What is the Herfindahl-Hirschman Index (HHI)?
The Herfindahl-Hirschman Index is an index that measures the market concentration of a certain industry. A highly concentrated industry would mean a high degree of concentration, whereby 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 would mean that the industry is closer to a perfect competition scenario, whereby there are many firms of more or less equal size that 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, or that companies can include in their M&A proposals to indicate that the merger would not lead to a monopolistic market. The lower an HHI is, the more power consumers hold in that industry. Thus, prices would be lower, and company margins would be 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 all companies hold in the given industry
Herfindahl-Hirschman Index Scale
The HHI 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, which would lead to an HHI of 10,000. 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, an HHI of more than 2,500 represents 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 would be subject to greater scrutiny, and the deal makers would need to prove that the merger did not make the industry excessively shift towards a monopolistic scenario.
Consider an American industry comprising 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. In such cases, the industry would be considered to be highly concentrated, and consumers would likely face artificially higher prices.
It is also important to note that in the calculation of the squares, the whole number version of the percentages is used. For instance, Firm A’s contribution to HHI is 1,225 which is the square of 35, not the square of 0.35.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: