How do we measure a Herfindahl-Hirshman Index? What does a low measure mean about the extent of competition?

The Herfindahl-Hirshman Index (HHI) is a measure of market concentration, which is an indicator of the competitiveness of an industry. The HHI is the sum of the squares of the market shares of all firms within an industry. A higher HHI indicates less competition and a more concentrated market, while a lower HHI signifies a more competitive and less concentrated market.

The first step in calculating the HHI is to obtain the market shares (as a percentage) of all the firms in the industry. Market share is the proportion of sales that a particular firm has in relation to the total sales in the industry. You can compute the market share by dividing the firm's sales by total sales in the industry and then multiply by 100 to get the percentage.

The second step is to square each firm's market share. This is done by simply multiplying each firm's market share by itself. For example, if a firm has a 20% market share, you would calculate \(20^2 = 400\).

The final step in calculating the HHI is to add up all the squared market shares of all firms in the industry. This sum will give you the HHI value. For example, if an industry consists of three firms with market shares of 50%, 30%, and 20%, the HHI can be computed as follows: HHI = \(50^2\) + \(30^2\) + \(20^2\) = 2500 + 900 + 400 = 3800

A low HHI value indicates that the market is less concentrated, and there is a higher degree of competition among firms. In such a market, the market power of individual firms is limited, and there is a higher likelihood of price competition and innovation. A low HHI value (closer to 0) means that the industry is more fragmented, with several small firms and no single firm dominating the market. While there is no strict threshold for what constitutes a low HHI value, an HHI value below 1500 to 1800 could be considered indicative of a competitive and less concentrated market. In summary, calculating the Herfindahl-Hirshman Index involves identifying market shares, squaring them, and summing the squared market shares to obtain the HHI value. A low HHI value reflects a more competitive and less concentrated market, with limited market power held by individual firms.