The Lerner index
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This theory was developed in 1934 by American economist Abba Lerner. Today, the Lerner index is one of the most widely used tools for measuring market power. It's often used in conjunction with the Herfindahl-Hirschman index, which measures market concentration. By combining these two theories, economists are able to take advantage of the strengths of each one to gain the best possible understanding about how much any single firm controls the market.
To calculate the market power of a firm, economists rely on the equation L=(P-MC)/P, where L is the value of the Lerner index. P in this equation is the market price that firm charges for its products, while MC is the marginal cost the firm incurs for each product. By taking the negative inverse of the Lerner index, analysts can find the demand elasticity for that particular firm's product. Demand elasticity ranges from -1 to 0, and measures how likely consumers are to stop buying the product or find a substitute if price increases.
Generally, the more elastic demand is for a product, the lower the market power of a firm will be, and thus, the lower its Lerner index value. This means that the firm has little control over price, because customers will simply switch to an alternate product. The lower the demand elasticity, the higher the market power, and the higher the Lerner Index value. For example, a special cancer drug may have a highly inelastic demand, meaning that customers will pay any price to get it. In this case, the maker of this drug has tremendous market power, and a Lerner index value close to 1.
The Lerner Index is an important economic and political tool that helps the government protect consumers from the effects of a monopoly. Without government intervention, monopolistic firms could engage in predatory pricing, or manipulate the market to keep new firms from entering. Governments and other regulating boards use Lerner index as one possible indication of a firm's market power. To reduce market power, the government may require the firm to break into smaller entities, or take away its patents to that other companies could produce the same products and ignite competition.
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