Measurement of Monopoly Power!
Professor A.P. Lerner has put forward a measure of monopoly power which has gained great popularity and is most widely cited. Lerner takes perfect competition as the basis of departure for measuring monopoly power.
He regards pure or perfect competition as the state of social optimum or maximum welfare and any departure from it would indicate the presence of some monopoly power leading to misallocation of resources or state of less than social optimum.
As we know, in perfect competition price is equal to marginal cost of the product in the equilibrium position. And it is this equality of price with marginal cost under perfect competition that ensures maximum social welfare or optimum allocation of resources.
Now, when competition is less than pure or perfect the demand curve facing a firm will be sloping downward and marginal revenue curve will lie below it. Consequently, when competition is less than pure (perfect), that is, when it is imperfect, in a seller’s equilibrium position; marginal cost will be equal to marginal revenue but price will stand higher than marginal cost or marginal revenue.
This divergence between price and marginal cost, according to Professor Lerner, is the indicator of the existence of monopoly power. The greater this divergence between price and marginal cost, the greater the degree of monopoly power possessed by the seller.
Based on this, Lerner has given the following precise index of the degree of monopoly power:
Degree of monopoly power = P – MC/P
Where P denotes price and MC denotes marginal cost at the equilibrium level of output.
When competition is pure or perfect, price (P) is equal to marginal cost and therefore Lerner’s index of monopoly power is equal to zero indicating no monopoly power at all, for when price is equal to marginal cost, P – MC will be equal to zero and the above formula will yield the value of index as zero.
Thus, under perfect competition, Lerner’s index of monopoly power = (P – MC/P) = 0/P = 0. On the other hand, when the monopolised product entails no cost of production, that is, when the product is a free good whose supply is controlled by one person, the marginal cost will be equal to zero and Lerner’s index of monopoly power (P-MC/P) would be equal to one or unity. Thus when MC is equal to zero P – MC/P = P – 0/P = P/P = 1
It is thus clear that Lerner’s index of monopoly power can vary from zero to unity. Within this range, the greater the value of the index (P – MC/P) the greater the degree of monopoly power possessed by the seller. For instance, if the price of a product is equal to Rs. 15 per unit and its marginal cost is Rs. 10, then the value of index of monopoly power will be 15 – 10/15 = 5/15 = 1/3 and when the price is equal to Rs. 20 and marginal cost is equal to 10, the index of monopoly power will be equal to 20 – 10/20 = 10/20 = 1/2.
Monopoly Power and Price Elasticity of Demand:
Now, it has been shown that Lerner’s index of monopoly power is equal to the inverse of the price elasticity of demand.
We can prove this as follows:
Since at the equilibrium level, marginal cost is equal to marginal revenue, we can substitute in the above formula marginal revenue for marginal cost.
Lerner’s index of monopoly power = P – MC/P
Since in equilibrium, MC = MR
Lerner’s index of monopoly power = P – MR/P…..(i)
We know that MR = P(1-1/|e|) where e is absolute value of the price elasticity of demand at the equilibrium output. Thus, putting P (1-1/|e|) in place of MR in (i) above we get,
Lerner’s index of monopoly power = P – MC/P = P – P (1 – 1|e|)/P = 1 – 1 + 1/|e| = 1\|e|
It therefore follows that Lerner’s index of monopoly power is equal to the inverse of price elasticity of demand. Thus degree of monopoly power can be judged by merely knowing the price elasticity of demand at the equilibrium output.
The degree of monopoly power varies inversely with the absolute value of price elasticity of demand for the good. It is worth noting that the price elasticity of demand in Lerner’s index refers only to the price elasticity at the equilibrium output.
Critique of Lerner’s Measure of Monopoly Power:
Lerner’s measure has many shortcomings. First, the chief shortcoming of Lerner’s measure is its inability to measure the strength of monopoly and competitive elements in the non-price competition and in cases of product differentiation as found in monopolistic competition and differentiated oligopoly.
Lerner’s index at the best measures the strengths of monopoly and competitive elements when the competition between the sellers is on the basis of price. When instead of competing on the basis of price the sellers in monopolistic competition and oligopoly compete on the basis of product variation, advertising and other of selling costs, Lerner’s index fails to indicate truly the degree of monopoly and competition involved in such market structures.
Suppose Lerner’s monopoly index for a firm selling a differentiated product yields a high figure. But this does not necessarily mean that the seller will be possessing a high degree of monopoly power and facing less competition.
It may be that the sellers of the various varieties of the product may not be competing on the basis of price and instead may be engaged in highly intense competition in product variation and advertising and other forms of selling costs to promote the sales of their products.
On the basis of the above non-price factors some firms may enjoy greater monopoly control over their products than others. Thus Professor Chamberlin rightly says that elasticity and Lerner’s index measures “pass over completely the important problems of competition and monopoly in the non price area; quality and other aspects of the product including location and advertising and other forms of selling costs.”
Secondly Lerner’s measure is based upon only one aspect of monopoly, namely, its control over price which depends upon the availability and effectiveness of existing substitutes. It ignores the restraints on monopoly power put by the potential substitutes which would come to exist with the entry of new firms into the industry as a powerful factor limiting be monopoly power of the existing sellers.
To quote Chamberlin again, “Neither elasticity nor the Lerner’s index measures anything the effectiveness of existing substitutes; it gives no indication as to potential substitutes (the important problem of entry).”
Thirdly, Lerher’s index is criticised on the ground that monopoly power does not express itself only in the divergence of price from marginal cost it also expresses itself in the restriction of output.