Mergers and the Herfindahl-Hirschman Index (HHI) - Online Tutor, Practice Problems & Exam Prep

Mergers occur when two firms combine into one, categorized as horizontal or vertical. Horizontal mergers involve firms in the same industry, raising competition concerns, while vertical mergers occur between firms at different production stages. The Herfindahl-Hirschman Index (HHI) measures market concentration: an HHI below 1500 indicates low concentration, 1500-2500 is moderate, and above 2500 signals high concentration, prompting government scrutiny. The HHI is calculated by squaring each firm's market share and summing the results, reflecting market power and potential economic impacts.

Mergers and the HHI

Alright. So now let's dive a little deeper into the topic of mergers. Right? Mergers are when two separate firms combine into one firm, right? They're merging into one firm. So let's see some of the implications of that. Business mergers, right, result from firms merging into one. So there are two types of mergers. We're going to have horizontal mergers, and this is mergers between firms in the same industry, firms in the same industry. A good example, which actually happened a few years ago, is when AT&T and T-Mobile were trying to merge and they had to lobby to government to say that this wasn't going to reduce competition, right, and that they were actually merging because they were going to be able to supply a better product to the consumers. In the end, the government didn't buy it and didn't allow the merger, right, so they thought that the merger would have reduced competition too much and given them too much market power.

The other type of merger is a vertical merger. This is a merger between firms at different stages of production. A real-world example of this was when eBay bought PayPal. Initially, eBay would have the auction on their website, and then when the auction completed, they'd go to the PayPal website to complete the transaction. Well, eBay just cut out the middleman and bought out PayPal so that they didn't have to pay PayPal for whatever fees they had before. We're going to see that the government is more concerned with these horizontal mergers than vertical mergers. With a horizontal merger, that's one way you're going to see situations where there is less competition in the market.

Great, so we're going to discuss the Herfindahl Hirschman Index, alright? This is how the government decides whether a merger is going to be too much for the market, or if it should allow the merger. We're going to use what's called the HHI, which is an index here, to gauge concentration in an industry. So to calculate the HHI, we're going to take the market share of each firm and square it then add them all together. So, the market share of firm A squared, the market share of firm B squared, the market share of firm C. Market share is the share of the total market that the firm has. In a monopoly, the firm's revenue is equal to the total revenue. They're the only firm in the industry so they're going to have a 100% market share. When we do our HHI, we want to have a percentage, something like 20%. We're not going to treat it as 0.2; we're going to use the absolute number of the percent. So if someone had a 20% market share, we would calculate the HHI using 20 squared, not 0.2 squared.

So let's go ahead and first define what our HHI standards are going to be, like what it means once we get our HHIs, and then we'll do some examples of different HHIs in different industries. The first is an HHI below 1500. If the HHI comes out below 1500, we're going to say that it's not concentrated. That's a low HHI. Mergers at that point would be allowed because they don't think that would reduce competition. Next is like middle range, between 1501 and 2500, they're going to say it's moderately concentrated. Now the government might take a little more caution when allowing mergers. And then there are HHIs above 2500. If the market is highly concentrated, this is when the HHI is above 2500, now the government is going to be really cautious about allowing mergers to happen. Okay, let's see some examples of some HHIs. Actually, let's pause right here, and let's do the examples in the next video. Cool, let's start that now.

Calculate HHI in the following industries: 

One firm with 100% market share 

Two firms with 50% market share 

Four firms with market shares of 30%, 30%, 20%, and 20% 

Ten firms with 10% market share

Alright, so I've got a few different HHIs to calculate here. I'm going to calculate the first one with you, and then I want you to pause the video after each one, solve it yourself, and then continue the video and make sure that you got it correct. Okay. So let's start here with one firm with a 100 percent market share. So the HHI, remember we're going to take the market share and square it, right? We square the market share to find the HHI. Since there's only one firm in this example, we're going to take their market share and square it. If there were more firms, we would then take their market share and square it, right? But this one has all of the market share already, so this is going to be all we have to do. One firm with a 100% market share, this is the maximum that the HHI could be. 10,000 is the highest HHI, right? Because you couldn't have more than a 100% market share. Cool? Alright, why don't you guys pause the video real quick and try the second one, two firms with 50% market share. Alright, so I'm going to guess that you guys paused the video and now we're restarting it here. So let's go ahead and solve it. Now we've got two firms with 50% market share. Well now our HHI, right, we're going to take the market share of the first firm, 50% and square it. Then we're going to add the market share of the second firm, 50% and we square it. Right? So 502, 502 is 2,500. We add those together and we're going to get 5,000 as our HHI in this second example, right? So we're still highly concentrated, right? We're still above that threshold of 2,500. That tells us we're highly concentrated, and it makes sense, right? There are two firms here and they each have 50% market share. So you'd imagine they still have a lot of market power. Alright, go ahead and pause again and try this next example with four firms. I'm really trying to make sure you guys pause here. Alright, so let's try the next one. Four firms, each with a market share and square it, right? We're going to have 302 plus 302 plus 202 plus 202. Right? This is going to give us the HHI. So we're going to add each of them squared. So 302 is 900, 302 is another 900, and 202 is 400, and again 400. Right? So if we add these together, 900 plus 900 plus 400 plus 400, that's going to give us an HHI of 2,600. Cool? So we're still above that threshold, right? That high concentration threshold, and that's because there's still very few firms in the market, right? So you can imagine if some of these firms were to merge together, that HHI would skyrocket, right? So let's try this last one. Ten firms with 10% market share. Go ahead and pause and try to solve it, and then let's continue. Alright, so let's go ahead and solve that problem now. So we're going to have an HHI of 102 plus 102 plus 102. Right? This is going to happen 10 times. 102 plus 102 plus 102, right? 10 times. That could be pretty tedious to write that out, right? But if you think about it, they each have the same market share of 10, right? So 102 is 100, right? And that's going to happen 10 times, right? So each one has 100, so it's going to be 100 plus 100 plus 100 plus 100, 10 times, right? So it's going to be 100 times 10, and we're going to get an HHI here of 1,000, alright? So there we go. Finally, 1,000; we've reached some sort of situation where it's no longer highly concentrated, right? A thousand that's below our low threshold of low concentration, so there are a lot of firms here, 10 different firms, all with not a huge market share, right? Just a 10% market share, and we get a lower HHI. Cool. So that's how we solve these here. Let's go ahead and move on to the next video.

The HHI for this industry is: 

• A. 2,704
• B. 4,439
• C. 100,000
• D. 3,688

The monkey smoking a cigar industry is: 

• A. Not concentrated
• B. Moderately concentrated
• C. Highly concentrated
• D. Not enough information

The HHI for this industry is: 

• A. 100
• B. 1,000
• C. 1,600
• D. 3,000

Here’s what students ask on this topic:

What is the Herfindahl-Hirschman Index (HHI) and how is it calculated?

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration used to determine the level of competition within an industry. It is calculated by squaring the market share of each firm in the industry and then summing the results. The formula is:

${\mathrm{HHI}}_{}=\sum _{i=1}^n{s}^2$

where $s$ is the market share of firm $i$ and $n$ is the total number of firms. An HHI below 1500 indicates low concentration, 1500-2500 indicates moderate concentration, and above 2500 indicates high concentration.

What are the differences between horizontal and vertical mergers?

Horizontal mergers occur between firms in the same industry, often raising concerns about reduced competition and increased market power. An example is the attempted merger between AT&T and T-Mobile. Vertical mergers, on the other hand, involve firms at different stages of production. These mergers are generally less concerning to regulators. An example is eBay's acquisition of PayPal, which integrated payment processing into its auction platform. Horizontal mergers are scrutinized more heavily due to their potential to significantly alter market dynamics.

Why does the government use the HHI to evaluate mergers?

The government uses the Herfindahl-Hirschman Index (HHI) to evaluate mergers because it provides a quantitative measure of market concentration. By assessing the HHI, regulators can determine whether a merger will significantly reduce competition and increase market power. An HHI below 1500 suggests low concentration and likely approval, 1500-2500 indicates moderate concentration requiring caution, and above 2500 signals high concentration, warranting stringent scrutiny. This helps ensure that mergers do not harm consumer welfare by creating monopolistic or oligopolistic market conditions.

What is considered a highly concentrated market according to the HHI?

A highly concentrated market according to the Herfindahl-Hirschman Index (HHI) is one with an HHI above 2500. In such markets, a few firms hold significant market power, which can reduce competition and potentially lead to higher prices and lower quality for consumers. When the HHI exceeds 2500, the government is likely to scrutinize mergers more closely to prevent further concentration and protect consumer interests.

How do horizontal mergers impact market competition?

Horizontal mergers impact market competition by potentially reducing the number of competitors within the same industry. This can lead to increased market power for the merged entity, allowing it to influence prices, output, and innovation. Reduced competition can result in higher prices and fewer choices for consumers. Consequently, horizontal mergers are subject to rigorous scrutiny by regulators to ensure they do not harm consumer welfare or create monopolistic conditions.