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What is Lerner Index?
The Lerner index is an economics measure to gauge monopoly. It determines the relationship between a commodity’s selling price and marginal cost of production. It is denoted by 'L.' When 'L = 0', it signifies perfect competition; similarly when 'L = 1,' it indicates a pure monopoly.
This parameter is used to ascertain a company's price-cost margin. It was proposed in 1934 by Abba Ptachya Lerner in his 'The Concept of Monopoly and the Measurement of Monopoly Power.' Lerner was a British-Russian economist.
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- Lerner index (L) is a profit cost margin indicator that determines the impact of market power over the price and demand of a firm's product.
- It is expressed as: ‘Lerner index = (Price – Marginal Cost) / Price’.
- A low Lerner index shows that the firm operates in a highly competitive market. If L = 0, the business has perfect competition and a low-profit margin. Also, the price elasticity of demand is high in such a market.
- When L = 1, the firm enjoys a monopoly in the market; in such a scenario, the profit margins are huge, and there is little price elasticity of demand in the market.
Lerner Index Explained
The Lerner index (L) is a price-cost margin ascertained by comparing the price of a particular commodity with its marginal cost of production. Product demand is closely related to the product price and product supply; thus, this parameter checks a product's price elasticity of demand.
However, in the case of high market power or monopolistic control over the market, price is not the driving factor behind a product's demand. In such scenarios, the value of 'L' is somewhere between 0 and 1, where 'L = 1' symbolizes the pure monopoly of a firm.
Similarly, in a perfectly competitive market, a commodity's price is the key factor upon which market demand depends. Therefore, as the price of goods or services rises, goods demand among consumers falls. Therefore, in perfectly competitive markets, the value of the Lerner index is zero. In such scenarios, product price equals the marginal cost of production—profits are low or negligible.
Clearly, competition within a market affects a firm's profitability. However, it is nearly impossible to acquire a negative Lerner index value. No company would sell a product below its marginal cost.
The Lerner index is a crucial indicator of market power in the banking sector. Since the value of marginal cost is not available directly, it is extracted using the total cost function. Competition among banks affects stability. Low Lerner values suggest that there is hefty competition among banks—profitability is low.
The biggest limitation of this method is the difficulty associated with marginal cost computation. To overcome this hurdle, a company can use average cost instead of marginal cost to determine the closest value of L.
Lerner Index Formula
The index assesses the price elasticity of demand for goods and services. The following formula is used for computation:
- Here. L is the Lerner index.
- P is the price of the output.
- MC is the marginal cost of production.
The relationship between the Lerner index and the price elasticity of demand is expressed as follows:
Here, Ed is the price elasticity of demand.
Implication
A lower Lerner value indicates high price elasticity of demand (for a particular commodity. In other words, Lerner values are higher when consumers are more sensitive to a commodity's price. In such a scenario, demand for a product decreases with price rise, and vice-versa.
On the other hand, a high Lerner value denotes reduced price elasticity of demand. This occurs when there is a monopoly. In the case of monopolistic control, price is not the driving factor behind a product's demand.
Calculation Example
Case 1
Let us assume that ABC Pvt. Ltd. sells each product unit at $7, and the marginal cost incurred by the business is $4 per unit. For the given values, determine Lerner values and the price elasticity of demand.
Solution:
Given:
Product Price Per Unit (P) = $7
Marginal Cost Per Unit (MC) = $4
L = (P – MC) / P
L = (7 – 4) / 7 = 0.43
Ed = (-1) / L
Ed = (-1) / 0.43 = -2.33
Since L = 0.43, we can say there is low market competition. Also, there is less price elasticity of demand, i.e., -2.33.
Case 2
Now, let us assume that ABC Pvt. Ltd. sold each product unit at $4 instead. The marginal cost remains the same at $4 per unit. Based on these values, what would be the Lerner value?
Solution:
Given:
Product Price Per Unit (P) = $4
Marginal Cost Per Unit (MC) = $4
L = (P – MC) / P
L = (4 – 4) / 4 = 0
Ed = (-1) / L
Ed = (-1) / 0 = ∞
Since L = 0, we can say that the firm is in a state of perfect competition; similarly, the infinity value indicates perfect elasticity of demand.
Frequently Asked Questions (FAQs)
It is an indication of an organization's price-to-cost margin, also referred to as the price elasticity of demand. It is the difference between the price of a firm's output and the marginal cost of production divided by the price. If L is the Lerner value, P is the price of the firm's output, and MC is the marginal cost of production, it is mathematically expressed as:
L = (P – MC) / P
When the Lerner index is zero (L = 0), the market price of a commodity is equal to the firm's marginal cost. In such scenarios, the business entity is considered perfectly competitive. In this scenario, there is no monopoly; market power has no control over the price or demand of the commodity.
When the Lerner index is higher than 0, the company is positioned to set a product price higher than its marginal cost, and if L = 1, the firm is in a state of pure monopoly.
No, L cannot be negative because firms never sell a product below its marginal cost—it will result in unnecessary business losses.
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