What it means
Market concentration matters because it affects competition. When a few firms control most sales, they can often raise prices, cut quality or ignore customers more easily than firms facing many rivals.
Counting competitors is not enough, because ten firms may exist but one may hold most of the market. The HHI deals with this by giving larger shares more weight.
Squaring each market share, expressed as a percentage, means that a 50% player contributes 2,500 points while a 10% player contributes only 100. The index ranges from close to zero for a market with very many tiny competitors to 10,000 for a pure monopoly.
Competition authorities use the HHI in merger reviews. They calculate the index before and after a proposed merger, and the increase equals twice the product of the two merging firms' shares.
Regulators publish thresholds that separate unconcentrated, moderately concentrated and highly concentrated markets, but those thresholds have changed over time, so check the current guidelines. Businesses use the measure too.
A strategy team can compare concentration across industries, a bank can assess lending exposure to a concentrated sector, and an investor can judge whether a leading company has pricing power. A supplier selling into a highly concentrated customer base should also expect strong bargaining pressure from buyers.
The index is only as good as the way the market is defined. A narrow definition, such as premium coffee in one city, can show high concentration, while a wide definition, such as all drinks nationwide, shows little.
It also ignores factors such as entry barriers, imports and the strength of potential rivals. Analysts sometimes use the reciprocal of the HHI, 10,000 divided by the index, to find the number of equal-sized firms that would give the same concentration.
An HHI of 2,500 is equivalent to four equal firms, which is a more intuitive picture than the raw score. The figure helps boards explain concentration to people who do not work with the index.
In practice
Real-world examples.
Example
A competition authority reviews a proposed merger between two regional grocery chains. It calculates the HHI before and after the deal in each local area and requires the sale of stores where concentration would rise sharply.
Example
A bank's risk team calculates the HHI of its loan book by industry. It finds that 55% of lending sits in one sector, which gives a high concentration score and prompts a limit on new loans there.
Example
A software start-up studies its target industry before entering. Seeing that the top three vendors hold 85% of sales, it decides to focus on a niche that the big firms ignore instead of competing head on.
Formula
Calculation
HHI = (share of firm 1)^2 + (share of firm 2)^2 + ... + (share of firm n)^2, with shares in percentages
Suppose four firms hold 40%, 30%, 20% and 10% of a market.
Firm 1: 40 x 40 = 1,600.
Firm 2: 30 x 30 = 900.
Firm 3: 20 x 20 = 400.
Firm 4: 10 x 10 = 100.
HHI = 1,600 + 900 + 400 + 100 = 3,000.
Now suppose the 20% firm and the 10% firm merge into a 30% firm. The new HHI = 1,600 + 900 + 900 = 3,400. The increase is 3,400 - 3,000 = 400, which matches twice the product of the two shares, 2 x 20 x 10 = 400.Case study
Seen in the real world.
Brackenridge Cement is a fictional producer in a market with four firms holding 35%, 25%, 20% and 15% shares, plus a small fifth player on 5%. Brackenridge holds the 20% share, and its board proposed buying the 15% competitor, so the finance team calculated the HHI before and after to test the regulatory risk.
Before the deal the index was 1,225 + 625 + 400 + 225 + 25 = 2,500. After the merger the combined firm would hold 35%, giving 1,225 + 625 + 1,225 + 25 = 3,100, an increase of 600, which equals 2 x 20 x 15. In this illustrative case the team concluded that the deal would probably draw a detailed regulatory review, so the board budgeted for a longer approval timetable and prepared to sell a plant if required.
Watch out
Common mistakes.
- Using decimal shares such as 0.40 in one place and percentages such as 40 in another, which produces numbers that cannot be compared.
- Defining the market too widely or too narrowly, which can hide or exaggerate concentration.
- Treating a high HHI as proof of anti-competitive behaviour, when it is only an indicator and other factors matter.
Questions
People also ask.
What is a good HHI?
There is no single answer; lower values mean more competition, and regulators set their own thresholds, which change over time.
What is the maximum HHI?
It is 10,000, which occurs when one firm holds 100% of the market.
How does the index change in a merger?
It rises by twice the product of the merging firms' market shares, so combining two large firms raises it the most.
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