Lerner Index (Market Power Formula)
Lerner Index = (P - MC) / P.
Measure a firm's market power: how far its price exceeds marginal cost.
From 0 (competition) to 1 (monopoly).
The Formula
The Lerner Index (L), developed by economist Abba Lerner in 1934, measures a firm's degree of market power — its ability to set prices above marginal cost.
P is the selling price and MC is the marginal cost of production. In a perfectly competitive market, P = MC so L = 0. A monopolist with high barriers to entry can set L close to 1, charging a price far above cost.
The Lerner Index equals the negative inverse of the price elasticity of demand: L = −1/ε_d. A firm facing elastic demand (ε_d = −5) has L = 0.2 (20% markup). A firm with inelastic demand (ε_d = −1.5) has L = 0.67 (67% markup). This is why monopolists with inelastic demand (insulin, essential drugs) can charge extreme prices.
Typical Lerner index values: grocery retail ~0.05. Airlines ~0.2–0.4. Pharmaceuticals with patents ~0.5–0.9. Pure monopoly utilities ~0.6–0.9. Antitrust regulators use market power measures like the Lerner Index to assess whether a merger will harm consumers.
Variables
| Symbol | Meaning | Unit |
|---|---|---|
| L | Lerner Index (0 = competition, 1 = max monopoly) | Dimensionless |
| P | Market price | $ |
| MC | Marginal cost of production | $ |
Example 1
A drug costs $2 to manufacture and sells for $50.
L = (50 − 2) / 50 = 48 / 50
L = 0.96 (extreme market power — consistent with patent-protected drug monopoly)
Example 2
A grocery store sells bread for $3.50 with marginal cost $3.15.
L = (3.50 − 3.15) / 3.50 = 0.35 / 3.50
L = 0.10 (modest market power, consistent with competitive retail)
When to Use It
- Antitrust and competition law analysis
- Measuring market power in industrial organization research
- Explaining why regulated industries must justify their prices
- Intermediate and advanced microeconomics coursework
Key Notes
- Formula: L = (P − MC) / P: Ranges from 0 (perfect competition, P = MC) to 1 (pure monopoly with zero marginal cost). A value of 0.3 means the firm charges 30% above marginal cost — capturing that much of the price as markup above the cost of producing the last unit.
- Relationship to price elasticity: L = −1/PED: Where PED is the price elasticity of demand (negative for normal demand). The less elastic the demand (|PED| closer to 1), the higher the Lerner index a profit-maximizing firm can sustain. With perfectly elastic demand (PED = −∞), L = 0 regardless of market structure.
- Market power and deadweight loss: Higher L means the firm prices further above MC, creating a larger gap between price and marginal cost. This gap generates deadweight loss — transactions that would benefit both buyer and seller at the competitive price don't happen.
- Limitations: Lerner index requires knowing MC, which is not directly observable for most firms. It is a static measure — it doesn't capture dynamic competition (contestable markets, innovation). High L can reflect brand value or genuine product differentiation, not just abuse of market power.
- Applications: The Lerner index is used in antitrust regulation and competition policy (measuring market power in merger reviews), industrial organization research (comparing pricing power across industries), and regulatory economics (setting allowed prices for utilities where MC is difficult to observe).