The Lerner Index has its foundations in a 1934 paper published in 'The Review of Economic Studies' in which Abba Lerner attempted to quantify the negative economic loss resulting from monopoly prices i.e. prices over and above that which would be charged in a competitive industry. This is expressed in simple terms via the formula:
Lerner Index Value = (P - MC) / P
I will return to the Lerner Index formula below, but first we should note from the outset that Abba Lerner was not a fan of capitalism or free-market economics, and was instead an avid socialist. His work was intended to contribute to a blueprint for a centrally planned economy that could avoid the social losses resulting from monopoly power. With that said, Lerner himself did not regard monopolies as a major source of inefficiency, and thought their actions to result in less than a one percent decrease in national income.
Another point to note is that, whilst Lerner wrote about the 'Lerner Index of Monopoly Power' a more accurate description would be to refer to 'market power' rather than 'monopoly power', but that term was not in common use until the 1950s. The point is that a firm does not need to be a monopoly to be able to influence prices i.e., a smaller firm than a monopolist, but still with a significant share of a market, may be able to exert some influence on market prices.
We should be aware that, since the Lerner Index uses the difference between price and marginal cost to estimate the market power that a firm has, any industry that has a high degree of price elasticity of demand will likely be regarded as one where a firm has little market power. When an industry exhibits a high price elasticity of demand, small increases in the price of the product in that industry will result in a large decrease in the amount of that product that consumers demand.
For example, if a local monopoly firm in the apples market decided to increase the price of apples, consumers would be quick to shift their spending from apples to some other competing product. Contrast that with a monopoly provider of electricity. Electricity is, in many regards, a basic necessity that people need in order to heat their homes and power their televisions, kitchen appliances, computers and so on.
The electricity industry therefore has a very low price elasticity of demand, and this would make it much easier for a monopoly provider of electricity to increase prices way above marginal cost without suffering a significant loss of sales. It is, of course, for this reason that many such industries have regulatory bodies that are tasked with keeping prices from rising unfairly.
As noted at the top of the page, the Lerner Index is expressed by the formula (P - MC) / P and, in words, this simply means that the price charged by a firm for its product over and above the marginal cost of producing that good is a measure of market power.
The idea is taken from the basic model of a perfectly competitive industry in which no individual firm is able to raise the prevailing price above the marginal cost. Recall that in such an industry output occurs where marginal cost intersects the firm's average cost curve at its minimum point, and that average cost includes a market rate of return sufficient for entrepreneurs to continue in business, but not more than that (i.e. there is some minimum amount of 'accounting profit', but no 'economic profit').
In this case, since economic profit is zero, price is equal to marginal cost, so plugging this into the Lerner Index formula (P - MC) / P gives a value of zero. Economic profit is only possible if a firm has enough market power to charge a price that is higher than the marginal cost of production. The higher the price can be raised above marginal cost, the higher the Lerner Index value. Note, however, that the value can not go higher than one. The Lerner index formula ranges in value from zero to one.
This simple formula has been widely adopted by the economics textbooks as a simple way to estimate the market power of a firm in any given industry, but it does have some flaws that have prevented it from being widely used in law for antitrust purposes - I will discuss these flaws in the criticisms section below.
Since we know that the Lerner Index ranges from zero to one, it is a common mistake to imagine that zero represents perfect competition and one represents pure monopoly. A quick example here should immediately prove why this is mistaken.
Imagine that you gained sole rights to manufacture and sell ZX81 computers. For younger readers, the ZX81 was one of the first microcomputers to hit the market -it was released in 1981 hence the name. Now, you can probably imagine that this computer is hopelessly antiquated by much more powerful modern home computers, and aside from a few fans that might be willing to buy a ZX81 for nostalgic reasons, ongoing demand for this product would very likely fall to nothing.
In other words, even with a pure monopoly of this product, not only would you be unable to charge a price higher than the marginal cost of production, you would also be highly unlikely to be able to charge a price that covers your costs and you would quickly have to go out of business.
In fact, the number one in the Lerner is just a theoretical abstract rather than an attainable goal. Any positive value for marginal cost necessarily implies that the Lerner Index score will be less than one.
At the other extreme, with a Lerner Index score of zero, it is entirely possible that market demand in a non-competitive industry is such that suppliers are unable to charge a price that is any higher than marginal cost, so the zero score here does not prove that a market is competitive.
One of the first limitations of the index comes with the nature of the industry cost curve for any given firm under scrutiny. This is because it is not always the case that firms in a competitive industry will always gravitate to an output level consistent with the lowest costs. I have illustrated this with my three articles about the cost structures in an:
In the short-run, in each of these industry structures a competitive firm will always charge a price that is different to marginal cost when there is a shift in industry demand. Only in the case of a constant cost industry will the long-run price return to its initial level, and in both of the other two cases any shift in industry demand will permanently alter prices.
This raises serious limitations at any given moment in time with regard to establishing whether a firm is charging a higher price than its marginal cost due to market power, or because of shifting demand. For that matter, how does the casual observer ever accurately estimate what a firm's marginal cost is, and therefore whether the price it charges is higher or lower than that cost?
Further limitations apply to industries where a supplier is affected by a monopsony buyer of its products, since market power works in both directions. A monopsony buyer may be able to exert its power to unfairly push prices below marginal costs, at least in the short run.
There is also a criticism of the Lerner Index in that it fails to recognize any of the other characteristics of an industry that give rise to the potential for market power i.e. the market concentration of the industry (i.e., how much of an industry is accounted for by a single supplier or limited number of suppliers), and barriers to entry that restrict competition.
Finally, the Lerner Index is limited in many real world scenarios where prices are difficult to observe due to marketing practices. One example comes with block pricing i.e., where two or more different goods are sold as a package deal it will be difficult to know what individual prices should apply to any particular good within that package.