The Herfindahl index (HI), also known as the concentration index, measures industry concentration by summing the squared market shares of the firms in the industry. It is commonly used to support antitrust claims. The index can be large or small, but decreases are indicative of a loss in pricing power and/or increased competition while increases suggest the opposite. Most mergers must pass the scrutiny of the Herfindahl Index before being approved by the Department of Justice.
Review the definition of an index. According to Investorwords, an index is, "A statistical indicator providing a representation of the value of the securities which constitute it." In this particular case, we are looking at an index that serves as the barometer for the level of concentration a company has in a particular industry.
Define the variables for an example. Let's say the medical supplies industry comprises 5 firms with market shares as follows: Co 1 has 30% market share Co 2 has 30% market share Co 3 has 20% market share Co 4 has 15% market share Co 5 has 5% market share.
Calculate the Herfindahl Index for the medical supplies industry. The index is calculated as follows. (Company 1 market share)^2 + (Company 2 market share)^2 + (Company 3 market share)^2 + (Company 4 market share)^2 + (Company 5 market share)^2. The calculation looks like this: (0.30)^2+ (0.30)^2 + (0.20)^2 + (0.15)^2 + (0.05)^2 = 0.245.
Substitute the example variables into the equation. The calculation is: (0.30)^2+ (0.30)^2 + (0.20)^2 + (0.15)^2 + (0.05)^2 = 0.245.
Interpret the results. The Herfindahl index for the medical-supplies industry is 0.245. In general, a Herfindahl index below 0.1 signifies low concentration, while an index above 0.18 signifies high concentration. If all companies in an industry have equal market share, the reciprocal of the index is is equal to the number of companies in the industry.