The competitiveness of any industry matters. One way to measure competitiveness is the Herfindahl Index, also known as the Herfindahl-Hirschman Index.
Competition Changes Market Outcomes
Consumers usually get a bad deal in “concentrated” markets. This is because markets with fewer significant players usually mean less competition. This matters to managers too. If you are considering entering a market less competition usually means higher profits. Most people think that they will perform better than any competitor, but most are wrong. Of course, you may be exceptional but without an excellent, objective, reason to think you are better than everyone else you should avoid entering industries with too much competition.
The benefits of free markets for consumers largely derive from the presence of competition. As such, economists and government agencies like to measure it. Lack of competition is a warning sign of problems for consumers. Anti-trust (anti-monopoly) agencies often use measures of how competitive an industry is. Probably the best-known measure is the Herfindahl-Hirschman index, also known as the Herfindahl Index, or simply the HHI.
Calculating The Herfindahl Index
The Herfindahl Index is calculated as the sum of the squares of market shares in the industry. So an industry with only one competitor has a score of 1 (i.e. 1^2 = 1). This can also be written as 100%^2 and so is known as 10,000 points. An industry with three players each with 1/3 of the market has a score of 1/3^2 + 1/3^2 + 1/3^2 = 3/9 = 1/3 or 3,333 points. (For more details see pages 38 and 39 of our book, Marketing Metrics). The higher the score the more concentrated the industry.
What Do Scores Show?
Scores are only an indicator. High scores don’t prove that there is no competition, while low scores don’t prove that competition exists. Generally, however, any industry with a high score generates a concern that consumers might not be getting a great deal. As the US Department of Justice (DOJ) Anti-Trust Division says:
The agencies generally consider markets in which the HHI is between 1,500 and 2,500 to be moderately concentrated and consider markets in which the HHI is in excess of 2,500 to be highly concentrated.
US DOJ ,2013
If a merger is likely to create high scores this makes it less likely to be allowed.
The Herfindahl Index is thus a useful way of measuring competition in an industry. Of course, you first must define the boundary of the industry but that is a whole other question.
For more on measuring competition see here.
Read: US Department of Justice, Antitrust Division Website, HERFINDAHL-HIRSCHMAN INDEX, http://www.justice.gov/atr/public/guidelines/hhi.html, Accessed May 14th 2013 (checked 11/1/2021)