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The U.S. Department of Justice considers a market with an HHI of less than 1,500 to be a
competitive marketplace, an HHI of 1,500 to 2,500 to be a moderately concentrated marketplace,
and an HHI of 2,500 or greater to be a highly concentrated marketplace. As a general rule,
mergers that increase the HHI by more than 200 points in highly concentrated markets raise
antitrust concerns, as they are assumed to enhance market power under the section 5.3 of the
Horizontal Merger Guidelines jointly issued by the department and the Federal Trade
Commission.
HHI = s1^2 + s2^2 + s3^2 + ... + sn^2 (where s is the market share of the each firm expressed as
a whole number, not a decimal)
HHI = 40^2 + 30^2 + 15^2 + 15^2 = 1,600 + 900 + 225 + 225 = 2,950
This is considered a highly concentrated industry, as expected since there are only four firms.
But the number of firms in an industry does not necessarily indicate anything about market
concentration, which is why calculating the HHI is important. For example, assume an industry
has 20 firms. Firm one has a market share of 48.59% and each of the 19 remaining firms have a
market share of 2.71% each. The HHI would exactly 2,500, indicating a highly concentrated
market. If firm number one had a market share of 35.82% and each of the remaining firms had
3.38% market share, the HHI would be exactly 1,500, indicating a competitive market place.
Formula
where si is the market share of firm i in the market, and N is the number of firms. Thus, in a
market with two firms that each have 50 percent market share, the Herfindahl index equals
0.502+0.502 = 1/2.
The Herfindahl Index (H) ranges from 1/N to one, where N is the number of firms in the market.
Equivalently, if percents are used as whole numbers, as in 75 instead of 0.75, the index can range
up to 1002, or 10,000.
A small index indicates a competitive industry with no dominant players. If all firms have an
equal share the reciprocal of the index shows the number of firms in the industry. When firms
have unequal shares, the reciprocal of the index indicates the "equivalent" number of firms in the
industry. Using case 2, we find that the market structure is equivalent to having 1.55521 firms of
the same size.
There is also a normalised Herfindahl index. Whereas the Herfindahl index ranges from 1/N to
one, the normalized Herfindahl index ranges from 0 to 1. It is computed as:
where again, N is the number of firms in the market, and H is the usual Herfindahl Index, as
above. Using the normed Herfindahl index, information about the total number of players (N) is
lost, as shown in the following example: Assume a market with two players and equally
distributed market share; H = 1/N = 1/2 = 0.5 and H* = 0. Now compare that to a situation with
three players and again an equally distributed market share; H = 1/N = 1/3 = 0.333..., note that
H* = 0 like the situation with two players. The market with three players is less concentrated, but
this is not obvious looking at just H*. Thus, the normalized Herfindahl index can serve as a
measure for the equality of distributions, but is less suitable for concentration.
For instance, we consider two cases in which the six largest firms produce 90% of the goods in a
market. In either case, we will assume that the remaining 10% of output is divided among 10
equally sized producers.
Case 2: The largest firm produces 80% and the next five largest firms produce 2% each.
The six-firm concentration ratio would equal 90% for both case 1 and case 2. But the first case
would promote significant competition, where the second case approaches monopoly. The
Herfindahl index for these two situations makes the lack of competition in the second case
strikingly clear:
Expressed as a formula, the CAR equals the sum of the banks tier one capital plus tier two
capital, divided by its risk-weighted assets.
A banks tier one capital is the ordinary capital of the bank. This capital can absorb bank losses
without the bank having to suspend trading.
Tier two capital is the banks subordinated debt. This is the capital that can absorb losses if the
bank has to shut down.
Risk weighted assets are calculated by looking at the bank's loans and evaluating their riskiness.
Each loan is assigned a percentage number. The higher the percentage, the riskier the loan. A
government loan gets a low percentage, often zero. Loans to individuals can go as high as 100%.
The risk percentage is multiplied against the loan amount, and then added to the other loan
amounts multiplied against their risk percentages.
Assume Big Bank has $2 million in tier one capital and $1 million in tier two capital. It also has
three loans and their assigned riskiness is as follows:
To calculate the CAR formula, first add the tier 1 and 2 capital:
$3 million / $32,000,000 =
Based on the formula, Big Banks CAR is 9.375%, just above the 8% threshold.