Adjusting the Herfindahl index for close substitutes: an application to pricing in civil aviation Mark G. Lijesen * CPB, Netherlands Bureau for Economic Policy Analysis, Energy Unit, P.O. Box 80510, The Hague 2508 GM, The Netherlands Abstract The Herfindahl–Hirschman index (HHI) is a well known concentration measure, which is both widely used and widely criticized. The main shortcoming of the HHI is its sensitivity for the relevant market definition, in terms of both geographical boundaries and in terms of product homogeneity. In this paper we develop an adjusted version of the HHI that accounts for close substitutes. We test the adjusted HHI empirically for civil aviation, using airfare data. Our results suggest that the adjusted index generates better results than the traditional indicator. Ó 2003 Elsevier Ltd. All rights reserved. JEL classification: L110; L930; R41 Keywords: Civil aviation; Market power; Herfindahl index 1. 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. * Tel.: +31-70-338-3322; fax: +31-70-338-3350. E-mail address: mgl@cpb.nl (M.G. Lijesen). 1366-5545/$ - see front matter Ó 2003 Elsevier Ltd. All rights reserved. doi:10.1016/S1366-5545(03)00045-0 Transportation Research Part E 40 (2004) 123–134 www.elsevier.com/locate/tre