Lerner index
The Lerner index is an economic measure of a firm's market power, defined as the relative markup of price over marginal cost, $L = \frac{P - MC}{P}$, where $P$ denotes price and $MC$ marginal cost.[1] Introduced by British economist Abba P. Lerner in his 1934 paper "The Concept of Monopoly and the Measurement of Monopoly Power," it quantifies the degree to which imperfect competition enables pricing above production costs, with $L = 0$ under perfect competition where $P = MC$, and higher values indicating greater monopoly power up to a theoretical maximum approaching 1.[2] From the first-principles condition of profit maximization—where marginal revenue equals marginal cost—the index derives as $L = -\frac{1}{E_d}$, with $E_d$ the price elasticity of demand, implying that market power inversely correlates with demand responsiveness and requires $|E_d| > 1$ for positive profits.[2] Widely applied in industrial organization and antitrust analysis to assess competition empirically, the Lerner index facilitates evaluation of firm behavior across industries, though estimating $MC$ poses challenges in practice due to data limitations.[2][1]History and Origins
Development by Abba Lerner in 1934
Abba Ptachya Lerner, a Russian-born economist then studying at the London School of Economics, introduced the Lerner index in his seminal article "The Concept of Monopoly and the Measurement of Monopoly Power," published in the June 1934 issue of The Review of Economic Studies. In this work, Lerner defined monopoly power as the extent to which a firm could set price above marginal cost, proposing the ratio (P - MC)/P—where P is price and MC is marginal cost—as a direct quantitative indicator of that power, ranging from zero under perfect competition to unity under absolute monopoly.[2] This formulation emphasized behavioral evidence of market power over structural proxies like firm size or market concentration, which Lerner critiqued as insufficient for capturing the actual exercise of monopoly influence.[2] The index emerged amid interwar debates on imperfect competition, spurred by the recognition that real-world markets rarely conformed to classical models of perfect competition or pure monopoly. Lerner's analysis built on Joan Robinson's The Economics of Imperfect Competition (1933), which had formalized marginal revenue curves for firms facing downward-sloping demand and highlighted pricing inefficiencies in oligopolistic settings. While Robinson focused on equilibrium conditions under monopoly elements, Lerner sought a universal metric applicable across market forms, arguing that the price-cost markup inherently reflected the firm's control over output and price without presupposing specific industry structures.[2] This approach addressed a gap in contemporary theory, where measures of competition often relied on observable shares rather than underlying profit-maximizing behavior.[3] Lerner's innovation was particularly timely in the 1930s economic milieu, as theorists grappled with the implications of partial monopoly for resource allocation and welfare, influenced by the Great Depression's exposure of market rigidities. By linking monopoly degree to the elasticity of demand implicitly through the markup—without explicit derivation in the paper—he provided a tool for empirical assessment that prioritized causal pricing discretion over static market descriptors.[2] The index thus offered a theoretically grounded alternative to vague notions of "monopoly power," enabling analysis of deviations from competitive efficiency in diverse settings.Evolution in Economic Theory
In the years following Abba Lerner's 1934 formulation of the index as a measure of monopoly power, it was rapidly incorporated into industrial organization economics to delineate economic monopoly from its legal counterpart. Edward Mason, in a 1937 address, explicitly drew on the Lerner index to contrast the legal definition of monopoly—centered on a firm's ability to exclude rivals through patents or barriers—with the economic variant, which quantifies the divergence between price and marginal cost as evidence of pricing discretion.[3] This adoption underscored the index's utility in shifting focus from structural barriers alone to observable pricing behavior, influencing early empirical studies of market power in the late 1930s and 1940s.[3] The Lerner index played a foundational role in the emergence of the Structure-Conduct-Performance (SCP) paradigm during the 1940s and 1950s, as developed by Mason and Joe S. Bain at institutions like Harvard and the University of California. In this framework, market structure (e.g., concentration ratios) was hypothesized to shape firm conduct, ultimately determining performance metrics such as profitability; the index provided a theoretical anchor for interpreting price-cost margins—empirical proxies for (P - MC)/P—as indicators of excess profits stemming from reduced competition.[4] Empirical IO research under SCP increasingly regressed structural variables against markup data aligned with Lerner logic, enabling cross-industry analyses of how concentration correlated with market power, though often relying on accounting approximations due to data limitations on marginal costs.[5] By the mid-20th century, the index had evolved from a theoretical construct for monopoly analysis into a practical tool for antitrust policy and enforcement. Antitrust scholarship began integrating it around the 1950s, approximately two decades after its inception, to assess welfare losses from market power in merger evaluations and dominance cases, bridging abstract IO models with legal applications like those under the Sherman and Clayton Acts.[3] This transition facilitated quantitative guidelines for regulators, such as estimating deadweight losses via Lerner-derived markups, though implementation required adaptations for oligopolistic settings beyond simple monopoly.[4]Definition and Interpretation
Formal Mathematical Expression
The Lerner index L is defined as the ratio L = \frac{P - MC}{P}, where P represents the price charged by the firm and MC the marginal cost of production.[6] This expression quantifies the proportional markup of price over marginal cost. The index assumes values between 0 and 1: a value of 0 occurs under perfect competition, where P = MC, implying no market power; a value approaching 1 indicates substantial market power, as when MC approaches 0 relative to P.[6]
As a dimensionless ratio, the Lerner index enables direct comparisons of market power across firms, products, or industries irrespective of the monetary units used for P and MC.[7]
The index is conventionally computed at the firm-product level but can be aggregated for multi-product firms by constructing a composite measure, such as weighting by output shares, to assess overall market power.[8]