Definition
The Lerner Index measures the degree of market power, that is, the degree to which a firm can raise its price above its marginal cost (the cost of producing an extra unit of output). The formula for the Lerner Index is (P – MC) / P, where P stands for the firm’s price and MC for its marginal cost, both being measured at the equilibrium level of output.
Commentary
Marginal cost (MC) is taken as the benchmark in the formula for the Lerner Index because in a perfectly competitive market equilibrium, every firm will set its price at MC, so P = MC and the value of the Lerner Index is zero for all firms. It is positive for any markup of price above MC. This may come about if the conditions of perfect competition are violated, such as when there is limited competition (monopoly or oligopoly) due to barriers to entry, cost or quality differences between firms, differentiated products, or if consumers lack the information or motivation to search for lower prices.
Although marginal cost is a key concept in economic theory, it is very hard to estimate in practice. A crude approximation is possible if we assume that average costs (AC) per unit are constant over the relevant range of output which a firm produces. In that case, MC = AC, so we can restate the formula as (P – AC) / P, which is sometimes called the price-cost margin (PCM). Then if we multiply each term by the quantity of output produced (Q), the formula becomes [P x Q – (AC x Q)] / (P x Q). Now, P x Q is sales revenue, and AC x Q is total variable costs. Both these magnitudes can be calculated from a firm’s accounts. So the Lerner Index can be proxied by the ratio of gross (operating) profit to sales.
However, it must be emphasized that there are conceptual problems with this methodology, even apart from the assumption of constant average costs. Moreover, a high Lerner Index or PCM does not necessarily imply that the firm is making undue profits or engaging in anti-competitive behaviour. Some of the excess of revenue over variable costs must cover its fixed costs, which are necessarily high in capital-intensive industries. Such industries tend to be more concentrated. (See the entry on Economies of Scale for the distinction between fixed and variable costs and their relationship to concentration.) A high gross profit margin is necessary for a firm to remain viable in such cases. Furthermore, marginal costs are naturally low in industries like software, online advertising, and e-commerce, where the cost of supplying an additional unit is virtually zero. These industries also tend to be concentrated due to economies of scale, scope, and network effects. Pharmaceutical firms tend to have a high Lerner Index, because new drugs require high fixed costs in the form of research and development and regulatory compliance, as well as negligible marginal costs of production for each additional dose. Patents can protect their high margins.
Even in other industries, firms which have lower costs and/or can charge higher prices because of better quality will have higher values for their Lerner Index and PCM. These advantages, which can arise from better technology, management, economies of scale or scope, are pro-competitive and should not be penalized, unless they can be shown to arise from anti-competitive conduct. Such conduct in input markets (such as buyer cartels, or no-poach agreements in labour markets) should not be exonerated on the grounds that it reduces costs.
For all these reasons, the Lerner Index should be used only as a crude indicator of market power, and not as evidence of anti-competitive conduct, which must be proved separately. Although the Lerner Index does not seem to have been used in Indian competition cases, high profit margins (calculated as the ratio of profit to sales or turnover) have been cited in cartel cases involving producers of cement (Builders Association of India v Cement Manufacturers’ Association & Ors., paras 277-83) and tyres (Ministry of Corporate Affairs v Apollo Tyres & Ors, para 25). But the final determination has always been based on evidence of an anti-competitive agreement or understanding.
Case References
Competition Commission of India, Case No. 29 of 2010, In Re: Builders Association of India v Cement Manufacturers' Association & Ors.
Competition Commission of India, Reference Case No. 08 of 2013, Ministry of Corporate Affairs v Apollo Tyres & Ors.