It often can be difficult to gauge a particular market's concentration by simply looking at factors such as income, customers and locations. The Herfindahl-Hirschman Index is an equation that accurately measures market concentration among competitors. This is a popular tool not only for determining levels of concentration but also for proving the existence of monopolies and other unfair practices. Though this is a commonly accepted method, there still are many problems with its results.
For such a complex purpose, the Herfindahl-Hirschman Index has a surprisingly simple equation. In order to complete this calculation, market share must be determined for all companies involved. After market share is calculated, each organization's share percentage is squared and then all shares are added together. The resulting figure gives economists a concrete look at the concentration level of a given market.
An example of the Herfindahl-Hirschman Index in action would be taking four competing clothing stores, two with 30 percent market shares and two with 20 percent market shares. When these numbers are individually squared and added together, the resulting number is 2,600. This number on its own does not mean much, but financial experts use it as a snapshot of any given market.
The closer to zero the Herfindahl-Hirschman Index numbers are, the less concentrated a given market is. As the number of competing companies decreases, the resulting number increases. Markets between 1,000 and 1,800 are considered moderately concentrated. Anything higher than 1,800 is considered to be very concentrated.
The purpose of measuring a market's concentration lies in antitrust laws. The numbers generated by the Herfindahl-Hirschman Index are used in antitrust suits to prove one organization has a monopoly or is approaching that point. The index also is used in technology management and competition law to showcase the need for perfect competition and the near impossibility of that accomplishment.
The Herfindahl-Hirschman Index is used in many legal cases and economic studies, but it has received a fair amount of criticism. One of its weaknesses is the unrecognizable element of many markets. An example would be cinemas that can be compared to one another and look competitive but still could be suffering because of other options, such as cable television, Internet movies and video stores. Geographic scopes also are a tricky spot for narrowing down competition, especially in a global economy that has become more saturated by the Internet.