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11.2 THE IMPORTANCE OF PRICE ELASTICITY OF DEMAND 457
Thus, tells us the sensitivity of Coca-Cola’s demand to Coca-Cola’s price, hold-
Q A , P A
ing all other factors affecting Coke’s demand (including Pepsi’s price) fixed. 8

QUANTIFYING MARKET POWER: THE LERNER INDEX
When a firm faces a downward-sloping demand curve, either because it is a monopo-
list or (like Coca-Cola) it produces a differentiated product, the firm will have some
control over the market price it sets. For a monopoly, the ability to set the market
price is constrained by competition from substitute products. In the case of differen-
tiated products, a firm’s direct competitors constrain its pricing freedom (e.g., Pepsi’s
price limits the price Coca-Cola can charge).
When a firm can exercise some degree of control over its price in the market, we
9
say that it has market power. Note that perfectly competitive firms do not have market power The
market power. Because perfectly competitive firms produce at the point where price power of an individual eco-
equals marginal cost, while monopolists or producers of differentiated products will, nomic agent to affect the
in general, charge prices that exceed marginal cost, a natural measure of market power price that prevails in the
is the percentage markup of price over marginal cost, (P MC )/P (the left-hand side market.
of the IEPR). This measure was suggested by the economist Abba Lerner and is called
the Lerner Index of market power. Lerner Index of market
The Lerner Index ranges from 0 to 1 (or from 0 to 100 percent). It is zero for a power A measure of mo-
perfectly competitive industry. It is positive for any industry that departs from perfect nopoly power; the percent-
competition. The IEPR tells us that in the equilibrium in a monopoly market, the age markup of price over
marginal cost (P MC)/P.
Lerner Index will be inversely related to the market price elasticity of demand. As
we’ve discussed, an important driver of the price elasticity of demand is the threat of
substitute products outside the industry. If a monopoly market faces strong competi-
tion from substitute products, the Lerner Index can still be low. In other words, a firm
might have a monopoly, but its market power might still be weak.

APPLICA TION 11.3

Market Power in the Breakfast Lerner Indices and determinants of prices for 37
brands of breakfast cereals sold in supermarkets in
Cereal Industry Boston. 10 They estimated an average price markup of
28 percent over marginal cost. Table 11.2 provides
The breakfast cereal is dominated by four large sellers — some examples of estimated Lerner Indices. Corn
General Mills, Kellogg, Post, and Quaker Oats. Do Flakes had the highest percentage markups, while
these firms have some market power in the break- Cookie Crisps had the lowest. Markups and elasti-
fast cereal market? If so, how is that reflected in cities of demand varied substantially across cereal
prices? The availability of supermarket scanner data brands, and also across supermarket chains. For ex-
now allows economists to study questions such as ample, markups were higher at chains with higher
these with very good data. Such data were used by market share, suggesting that more efficient stores
Benaissa Chidmi and Rigoberto Lopez to calculate with lower marginal costs gain market share. The

8 See Chapter 2 for a detailed discussion of the difference between the brand-level and market-level price
elasticity of demand.
9 Monopolists and sellers of differentiated products are not the only kinds of firms with market power, as
you will learn in Chapter 13.
10 Benaissa Chidmi and Rigoberto Lopez, “Brand-Supermarket Demand for Breakfast Cereals and Retail
Competition,” American Journal of Agricultural Economics 27 (May 2007): 324–337.