ANSWER

The Herfindahl Hirschman Index (HHI) is a measurement used to understand the level of competition that exists within a market or industry, as well as give an indication of how the distribution of market share occurs across the companies included in the index.  Understanding the level of market competition can be important for strategic planning as well as when trying to establish pricing for a company’s products or services.  The calculation of the HHI differs from the standard Concentration Ratio in that it squares each market share value which places a higher importance on those top companies that have a larger market share.  The formula for determining the HHI is as follows:

HHI = MS₁² + MS₂²  + MS₃²  + MS₄² …+ MS_n²

The HHI can have a theoretical value ranging from close to zero to 10,000.  If there exists only a single market participant which has 100% of the market share the HHI would be 10,000.  If there were a great number of market participants with each company having a market share of almost 0% then the HHI could be close to zero. 

• When the HHI value is less than 100, the market is highly competitive.
• When the HHI value is between 100 and 1000, the market is said to be not concentrated.
• When the HHI value is between 1000 and 1800, the market is said to be moderately concentrated.
• When the HHI value is above 1800, the market is said to be highly concentrated.

These values are used by the Department of Justice when evaluating whether to permit a merger of two companies.

Using the HHI, we can quickly gain insight into the distribution of market share within an industry.  The example below demonstrates the additional information that can be gleaned from the HHI over the Concentration Ratio.

Example 1

Example 2

In this example, both industries have 15 companies that make up 100% of the market share.   In example 1, the industry has a more evenly distributed market share across the 15 companies, while example 2 shows a heavy concentration of market share among the top three companies.

If a business analyst were only to look at the difference in Concentration Ratios (accounting for the top 8 companies) between the two examples, they would see that the CR₈ of example 2 with a value of 92 is only 11 percent greater than the CR₈ of example 1 with a value of 83.  However, using the HHI they would find that the HHI of example 2 at 2381 is 259% greater than the HHI of example 1 at 920.

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Chris Adams
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