Question

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

Short answer

To calculate the Herfindahl-Hirshman Index (HHI), obtain the market shares of all firms in the industry, square each market share, and then sum the squared market shares. A low HHI value (generally below 1500 to 1800) indicates a more competitive and less concentrated market, signifying limited market power held by individual firms.

Step-by-step solution

Understand the Herfindahl-Hirshman Index

The Herfindahl-Hirshman Index (HHI) is a measure of market concentration, which is an indicator of the competitiveness of an industry. The HHI is the sum of the squares of the market shares of all firms within an industry. A higher HHI indicates less competition and a more concentrated market, while a lower HHI signifies a more competitive and less concentrated market.

Identify the market shares of all firms

The first step in calculating the HHI is to obtain the market shares (as a percentage) of all the firms in the industry. Market share is the proportion of sales that a particular firm has in relation to the total sales in the industry. You can compute the market share by dividing the firm's sales by total sales in the industry and then multiply by 100 to get the percentage.

Square the market shares

The second step is to square each firm's market share. This is done by simply multiplying each firm's market share by itself. For example, if a firm has a 20% market share, you would calculate \(20^2 = 400\).

Sum the squared market shares

The final step in calculating the HHI is to add up all the squared market shares of all firms in the industry. This sum will give you the HHI value. For example, if an industry consists of three firms with market shares of 50%, 30%, and 20%, the HHI can be computed as follows: HHI = \(50^2\) + \(30^2\) + \(20^2\) = 2500 + 900 + 400 = 3800

Interpreting a low HHI value

A low HHI value indicates that the market is less concentrated, and there is a higher degree of competition among firms. In such a market, the market power of individual firms is limited, and there is a higher likelihood of price competition and innovation. A low HHI value (closer to 0) means that the industry is more fragmented, with several small firms and no single firm dominating the market. While there is no strict threshold for what constitutes a low HHI value, an HHI value below 1500 to 1800 could be considered indicative of a competitive and less concentrated market. In summary, calculating the Herfindahl-Hirshman Index involves identifying market shares, squaring them, and summing the squared market shares to obtain the HHI value. A low HHI value reflects a more competitive and less concentrated market, with limited market power held by individual firms.

Key concepts

Market Concentration

Market concentration refers to how much of the market is dominated by a few firms. It’s an important aspect because it determines the level of competition within an industry. When a few firms hold a large portion of the market, this results in high concentration. Conversely, when many firms each have a smaller share of the market, concentration is low. The Herfindahl-Hirshman Index (HHI) is a popular method used to measure this concentration.

• A high HHI indicates a market dominated by a few firms.
• A low HHI suggests a competitive market with many firms holding smaller shares.

Understanding market concentration is crucial for businesses and regulators as it impacts consumer prices, the availability of choices, and innovation within the industry.
Marketers and policymakers often use measures like the HHI to ensure no single entity can unfairly control the market to the detriment of consumers.

Market Shares

Market shares represent the portion of total sales in a market captured by a specific company. Calculating market shares helps businesses and analysts understand which players hold the most power or influence in an industry. To find a company's market share:

• Divide the company's total sales by the total sales in the industry.
• Multiply by 100 to get a percentage.

This percentage tells how large or small a role a company plays relative to others. For calculating the Herfindahl-Hirshman Index, squaring each firm's market share before summing them provides insights into the market's overall concentration. Squaring emphasizes larger market shares and can show the effect of dominant firms more clearly.
Market shares are an informative tool in strategic planning and competition analysis.

Competition Measurement

Competition measurement refers to methods used to assess the level of competition in a market. An industry with a higher level of competition usually has better outcomes for consumers, such as lower prices and more innovation. The Herfindahl-Hirshman Index is a key tool in competition measurement because it simplifies understanding complex market dynamics by providing a single figure.

• An HHI close to zero indicates a highly competitive market.
• A high HHI shows less competition and a market controlled by fewer players.

These metrics are essential in regulatory settings to prevent monopolistic structures and ensure policies support fair competitive practices. They help determine whether mergers or acquisitions could potentially harm buyer choice and market health by reducing competition.
Careful competition measurement ensures markets thrive on fair competition, benefiting consumers and the economy alike.

Industry Competitiveness

Industry competitiveness is an indicator of how effectively firms within an industry compete against each other. A competitive industry typically features many different firms striving for market dominance, leading to benefits such as innovation, variety, and lower prices for consumers.
The level of competitiveness is often assessed using market concentration indices like the Herfindahl-Hirshman Index. An industry with a low HHI value demonstrates:

• High fragmentation
• Numerous small players
• No single firm dominating the market

This scenario encourages a vibrant competitive environment where companies constantly innovate to gain or maintain market share. By understanding industry competitiveness, both businesses and policymakers can make informed decisions that foster healthy growth and competition, ensuring long-term consumer benefits and economic vitality.