Mergers and the Herfindahl-Hirschman Index (HHI): Videos & Practice Problems

The Herfindahl-Hirschman Index (HHI) is a measure used to determine market concentration and competition within an industry. It is calculated by summing the squares of the market shares of all firms in the market. Market share is expressed as a percentage, and the formula is given by: $\mathrm{HHI}=\sum _{\mathrm{i=1}}^n{S}^2$, where $S$ is the market share of firm $i$ in percent. For example, if a firm has 20% market share, you square 20 (not 0.2) to get 400. The HHI helps regulators assess whether a merger would reduce competition by increasing market concentration.

Horizontal mergers occur between firms operating in the same industry, combining competitors into one entity. An example is the attempted merger between AT&T and T-Mobile, which raised concerns about reduced competition. Vertical mergers happen between firms at different stages of production or supply chain integration, such as eBay acquiring PayPal to streamline payment processing. Governments tend to scrutinize horizontal mergers more closely because they can significantly reduce competition, while vertical mergers are generally less concerning as they often improve efficiency without eliminating competitors.

The government uses the Herfindahl-Hirschman Index (HHI) to evaluate the potential impact of mergers on market competition. The HHI thresholds are: below 1500 indicates a low concentration market where mergers are usually allowed; between 1500 and 2500 indicates moderate concentration, prompting more careful review; and above 2500 indicates high concentration, where mergers are scrutinized heavily or often blocked. If a merger significantly increases the HHI in a highly concentrated market, it suggests reduced competition and potential market power abuse, leading regulators to possibly reject the merger.

Horizontal mergers combine firms that directly compete in the same industry, which can reduce the number of competitors and increase market concentration. This often leads to higher prices, less innovation, and reduced choices for consumers. Vertical mergers, on the other hand, involve firms at different production stages, such as a manufacturer merging with a supplier. These mergers typically improve efficiency and coordination without eliminating direct competition. Therefore, regulators focus more on horizontal mergers because they pose a greater risk of harming competitive market dynamics.

An HHI score above 2500 indicates a highly concentrated market. This means that a few firms hold a large portion of the market share, which can lead to significant market power. In such markets, mergers are closely scrutinized because they may further reduce competition, potentially leading to monopolistic behavior, higher prices, and fewer choices for consumers. Regulators often impose restrictions or block mergers that would increase the HHI beyond this threshold to maintain competitive markets.