Question

How do we measure a Herfindahl-Hirshman Index? What does a low measure mean about the extent of competition?

Short answer

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration and competition, calculated by squaring the market share percentages of all firms in a market and summing them up. A low HHI value, closer to 0, indicates a less concentrated and more competitive market, as there are numerous firms with smaller market shares. Conversely, a higher HHI value, closer to 10,000, indicates a more concentrated and less competitive market, as few firms dominate with larger market shares.

Step-by-step solution

Understand the concept of Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration and competition. It is calculated by squaring the market share percentages of all firms in the market and then summing them up. A lower HHI value is indicative of a more competitive market, while a higher HHI value suggests higher market concentration and less competition among firms.

Identify the market shares of all firms

To calculate HHI, you will need information on the market shares of all firms in the industry. These market shares can be in terms of revenue, sales, or any other relevant metric for the market under consideration. If required, the market shares can be expressed in percentages for easier calculation.

Calculate squared market shares

For each firm in the market, square their market share percentages. For example, if a firm has a market share of 20%, you will calculate \(20^2\) or 400. If a firm has a market share of 5%, you will calculate \(5^2\) or 25.

Sum the squared market shares

Add up the squared market shares calculated in Step 3 to obtain the Herfindahl-Hirschman Index (HHI). This value represents the concentration of the market and ranges from close to 0 (high competition, low concentration) to 10,000 (low competition, high concentration).

Interpret the HHI value

A low HHI value (closer to 0) means that the market is less concentrated and more competitive as there are numerous firms with smaller shares of the market. On the other hand, a higher HHI value (closer to 10,000) indicates that the market is more concentrated and less competitive as few firms dominate the market with larger market shares. In conclusion, the Herfindahl-Hirschman Index (HHI) is a valuable tool for measuring market concentration and competition. Calculating the HHI requires identifying the market shares of all firms, squaring each firm's market share, and summing the resulting values. A lower HHI value indicates a less concentrated and more competitive market, while a higher HHI value signifies a more concentrated and less competitive market.