Survival of the Fittest: An Assessment of the Herfindahl Index and Product Market Competition
38 Pages Posted: 14 Dec 2013 Last revised: 16 Mar 2014
Date Written: March 15, 2014
A large body of recent empirical work uses the Herfindahl index to proxy for industry-level product market competition. However, researchers use a variety of data and methods to construct the index. This paper measures the ability of the Herfindahl index to reflect changes in product market competition and introduces a new meaure of product market competition, the Boone indicator. I examine the effect of an exogenous shock to competition (the US-Canada Free Trade Agreement) on the Herfindahl index. The Herfindahl index does not respond to the reduction in import and export tariffs, even among industries that are most affected by the shocks. In contrast, the Boone indicator reflects changes in competition. In industries that receive shocks to both import and export tariffs, the Boone indicator increases, confirming that these industries become more competitive following the tariff shock. These findings question the validity of the Herfindahl index to proxy for industry competition and point to the Boone indicator as a viable alternative.
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