The Lerner index measures a firm’s level of market power by relating price to marginal cost. When either exact prices or information on the cost structure of the firm are hard to get, the Lerner index uses price elasticity of demand in order to measure market power: the Lerner index is equivalent to the inverse of the elasticity in its absolute value faced by the firm when price is set to maximise profits. Both formulas are equivalent:
Economist Abba Lerner developed this relationship in his article “The Concept of Monopoly and the Measurement of Monopoly Power”, 1934. This was Lerner’s first major article on welfare economics, in which he introduced the idea that monopolies are a matter of degree, stating that their power depend on the excess of price over marginal costs, discussing also Pareto optimality and loss of total welfare in monopolies.
The extent to which a firm can take advantage of its monopolistic condition will highly depend on the flexibility of its demand curve. If it is more rigid (steeper), it will only have to reduce its production in order to achieve a higher price. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices.
Therefore, Lerner index will always be between 0 and 1: the closer it is to 0, the closer it is to perfect competition; the closer it is to 1, the higher market power the seller has and hence closer to a monopoly. A monopolist seeking to maximise profits will never be on the inelastic part of the demand curve, E < 1, which is why elasticity will always be such as ∞ ≥ E ≥ 1.