The Herfindahl-Hirschman Index is an index that measures the market concentration of an industry. A highly concentrated industry is one where only a few players in the industry hold a large percentage of the market share, leading to a near-monopolistic situation. A low degree of concentration means that the industry is closer to a perfect competition scenario, where many firms of more or less equal size share the market.
The Herfindahl-Hirschman Index is used to monitor the potential impact of mergers and acquisitions on an industry. It is a quantitative measure that regulators can cite to veto an M&A transaction. Conversely, companies can include the index in their M&A proposals to indicate that the merger would not lead to a monopolistic market. The lower the HHI is, the more power consumers hold in that industry. Thus, prices are usually lower, and company margins compressed.
How is the Herfindahl-Hirschman Index (HHI) Calculated?
To calculate the Herfindahl-Hirschman Index, we take the percentage market share of each firm in an industry, square that number, and then add all the squares together. The formula to calculate Herfindahl-Hirschman Index is as follows:
S1, S2, etc… – refers to the percentage market share that various companies hold in the given industry
Herfindahl-Hirschman Index Scale
The Herfindahl-Hirschman Index ranges from 1 (least concentrated) to 10,000 (most concentrated). The 10,000 figure comes from a theoretical scenario where there is only one company operating in the industry, with 100% of the market share. According to the U.S. Department of Justice, an HHI of less than 1,500 represents an industry with low market concentration. An HHI ranging between 1,500 and 2,500 represents moderate concentration. HHI values of more than 2,500 represent a highly concentrated industry. The graphic below illustrates this classification:
The U.S. Department of Justice also maintains a general rule of thumb that if an M&A transaction is projected to raise an industry’s HHI by more than 200 points, there could be legitimate concerns that the transaction might breach certain antitrust laws. Thus, such transactions are subject to greater scrutiny. The deal makers would need to offer evidence that the merger would not make the industry excessively shift towards a monopolistic scenario.
Herfindahl-Hirschman Index Example
Consider an American industry comprised of eight firms, with market shares of 35%, 20%, 6%, 4%, 3%, 10%, 13%, and 9%, respectively. The government wants to assess the degree of concentration of the industry.
In the table above, we see that the HHI of the industry in question is 2,036, which classifies it as a moderately concentrated industry. Further M&As led by Firm A could potentially raise the HHI by more than 200 points and even push the index to over 2,500.
It is also important to note that in the calculation of the squares, the whole number version of the percentages is used. For example, Firm A’s contribution to HHI is 1,225, which is the square of 35, not the square of 0.35.
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