Herfindahl-Hirschman Index (HHI)

Economic area – Real economy

Herfindahl-Hirschman Index (HHI)

Theory

The Herfindahl-Hirschman index (HHI) is one of the most commonly used mechanisms for determining market competitiveness.

It is based on the relative distribution of company importance in the market under consideration. It approaches 0 (zero) when the market is occupied by a large number of companies of relatively equal size, and reaches its maximum of 10.000 points when the market is controlled by a single firm. It is calculated according to the formula:

HHI = Σ (si²)

Si – market share of company "i" on the given market

Competitiveness assessment is most often formed according to the following principles:

If the HHI is less than 1.500 points, the market is considered competitive;
If the HHI is between 1.500 and 2.500 points, the market is moderately competitive;
If the HHI is over 2.500 points, the market is highly concentrated and competition is lower due to the strong market share of a few companies.

Depending on the type of market, market activities, M&A activities and the like, characteristic scenario of index movement can be:

HHI increases as the number of companies in the market decreases;
The HHI increases when there is a gap between a large number of small players and a smaller number of large market players, which is why it is often combined with the concentration indicator of the top 5 or top 10 companies.

Interesting stories

The creators of the HHI index are German economists Albert Hirschman (Albert O. Hirschman 1915 – 2012) and American economist Oris Herfindahl (Orris C. Herfindahl 1918 – 1972) who, in just a few years of difference, laid the foundations of the analysis on the measurement of market concentration. First, in 1945, Hirschman proposed that when measuring concentration, those firms with a larger market share should be given a greater weight because they have a greater influence on the competition and market competition settings. Then, in 1950, the theory was developed by Herfindahl in his doctoral dissertation and analysis of concentration in the American steel industry.

Anti-fascist struggle and saving lives - Albert Hirschmann, born into a Jewish family in Berlin, had to leave Germany at the age of 18, where Nazism was growing strongly. He was dedicated to the fight against Nazism by volunteering against Franco's government in the Spanish Civil War, but also as one of the organizers of a network for the escape of refugees from occupied France.

Theory of behavior of individuals and groups - Throughout his career, Hirschman was always a "challenger" to the makers of macroprudential measures and questioned conventional approaches in creating economic order and progress. He believed that the focus should be on an environment that encourages gradual improvement and economic growth, rather than big and one-size-fits-all solutions. In his best-known work, "Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations, and States." (“Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States,”), precisely explains the behavior of individuals and groups through the fact that they have 3 choices in front of them - to exit/leave the company, to use their 'voice' for change or to demonstrate loyalty by staying and working to improve the company's work.

Focus on natural resources, result in economy - Oris Herfindahl spent a good part of his career focused on finding ways to optimally use natural resources for ecological purposes. The focus of his doctoral dissertation at Columbia University was on the analysis of the steel industry in the USA, which after the global war and the reconstruction of the economy, represented the flywheel of the American economy and growth. Through his work, he proposed a metric for measuring market concentration in the steel industry with the aim of optimizing operations and long-term sustainability of that economic branch.

Love for the mountains - Herfindal was a passionate mountaineer with valuable achievements in conquered peaks. He traveled and was part of expeditions that conquered the mountain peaks of North America and Asia. It was during one of his trips to Nepal in 1972 that he died.

And where are we and how can we recognize theory in practice

The HHI index is one of the most commonly used measures that economists and antitrust bodies use when analyzing competition in a certain market.

Despite being a simple measure and calculation, antitrust agencies around the world, including the US Department of Justice, use the HHI as a starting point in analyzing market concentration – whether it is near monopoly or highly competitive.

Also, the index plays a key role in evaluating potential merger and acquisition transactions. If, during certain M&As, the HHI is expected to increase by more than 200 points, additional measures and analyzes are carried out in order to prevent the appearance of monopolistic behavior on the market.

When we have only a few market participants - for example in the field of mobile telephony in Serbia - it is natural that the HHI index will be over 3.000 and that three participants will determine the price of the service and that the market competition will not be in favor of small consumers. On the other hand, in the retail sector, every entry of a new market player brings a drop in the HHI index, increasing competitiveness and, consequently, prices. The entry of the German retail chain Lidl is the best indicator of this economic theory in practice.

Sources and further reading

"Macroeconomics: European textbook" Michael Burda and Charles Wiplosh, 2001, translated by Professor Danica Popović in 2004.
"Economic Dictionary", University of Belgrade, Faculty of Economics, Belgrade 2001
US Department of Justice website; https://www.justice.gov/atr/herfindahl-hirschman-index
publicly available relevant sources on Albert Hirschman and Oris Herfindahl