Every economy strives to make its general marketplace more effective and competitive so that anybody who wants to do business can have access to all the required resources. Sometimes, firms or companies try to impose their dominant position in an industry and harm the small players directly or indirectly which affects the environment and discourage healthy competition. Regulatory bodies and watchdogs continuously look for these scenarios that could increase concentration in any industry. The motive here is not to discourage any firm’s large market share, but to prune some practices which affect competition in general.
HHI takes into account the relative size of the firms in a market and approaches zero when a large number of firms with relatively equal size are present. On the contrary, when only one firm is present in a market, it reaches its maximum of 10,000 and indicates the presence of a monopoly. Despite its disadvantages, HHI is a very good tool to assess the market structure and ascertain concentration.
This has been a guide to what is the Herfindahl-Hirschman Index and its definition. Here we discuss the formula to calculate the Herfindahl index along with a detailed explanation of how HHI works. You can learn more about accounting from following articles –