Lerner+index

Definition
The Lerner index is a measure of market power measured by the difference between price and marginal cost expressed as a percentage of price. For a monopoly, this ratio is equal to the reciprical of the price elasticity of market demand.

Lerner provides an alternative way of thinking about market power. In the context of a monopoly, Lerner argues taht market power can be measured by how high price (P) can be elevated above the marginal costs (MC) of production. He shows mathematically that the ability to elevate price above costs depends on the price elasticity of market demand (Em) facing the monopolist. The Lerner index of monopoly power (L) can be written as:

L= (P-MC)/P = 1/Em

The Lerner index implies that the markup of price above marginal cost as a percentage of price in inversely proportional to the price elasticity of market demand. The ability to elevate price above marginal cost is limited by the responsiveness of consumers to a price increase. If we assume that marginal costs equal average total costs, the Lerner index can be rewritten as:

L= (P-ATC)/P

Problems with the Lerner Index
One might conclude that most health insurers possess significant market power because of the profit rates. However, other factors must be considered before drawing this conclusion. First, the reported rates represent accounting and not economic profits. Economic profits consider the opportunity cost of all resources and not just the resources that are purchased by the company. Accounting profits generally overstate economic profts and sometimes complicate comparisons across companies. Second, remember that even perfectly competitive firms earn a normal economic profit rate. Profit-maximizing firms must receive at least a normal return on their capital or they will exit the industry to earn a higher return elasewhere. That means there must be an economy-wide competitive rate of return. For example, industries in the general economy may normally earn a six percent return on capital. Third, remember that investments in some industries are riskier than others. Finally, economic theory suggests that a perfectly competitive indsutry earns a normal rate of return in the long run. However, favorable and unfavorable industry shocks may cause economic profits to deviate from the long run normal rate and this may cause firms to enter or exit.

Questions
1. The Lerner Index is: a. An accounting tool b. A measure of debt c. A measure of market power d. A measure of consumer utlity (ANSWER:C)

2. In a monopoly, the Lerner Index is equal to: a. The reciprocal of the price elasticity of market demand b. Marginal Cost c. The marginal benefit d. The mortality rate (ANSWER: A)