What is the Herfindahl Index?
How Does the Herfindahl Index Work?
The Herfindahl Index formula is calculated by squaring the market share for each firm (up to 50 firms) and then summing the squares.
Here's an example:
Let's say there are four grocery stores in your town: Albert's, Bob's, Carl's and Donald's. Market share is broken down as follows:
HHI = 502 + 252 + 152 + 102 = 3,450
In a perfectly competitive market, HHI approaches zero. Let's say there are thousands of restaurants in your city, but the top 50 each have 0.1% of the market share. The HHI is 0.12 x 50 = 0.5.
In a monopoly, HHI approaches 10,000. If the one largest firm has 100% of the market share, HHI = 1002 = 10,000.
Why Does the Herfindahl Index Matter?
Most analysts do some sort of industry analysis to understand where a particular company's source of growth and competitive advantage comes from, and competition structure is one of the main components of industry analysis. For example, if a company exists in a highly competitive industry, it will be more difficult for it to maintain above-average profit margins in the future, even if it has above-average profit margins today.
Furthermore, the Justice Department uses the Herfindahl Index to decide whether a merger is good for competition in the marketplace. A market with an HHI under 1,000 is considered competitive. The Justice Department is likely to scrutinize a merger in an industry with a post-merger HHI of between 1,000 and 1,800, and it is almost certain to outright reject approval for mergers that result in a post-merger HHI exceeding 1,800.