Herfindahl Index | How To Determine Industry Concentration

Determining the degree of industry concentration helps to identify monopolized markets. This degree of industry concentration is a way to identify how much of the industry’s output can be accounted for by the biggest companies in that market. It is measured and identified using the ‘four-firm concentration ratio’ and the ‘Herfindahl Index‘. The ‘four-firm concentration ratio’ is a percentage and is calculated by dividing the output of the four largest companies in an industry by the total output of that industry. If the four largest companies account for a percentage of 40 or more, then the market is considered to be an oligopoly. If it is less than 40%, the industry is most likely monopolistically competitive. The Herfindahl Index is the total of the market shares (squared) of all of the companies within an industry.

Advantageous to use the Herfindahl Index

It may be most advantageous to use the ‘Herfindahl Index’ as there are some disadvantages to using the concentration ratio formula in order to identify some monopolized industries. The concentration ratio accounts for the Country in it’s entirety but local monopolies on a smaller scale can also exist. A market can be saturated within town, city or state limits as well. It can also be difficult to identify exact industry standards as interindustry competition could also be taking place. This is competition between two products that come from two totally different industries. This normally accounts for advances in technology, where there are new, more advanced items that are replacing commonly accepted products. There can also be import competition which is the competition from products that are foreign. The concentration ratio only account for industries located within the U.S, however, foreign competition is growing every day. The ‘Herfindahl Index’ helps to fix all of these problems because it is the sum of the squared percentage of the market shares of all companies within the industry.

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