Herfindahl Index - Example

Example

For instance, two cases in which the six largest firms produce 90% of the goods in a market:

• Case 1: All six firms produce 15% each, and
• Case 2: One firm produces 80% while the five others produce 2% each.

We will assume that the remaining 10% of output is divided among 10 equally sized producers.

The six-firm concentration ratio would equal 90% for both case 1 and case 2. But the first case would promote significant competition, where the second case approaches monopoly. The Herfindahl index for these two situations makes the lack of competition in the second case strikingly clear:

• Case 1: Herfindahl index = 6 * 0.152 + 10 * 0.012 = 0.136 (13.6%)
• Case 2: Herfindahl index = 0.802 + 5 * 0.022 + 10 * 0.012 = 0.643 (64.3%)

This behavior rests in the fact that the market shares are squared prior to being summed, giving additional weight to firms with larger size.

The index involves taking the market share of the respective market competitors, squaring it, and adding them together (e.g. in the market for X, company A has 30%, B, C, D, E and F have 10% each and G through to Z have 1% each). If the resulting figure is above a certain threshold then economists consider the market to have a high concentration (e.g. market X's concentration is 0.142 or 14.2%). This threshold is considered to be 0.25 in the U.S., while the EU prefers to focus on the level of change, for instance that concern is raised if there is a 0.025 change when the index already shows a concentration of 0.1. So to take the example, if in market X company B (with 10% market share) suddenly bought out the shares of company C (with 10% also) then this new market concentration would make the index jump to 0.162. Here it can be seen that it would not be relevant for merger law in the U.S. (being under 0.18) or in the EU (because there is not a change over 0.025).