Herfindahl Index (Herfindahl-Hirschman Index)

The Herfindahl Index, also referred to as the Herfindahl- Hirschman Index, is a measure of MARKET CONCENTRATION, the degree to which a few firms control the pricing and output in a market. In perfectly competitive markets there are many firms, and no one firm is large enough to influence the market outcome. In a MONOPOLY, however, there is only one firm, and its actions determine the market outcome. Herfindahl Indices are most often associated with oligopolies, markets where there are only a few competitors. A market’s Herfindahl Index is the sum of the squares of the market shares of each firm in the industry. For example, if there are only four firms in a market and two firms each have 30 percent of market sales, and the other two firms each have 20 percent of market sales, then the Herfindahl Index is:

302 + 302 + 202 + 202 = 2600

This market would be considered highly concentrated by the antitrust division of the U.S. Justice Department, which considers any market with a Herfindahl Index of less than 1800 to be competitive. When deciding whether to allow the merger or acquisition of companies, the Justice Department calculates the Herfindahl Index that would result if the merger or acquisition. One of the problems is defining the market in question. For example, the main competitors in the U.S. retail telecommunications market are the three large telephone companies AT&T;, MCI, and Sprint, but consumers also use cellular phones and the INTERNET to communicate. If only these three large telephone companies are used to calculate the Herfindahl Index, it will be much higher than if the market is defined more broadly. Before the development of the Herfindahl Index, the traditional measure of market concentration was the fourfirm concentration ratio. This index was created by adding the market shares (percentage of market sales) of the four largest firms in the industry, a measurement that did not account for the size distribution of firms in the market.
See also OLIGOPOLY.