FINANCE

Finance



Finance

Introduction

The Herfindahl-Hirschman index (HHI) is defined as the sum of squared market shares of firms in a market and thereby provides an easily interpretable measure of concentration. It was first used in the 1940s as a measure for skewness, but it was not until 1976 that it was formally linked to economic theory, more specific to Cournot competition ([Cowling and Waterson, 1976]). In 1984, The US Department of Justice adopted the HHI as a concentration measure for merger reviews. This practice has since been followed by several other regulatory bodies in the US, such as the Federal Reserve Board (banking), the Federal Energy Regulatory Commission (electricity) and the Department of Transport (aviation). The HHI is used often as a concentration measure in academic research as well.

The HHI is not only widely used, it is also widely criticized. We divide between two main types of criticisms, the ones regarding robustness with respect to the definition of the market and the ones questioning the relationship between concentration and market power. The second point is stressed by [Tirole, 1988], who mentions that concentration measures in general ignore other important factors determining market power, such as costs of entry and asymmetries in costs or demand. [Boone and Weigand, 2000] show several counter-examples where institutional changes intuitively associated with an increase in competition, yield higher concentration levels instead of lower.

Recent critiques of the first type, identifying the definition of the relevant market as the major problem, include [Hannan, 1997], [Kwoka, 1998], [Nevo, 2000], [Maldutis, 1997] and [Cesari, 2000]. This definition problem has several dimensions, such as the level of aggregation, geographic dimensions and product characteristics dimensions. This paper seeks to adjust the Herfindahl index for differences in product characteristics. We develop an adjusted index, accounting for these differences and test it empirically, using civil aviation data.

Several earlier studies focussed on empirical relations between airfares and competition. [Brander and Zhang, 1993a] established that the Cournot model fits city pair markets better than a Bertrand or a cartel model. In a later paper, [Brander and Zhang, 1993b] reject all three models, finding that the data of Chicago based duopoly routes seem more consistent with a quantity-setting regime switching model. This type of model allows for switches between collusive phases and phases of punishment. [Oum et al., 1993] find that carriers adjust their strategies according to the competitive conditions on individual routes and that these strategies are generally closer to Cournot behavior than to Bertrand behavior.

The remainder of this paper is organized as follows. In the following section we devote our attention to the properties of the HHI. Section 3 proposes an adjusted form of the index in order to account for close substitutes, followed by a framework for application to civil aviation. Section 5 discusses the data and empirical results and the final section contains some concluding remarks.

2. Properties of the HHI

The theoretical foundation of the HHI, as outlined by [Cowling and Waterson, 1976] stresses that a positive relation exists between concentration in a market and industry ...