Herfindahl-Hirschman Index or HHI, is a commonly used metric for measuring market concentration.
It is calculated by squaring the market share of each firm competing in the market and then summing the resulting [tweetmeme source=”pricingright”]numbers. For example, for a market consisting of four firms with shares of thirty, thirty, twenty and twenty percent, the HHI is 2600 (302 + 302 + 202 + 202 = 2600).
It serves as a quick reading to see whether the market has few big players or many small players based on their percentage market share. It is based on an observable and easily measurable metric – market share.
It may help the Justice Department, but is this relevant or actionable? Does it say anything about relative success of each player? The problem is reinforces the focus on market share and the almost monomaniacal drive to increase one’s market share.
What would be relevant is a measure of profit concentration of a market. Why isn’t there such a metric? That is because while it is simple and straightforward to compute market share, there isn’t a way to compute the profit share. One way would be to add up the profits of each market player, compute their respective share of the pool and compute an index like HHI. It says something about current pricing and operational efficiency but it says nothing about what is the potential total profit in the market.
What is needed is a way to measure the total possible profit in a market and how it is expected to change. Then a HHI like metric like show who is profit maximizing and who is not.
There isn’t a HHI like metric for market profits because, to repurpose Ford’s statement on costs,
“Profit is always a computed number. Anyone can compute what it is but no one can say what it ought to be”.