Herfindahl-Type Index as a Measure of Industrial Concentration - Essay Example

The ‘n’ firm concentration ratio is calculated as the percentage of the share of the market captured by the ‘n’ largest firms in the industry. So, it can be expressed as

CRn = S1 + S2 + S3 +  ... + Sn; Si = market share of the ‘i’th firm

The Herfindahl index is conceptually similar. There are two main differences between the Herfindahl index with the concentration ratio. The Herfindahl index uses all the firm's market shares rather than using any particular number of the largest firms and furthermore, it uses the squares of the values of the market shares to compute the extent of concentration. So, if we assume N firms in the industry, the Herfindahl index looks like this:

HI = s12 + s22 + s32 +  ... + sN2

To identify the relative advantages of the Herfindahl-type index it is pertinent to note the desirable properties such competitiveness indices should exhibit. First, any competitiveness index should exhibit a decreasing trend with a rising number of firms. This is simply a reflection of the fact that as the number of firms increases the competitiveness rises and hence any index that captures the extent of concentration in the industry should reduce in value (Tirole, 1988). Secondly, any index of concentration should also be non-increasing if not declining with an increase in the extent of symmetry in the market shares of the associated firms (Tirole, 1988). Thus, having perceived the basic features any adequate index of concentration should have, we now proceed to comparatively analyze the two aforementioned measures to the extent they meet up to these requirements.

Evidently, the concentration ratio, as well as the Herfindahl index both, satisfies the first requirement. Both of the indices shall exhibit declining trends as the number of firms starts rising since the individual market shares as a percentage of the total market output shall fall. However, the concentration ratio fails to satisfy the second requirement. If there was a redistribution of market shares among the considered firms with some of them gaining higher market shares while that of the others falling so that the total market share of these firms taken together remained the same, the concentration ratio would not change. However, in the Herfindahl index, the squared values of the individual market shares are taken which leads to higher weights being accorded to the larger firms. As a result, the alteration in market shares would be reflected in the Herfindahl index (Shy, 1995). So, the Herfindahl index satisfies the second requirement as well. So we find the Herfindahl index to be better in this regard as it is able to accord higher weights to the larger firms thereby internalizing the effects of alterations in the distribution of market shares across the largest firms.

Finally, to conclude one should also note that another obvious advantage of the Herfindahl-type index lies in the fact that it considers all the firms in the industry and is therefore armed with a greater coverage implying greater veracity in the reflections made by this measure as compared to the concentration ratio which by definition is to consider the market shares of the largest n number of firms. Though this criticism can be negated if n = the total number of firms in the industry, the concentration ratio will still not be able to fulfill the second requirement of being responsive to changes in the extent of symmetry within the considered firms.