In the textbook, I came across a little section talking about the Herfindahl index, which is used to determine market competitiveness. It measures market concentration by adding together the square of each firm’s market share. This index can range from 0 to 10,000.
HHI = (%S1)2 + (%S2)2 + (%S3)2 + (%S4)2 + … (%Sn)2
The higher the HHI value indicates the less competitive a market is (more like a monopoly). So, when HHI = 0, the market is perfectly competitive and when HHI = 10,000, the market is a pure monopoly. The U.S. Department of Justice considers any market with an HHI of less than 1,500 to be competitive, between 1,500 to 2,500 to be moderately concentrated, and higher than 2,500 to be highly concentrated.
For example, let’s say there’s an industry with four firms in total.
Firm one has a 10% market share.
Firm two has a 20% market share.
Firm three has a 40% market share.
Firm four has a 30% market share.
So the HHI = (10)2 + (20)2 + (40)2 + (30)2 = 3,000
Without doing the calculation for the HHI, we would assume that this is a highly concentrated industry because there are only four firms (which in this case is correct, the HHI >2,500 so it is highly concentrated). However, the number of firms doesn’t necessarily indicate market concentration which is why doing the HHI is very important. If we had an industry with 10 firms, one with 49.8% market share, and the rest each have 5.7% market share, the HHI = 2,770, indicating a highly concentrated industry.
Don’t assume that an industry is competitive just because it has many firms, remember to calculate your HHI!
The Herfindahl index also helps identify how the relationship between employer diversity and employee freedom to negotiate wages manifests in different parts of the US. According to Bloomberg, the majority of US commuting zones, which contribute to 17% of employment, have Herfindahl indices that are greater than 2,500. The areas are highly concentrated in terms of companies, leaving workers with few options. This contributes to a cycle in which the economy has grown significantly over the past decade, but worker wages haven't changed to the same extent. Employers are thus able to limit the wages of their employees, even with higher minimum wage laws.
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