The Herfindahl Hirschman Index (HHI) is used to measure company market share concentration within an industry. It gives government regulators an unbiased, objective guideline for comparing different businesses. Here is how to calculate the Herfindahl Hirschman Index.
"Index Used for Measuring Industry Concentration"
Capitalism cannot work if there is too much of a concentration or monopoly in one industry. The concepts of supply and demand require perfect competition between a number of firms with similar market shares. When one corporation dominates a field, it begins to exert excessive control by increasing prices, reducing innovative and allowing for lower customer service.
After the Civil War, the northern robber barons were able to concentrate the control over large amounts of the oil, steel and railroad industries in the hands of the very few. In 1890, the Sherman Antitrust Law was passed to deal with these unfair anti-competitive practices. The Sherman Antitrust Law was used to break up monopolies, including the Bell telephone system in order to spur creativity and lower prices.
"Herfindahl Hirschman Index Calculation"
Orris C. Herfindahl and Albert O. Hirschman created the Herfindahl Hirschman Index as an objective, mathematical reference point to determine if a single corporation dominated its industry. The Herfindahl Hirschman Index is created by adding the squares of the 50 largest (or all the largest if the industry is small) corporation's market shares for an industry. This can be done using either a fraction or a percentage.
Government regulators consider the HHI's scale of 0 to 10,000 basis points (0.00 to 1.00%). Every nation has its own threshold, the United States uses 0.25 (2,500 points) while the European Union uses 0.142 (1,420 points). Any firm with a market share above this threshold would be considered to be anti-competitive or monopolistic.
When firms submit merger or acquisition proposals to the United States or European Union government regulators, this index can be used to determine if the resulting combination would have too high of a concentration of market share power. These regulatory authorities can objectively reject anti-competitive combinations by referring to the HHI.
Nations have permitted state-sponsored monopolies, such as the Dutch East India Company or Ma Bell to develop unproven technologies. When that market becomes mature, increased competition permits diversification, innovation and lower prices. The HHI can be used to assist with this economic transition.