What is the most important reason for a firm to do periodic marginal Analyses?

journal article

Reviewed Work: The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting. by Oliver E. Williamson

Review by: Armen A. Alchian , Susan Woodward

Journal of Economic Literature

Vol. 26, No. 1 (Mar., 1988)

, pp. 65-79 (15 pages)

Published By: American Economic Association

https://www.jstor.org/stable/2726609

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The Journal of Economic Literature (JEL), first published in 1969, is designed to help economists keep abreast of the vast flow of literature. JEL issues contain commissioned, peer-reviewed survey and review articles, book reviews, an annotated bibliography of new books classified by subject matter, and an annual index of dissertations in North American universities.

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journal article

The Bell Journal of Economics

Vol. 7, No. 1 (Spring, 1976)

, pp. 197-206 (10 pages)

Published By: RAND Corporation

https://doi.org/10.2307/3003196

https://www.jstor.org/stable/3003196

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The RAND Corporation is a nonprofit institution that helps improve policy and decisionmaking through research and analysis. RAND focuses on the issues that matter most such as health, education, national security, international affairs, law and business, the environment, and more. With a research staff consisting of some of the world's preeminent minds, RAND has been expanding the boundaries of human knowledge for more than 60 years. 

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Author Definition

Definition

The Lerner index, measured as the percentage markup of price above marginal cost, (P-MC)/P, has often been used as a measure of a firm’s market power. The Lerner index always has a value between zero and one. For a textbook-perfectly competitive firm, P=MC so that L=0. The larger is L, the greater is the degree of market power.

Commentary

The Lerner index was first developed in Abba Lerner’s 1934 paper, The Concept of Monopoly and the Measurement of Monopoly Power. Elzinga and Mills (2011) offer a historical overview and update. Perhaps the most useful adaption of the Lerner Index comes from the fact that a profit-maximizing firm will price its product inversely to the elasticity of demand facing the firm, L = -1/Ed. Unfortunately, determining a firm-related demand elasticity is much more difficult than determining a market demand elasticity, since a firm must consider how its competitors will react to price changes.

There is a significant limitation to the Lerner Index that has particular relevance in today’s technology-driven world. A firm may price substantially above its marginal cost (at its average rather than marginal cost). The reason: the firm needs to cover its fixed costs (moreover, if those expenditures pay for assets that are not redeployable elsewhere, they create a barrier to entry).

The most common source of the price-cost divergence arises when there are scale economies and the firm prices based on marginal cost. The computer software and pharmaceuticals industries are illustrative. For most software or pharmaceutical companies, marginal cost will be close to zero. Therefore, the presence of substantial fixed costs will lead to a Lerner Index slightly below 1.0, whether the software company is big, small or otherwise, and whether the market is highly competitive or monopolistic.

The Lerner Index has not been used extensively in antitrust enforcement. The primary reason is that market power requires the presence of meaningful barriers to entry, whether structural (e.g., substantial scale economies) or behavioural (e.g., substantial brand equity). For antitrust enforcement, the primary focus is on barriers to entry and the secondary focus is on substantial, sustainable high market shares (which are estimated, for example, through the use of the Herfindahl-Hirschman index (HHI).

In the US, the Lerner Index received quite a bit of attention in the 1995 monopolization case brought by the Department of Justice (DOJ) against Eastman Kodak. The DOJ’s expert used an estimated demand elasticity of 2 to infer a high Lerner Index (.5) and substantial market power. The court correctly rejected this view, citing among other things the presence of substantial fixed costs (p.109).

In the decades following the Kodak opinion, U.S. courts have continued to be critical of reliance on the Lerner Index to prove market power, while not ruling out the possibility that it may nevertheless be informative. In Dial Corp. v. News Corp (2016), for example, the court held that the plaintiff’s expert’s use of the Lerner Index in a critical loss analysis of market definition could not be excluded, noting that the Second Circuit’s Eastman Kodak decision did not prohibit use of the Lerner Index in all circumstances (pp. 41-42).

Furthermore, in In re Solodyn (Minocycline Hydrochloride) Antitrust Litigation, (2018 U.S. Dist. LEXIS 11921) the court found that the presence of high sunk costs does not rule out the price of a branded drug being anticompetitive. The Court noted that high margins indicated by a Lerner Index calculation, without more, are insufficient to demonstrate supra-competitive pricing. A similar conclusion was reached by the court in In re Intuniv Antitrust Litigation 2020 U.S. Dist. LEXIS 187579 (D. Mass. Sep. 21, 2020), with the Court noting that high margins indicated by a Lerner Index calculation, without more, are insufficient to demonstrate supracompetitive pricing.

Explicit use of the Lerner Index in the UK and the European Union has been even less common than in the U.S. Two telecom cases are worth noting. First, the European court found Slovak Telekom in violation of Article 102 (Council Regulation (EC) 1/2003 on Case AT.39523 – Re Slovak Telekom, 2014 O.J. (C 7465)), but also found the use of the Lerner Index to calculate a market demand elasticity (not an individual demand) to be highly implausible as the basis of a relevant market analysis. Along similar lines, the UK Competition Appeals Tribunal agreed with the lower court in British Telecommunications Plc v. Office of Communications (British Telecommunications Plc, Everything Everywhere Ltd. v. Office of Communications, (U.K. Competition Appeal Tribunal (Aug. 1, 2011)) that the Lerner Index is likely to suggest overly elastic demand when products included in Lerner Index are complements.

Case references

U.S. v. Eastman Kodak Co., 63 F.3d 95 (3d. Cir. 1995)

Dial Corp. v. News Corp., 165 F. Supp 3d 25 (S.D.N.Y. 2016)

In re Solodyn (Monocycline Hdydrochloride) Antitrust Litig., 2018 U.S. Dist. LEXIS 1921 (D. Mass 2018)

In re Intuniv Antitrust Litig., 2020 U.S. Dist. LEXIS 187579 (D. Mass 2020)

FTC v. Swedish Match M. Am. Inc., 131 F. Supp. 2d 151 (D.D.C. 2000)

In re Aggrenox Antitrust Litig., 199 F. Supp. 3d 662 (D. Conn. 2016)

Slovak Telekom, Re (COMP/AT.39523)

British Telecom Plc v. Office of Communications, Nos. 1151/3/3/10, 1168/3/3/10, 1169/3/3/10, 2011

Bibliography

Elzinga, Kenneth G. and David E. Mills, “The Lerner Index of Monopoly Power: Origins and Uses,” American Economic Review: Papers & Proceedings, 2011. 101:3, 558-564 ;

Pindyck, Robert S. and Daniel L. Rubinfeld, Microeconomics, 9th Edition, Pearson, 2019 ;

Lerner, Abba, P. “The Concept of Monopoly and the Measurement of Monopoly,” Review of Economic Studies, 1: 157-75.

For which decision would marginal analysis be most relevant?

For which of the following decisions is marginal analysis least beneficial?

What best enables a firm to establish its profit maximizing quantity of output?

Which term describes costs that are incurred regardless of a firms rate of production?