This is the third entry in the “Antitrust Basics” series. See below for previous posts.
Market concentration is the most common reason for antitrust intervention. If a company has too large a market share, it can abuse that market power to raise prices, restrict output, and engage in all manner of anti-competitive business practices. A merger that would create a dominant player or significantly reduce the number of competitors is likely to be blocked. But how should market concentration be measured? Should it be by number of firms? Or by how much market share the biggest players control?
The Herfindahl-Hirschman Index (HHI) accounts for both factors. It also gives analysts a single numerical score they can work with, ranging from 0 to 10,000. It is also easy to calculate; the Justice Department shares the HHI formula here. A market with a large number of companies, in which each has an equally small market share, will have a low score. A market with few companies and one dominant player will have a high score.
For example, imagine two different markets, each with four companies. In one case, each company has an equal 25 percent market share. This market has an HHI score of 2,500. In the second case, one company has a 97 percent market share, and the other three each have a one percent market share. This yields a 9,412 HHI score, and quite possibly an antitrust case.
According to the Justice Department and Federal Trade Commission’s joint Horizontal Merger Guidelines, an HHI of over 2,500 constitutes a highly concentrated market. The HHI is usually used in mergers to decide whether or not to allow a deal to go through—under the Hart-Scott Rodino Act of 1976, all mergers over a certain size have to be reviewed by regulators before they can be consummated.
According to the guidelines, Mergers in a moderately concentrated market (HHI score of 1,501 to 2,500) that increases HHI by more than 100 points “potentially raise significant competitive concerns and often warrant scrutiny.”
Mergers in a highly concentrated market (HHI of more than 2,500) raising HHI by more than 200 points “will be presumed to be likely to enhance market power.”
These guidelines are not binding. The decision to block such a merger can vary with which party holds power, if a company is receiving bad publicity, or any other factor besides a predictable law. This uncertainty can have a chilling effect on deals that could benefit consumers.
This kind of quantitative analysis makes it easier for the Justice Department or the Federal Trade Commission to decide whether or not to bring a case against a company, or to block a proposed merger.
The HHI has a fatal flaw, though: the relevant market fallacy. The person crunching the numbers can define the relevant market any way they please, and can thus come up with nearly any HHI score they desire. This makes it analytically useless. In fact, during the fact-finding phase of a merger investigation, opposing counsel routinely fight over the relevant market size to be used in that case’s HHI calculations. Whatever decision is reached is arbitrary, and often depends more on the judge’s political views than anything else.
The fact that the Herfindahl-Hirschman Index is so easy to game is by itself fatal. But that is not its only significant problem. As Judge Richard Posner observed in the second edition of his book “Antitrust Law,” “There is no sound basis in economic theory for thinking that if there are just a few major sellers in a market, competition will disappear automatically.” That is an empirical question, and one that regulators are incapable of answering.
This is not necessarily their fault; no one can predict the future. Even the merging companies themselves are unsure how their deal would work out. AOL and Time Warner found this out the hard way. By giving the illusion of quantitative rigor, the HHI often fools regulators into thinking they have solved the knowledge problem that vexes so many policymakers’ plans. This false confidence is dangerous to consumer welfare.
The Herfindahl-Hirschman Index is useless in answering the question of whether a merger or a given level of concentration would cause consumer harm. It should barred from use in antitrust cases.
For more, see Wayne Crews’ and my study, “The Case against Antitrust Law: Ten Areas Where Antitrust Policy Can Move on from the Smokestack Era.” Further resources are at antitrust.cei.org.
Previous posts in Ryan Young’s “Antitrust Basics” series:
Inertia Wins! 