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What Is The Herfindahl-Hirschman Index? Herfindahl-Hirschman Index In A Nuthell

The Herfindahl-Hirschman Index (HHI) is a measure of the market concentration of an industry. The index is used to determine market competitiveness and is sometimes before and after a merger or acquisition.

Understanding the Herfindahl-Hirschman Index

The Herfindahl-Hirschman Index was named after American economists Orris C. Herfindahl and Albert O. Hirschman. The index was originally invented by Hirschman in 1945. However, a similar model was proposed by Herfindahl in a 1950 doctoral dissertation on the steel industry while studying at Columbia University.

The Herfindahl-Hirschman Index measures the market concentration of an industry. In a highly concentrated industry, a few companies hold most of the market share with either of them able to form a monopoly. In an industry characterized by low concentration, many more firms of similar size hold an equally similar market share.

The index is also used to monitor the impact of mergers and acquisitions on an industry. Regulators can cite quantitative index data to veto any merger or acquisition they deem to be anti-competitive. By the same token, companies involved in the transaction can also use data to suggest the move would not lead to a monopolistic market.

Calculating the HHI

Calculating the HHI involves squaring each market share value to place more importance on the companies with more of the market. Each market share value is then summed.

The formula for determining the HHI is as follows:

HHI = MS1+ MS22 + MS3+ MS42 … + MSn2

The HHI value can fall anywhere between close to zero and 10,000. A value approaching zero might be possible when there are so many market players that their individual share of the market is very small. Conversely, a score near 10,000 would result in a market where one company had close to 100% market share.

The categorization of HHI values is somewhat subjective and many industry bodies use their own scale. With that said, here is the scale used by the U.S. Department of Justice when deciding whether to permit a merger between two companies:

  • Highly competitive – for values under 100.
  • Not concentrated – for values between 100 and 1000.
  • Moderately concentrated – for values between 1000 and 1800.
  • Highly concentrated – for values above 1800.

Limitations of the Herfindahl-Hirschman Index

Like concentration ratios, the Herfindahl-Hirschman Index is rather simplistic, lacks nuance, and may fail to properly account for market complexities. 

For example, an industry with six supermarkets taking 15% of the market share would appear to be non-monopolistic. Upon closer inspection, however, one supermarket has 85% of the online shopping market while another controls 90% of liquor sales. Since online shopping and liquor sales are part of the same retail industry, the results are inaccurate. The Herfindahl-Hirschman Index fails here because it does not consider the complex nature of markets. 

What’s more, the index does not account for the geographical scope of a market. Three logistics firms with 15% of the market each may occupy three different regions and thus not compete. Determining the scope of the market has, in some industries, been made more difficult by globalization.

Key takeaways:

  • The Herfindahl-Hirschman Index is a measure of the market concentration of an industry. The index is used to determine market competitiveness and is sometimes used before and after a merger or acquisition.
  • The Herfindahl-Hirschman Index is calculated by summing the square of the market share of each company in an industry. Scores near zero indicate many companies in a competitive environment, while scores near the maximum of 10,000 mean the market is dominated by a single company.
  • The Herfindahl-Hirschman Index lacks nuance, particularly in complex industries with many subsectors. Like concentration ratios, the HHI index also fails to account for the geographic scope of a market.

Connected frameworks to assess competitiveness of a market

Porter’s Generic Strategies

porters-generic-strategies
In his book, “Competitive Advantage,” in 1985, Porter conceptualized the concept of competitive advantage, by looking at two key aspects. Industry attractiveness, and the company’s strategic positioning. The latter, according to Porter, can be achieved either via cost leadership, differentiation, or focus.

Porter’s Value Chain Model

porters-value-chain-model
In his 1985 book Competitive Advantage, Porter explains that a value chain is a collection of processes that a company performs to create value for its consumers. As a result, he asserts that value chain analysis is directly linked to competitive advantage. Porter’s Value Chain Model is a strategic management tool developed by Harvard Business School professor Michael Porter. The tool analyses a company’s value chain – defined as the combination of processes that the company uses to make money.

Porter’s Diamond Model

porters-diamond-model
Porter’s Diamond Model is a diamond-shaped framework that explains why specific industries in a nation become internationally competitive while those in other nations do not. The model was first published in Michael Porter’s 1990 book The Competitive Advantage of Nations. This framework looks at the firm strategy, structure/rivalry, factor conditions, demand conditions, related and supporting industries.

Porter’s Four Corners Analysis

four-corners-analysis
Developed by American academic Michael Porter, the Four Corners Analysis helps a business understand its particular competitive landscape. The analysis is a form of competitive intelligence where a business determines its future strategy by assessing its competitors’ strategy, looking at four elements: drivers, current strategy, management assumptions, and capabilities.

Six Forces Models

six-forces-models
The Six Forces Model is a variation of Porter’s Five Forces. The sixth force, according to this model, is the complementary products. In short, the six forces model is an adaptation especially used in the tech business world to assess the change of the context, based on new market entrants and whether those can play out initially as complementary products and in the long-term substitutes.

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