Competition Law

Lerner’s Index

Name: RAKSHIT RAJ SINGH

Class: VII Semester ‘B’

Roll No: 1302

 ACKNOWLEDGMENT
I am using this opportunity to express my sincere gratitude to everyone who supported me
throughout the course of this project in Competition Law. I am thankful for their aspiring
guidance, invaluably constructive criticism and friendly advice during the project work. I am
sincerely grateful to them for sharing their truthful and illuminating views on a number of
issues related to the project.

I express my warm thanks to the National University Of Advanced Legal Studies,Kochi, for
giving me this oppurtunity to do this enlightening project.

My sincere thanks goes to Dr. Mini S, faculty, National University Of Advanced Legal
Studies, Kochi, for her support and guidance.
INTRODUCTION

The study of market power has been important in economics because of its implications for
efficiency but also for distribution. In recent years, a further dimension to these issues has
been recognized: losses at a second level may occur if profits are dissipated through rent seek
recognized: losses at a second level may occur if profits are dissipated through rent seeking.
But, in the introduction to a series of papers on empirical approaches to market power,
Scheffman and Spiller (1989) argue that there is no consensus among economists concerning
its empirical incidence and significance. They call for research on the assessment of market
power at the firm and industry levels.

For over half a century an index proposed by Lerner (1934) has been used to measure
monopoly power. Expressed as L = (p - MC)/p, where p is price and MC is marginal cost, the
index has recently been the subject of increased interest. Encaoua and Jacquemin (1980)
derive a link between indices of structure, such as Herfindahl's index of concentration, and
Lerner's. (1987). Martin (1984) derives the Lerner index from a simple model of profit
maximization, and observes that several studies use the index as a measure of monopoly.

PRINCIPLES OF LERNER'S INDEX

Lerner's expressed intent in proposing the index was to measure the divergence of an industry
from competition. Competition has a number of characteristics, of which three are listed here:
(1) Under competition there is no power to affect price, i.e., infinite elasticity of demand. (2)
In consequence, competition eliminates monopoly profit. (3) In certain circumstances,
competition maximizes welfare, by equating price and marginal cost. It is argued below that
each of these has different implications for the perception of the exercise of monopoly power
in actual industry. Therefore, as a guide to thinking, the following four principles are
proposed for the building of a Lerner-style index. Principle1: The Lerner measure is an index:
it is unit-free and normally can be constructed to lie between zero and one. The meaning of
the zero point of the index is of central significance.
A competitive industry has an index of zero. If there is no possibility of a competitive
industry the zero point must be correctly defined.
Principle II: The index should be observable. Dansby and Willig 1 look upon observability as
"a constraint of index-number methodology".

1
(1979, pp. 249, 253)
Principle III: The index should fully reflect monopoly power, and only power. It should avoid
double counting of sources of rents. Otherwise the can become confounded with measures of
other phenomena and its meaning unclear.
Principle IV: The index should be able to provide a meaningful measure of monopoly power
in any situation, not just that in which maximizing profits somehow defined.

COMPETITION AND OPTIMALITY

In Lerner's article the "MC" term in the numerator is all three of (1) the firm's own incurred
marginal cost, (2) the social marginal cost at the observed output and (3) what the marginal
cost at that output would be if the industry were competitive. In theory and in actual
industries these can differ. A competitive industry will not achieve a social optimum if there
is an unpriced externality. The literature on the Lerner index (e.g. Encaoua and Jacquemin,
1980; Pindyck, 1985) explicitly or implicitly assumes there is no externality. But if there is,
what is the appropriate marginal cost concept, a private one or the social marginal cost which
includes the cost of the externality? The latter can be dismissed by observing that use of the
social marginal cost can lead to an absurd result. Consider a negative externality which is so
severe that the social marginal cost exceeds the monopoly price when the externality is
unpriced. Use of social marginal cost in the index will give a negative degree of monopoly
power, contrary to Principle I, even when monopoly power is being exerted in pricing. If the
industry is competitive the measured degree of monopoly power will be even more negative,
rather than zero. Using social marginal cost in the index would entail confounding the effect
of monopoly power with the failure (or inability) of society to provide an institution to
internalize the externality, contrary to Principle IH. If the externality were internalized, a
competitive industry would achieve the social optimum, and a monopolist would charge a
price higher than its marginal cost. The index would be positive. Granted, it would be
different from the index measured without internalization. But conditions would have
changed. The index depends not only on price but on cost; indeed, an index of 1 is achieved
only if marginal is zero.

The combined effect of all departures from optimality is better measured by Dansby and
Willig's (1979) industry performance gradient index. Their reference to a welfare function
implies that they are using social marginal cost in their index. The planner's response to non-
optimality may include subsidization or pollution taxes or other policies having nothing to do
with monopoly power. What if actual marginal costs in an industry diverge from what would
be observed under competition? For example, a non-competitive firm may have a lower cost
of capital if it has more stable earnings. In these situations, Principle II suggests use of the
actual marginal costs incurred or perceived by the firm.4 On the other hand, suppliers with
monopoly power could drive up marginal cost. Should the power of managers, workers, etc.
figure in the index? A partial answer is provided by Lerner's insistence that exerted monopoly
power be measured (Principles II and IV). Even if the firm were not inclined to non-optimal
pricing, these suppliers could recognize the potential of exerting their own power. Therefore,
their power should be attributed to the factor market. Suppose that a non-competitive firm
does not minimize cost. For example, a (rate-of-return-) regulated monopolist may have costs
which are higher than optimal and hence have what Callen, Mathewson and Mohring (1976)
call a pseudo-cost function. We cannot estimate the minimum cost unless we make some
possibly suspect assumptions. But we may consistently attribute any non-optimality to the
regulation, which discourages optimal substitutability based on market prices. If we attribute
observed profits to the monopoly, we can calculate an index of monopoly power from the
observed cost function (Principle H). What if profits are taken in a quiet life, and costs are
raised thereby? In his discussion of X-inefficiency Tiróle (1988) seems to imply that this is a
question of principle-agent monitoring. If so, then the device used in the last paragraph (and
the externality case) is applicable. But the problem can also arise in a sole proprietorship. In
this situation, if there were competition, in-kind profits would be squeezed out. Measuring the
true value of unpriced benefits presents a host of problems. Observability (Principle II) may
be a real constraint if unpriced transfers occur. If the transfers can be estimated and netted
out, they should be.

SINGLE-PRODUCT NATURAL MONOPOLY

When there are increasing returns to scale, production by private firms is subject to two types
of condition:
(1) Profit maximization entails p>MR=MC, whereas Pareto optimality dictates that p=MC.
(2) Feasibility entails p>AC, whereas a second-best solution under the feasibility constraint
entails p>AC.

THE DEMAND SIDE

When a firm is able to discriminate, the issue of distortion vs. monopoly profit takes on an
important nuance. With perfect (first-degree) price discrimination, the marginal price equals
marginal cost and there is no distortion. A Pareto optimum is achieved. But one is inclined to
view a perfect price discriminator as having complete power over the market defined by the
demand curves of consumers. Even though economic efficiency is attained, one would
presumably not wish to propose an index of monopoly power of zero.

Moreover, imperfect price discrimination, such as through a two-part tariff, may be welfare-
superior to any linear tariff. But this welfare improvement depends on the use of a
monopolistic ability to discriminate: Oren, Smith and Wilson (1983) find that, even when
costs are customer-specific, as the number of profit-maximizing rivals in Cournot equilibrium
increases without bound, the non-linear tariff tends to a linear price equal to marginal cost,
and profit tends to zero. Competition eliminates the ability to discriminate.

Given the observation that perfect discrimination reflects maximal monopoly power subject
to the cost conditions and that, once more, zero monopoly power (competition) is connected
to zero monopoly profit, we may propose additional modifications to Lerner's index for a
single-product firm. First, if qMC(q) > C(q)9 where q = S qj is the sum of consumption of the
firm's output over consumers, j, it can define a Lerner index for consumer j, who pays a total
charge of Yj (qj ) for consumption of qj units.

CONCLUSION

It’s reconsidered Lerner's index of monopoly power utilizing four principles based the intent
of the index. In defining the zero point, the relevant consideration has been whether there is
monopoly profit rather than whether there are distortions induced by non-competitive pricing.
It has been interpreted that the index in terms of the conduct of the firm, and shown links to
one aspect of performance. Because it is dependent upon cost conditions as well as pricing
behaviour, modifications to the index have been proposed to deal with externality, certain
dynamic features of markets, increasing returns and multiproduction. The modifications
produce a lower value of the index when there are increasing returns. Under multi-
production, incremental costs are important, and a single index may involve subsets of more
than one product. Moreover, if pricing behaviour is complicated, if there is non-linear
pricing, or non-zero cross-elasticities of demand, for example-further adjustments must be
made. The share of profits in sales, a ratio often quoted in practical evaluations of
performance, is the relevant performance concept. But one must be careful to limit these
profits to monopoly profits. Other types of profit, related to the production technology, may
also exist. The latter has been identified as rents and defined an index of rent. In so doing it
has been dispensed with the concept of monopsony revenue, but have been preserved the
property whereby costs, rents and monopoly profits sum to total revenue.