Question

NEED ESSAY TYPE ANSWER

Provide a thorough discussion of the following statement:

“By defining the concept of the percentage markup of prices over marginal cost as:   

(P -MC/P) = - 1/ƐD, where ƐD refers to the price elasticity of demand of the monopoly firm, one can use this concept to determine the market power of this profit-maximizing monopoly firm.”

Answer 1

(P -MC/P) = - 1/ƐD This is also called as Lerner Index which relates price and marginal cost to the elasticity of demand and try to determine the market power of the monopolist. Price charged in the monopolist market is the mark-up over marginal cost.

Now, in perfect competition, at equilibrium price = marginal cost. However, in monopoly, P > Marginal Cost.

Lerner Index is the measure of monopoly power calculated as excess of price over MC as a fraction of price.

A monopolist always operate at a elastic portion of the demand. So, elasticity is always > 1 in monopoly.

As the demand becomes elastic, the Lerner Index falls as 1/ed will fall. Lower Lerner Index shows less power of the seller in the market. In such case, the monopolist will have little power over market.

As Lerner Index becomes = 0, then

(P -MC/P) = 0

P = MC. So, the market becomes perfectly competitive and the seller has no market power.

As Lerner Index approaches to 1, the market power of the monopolist starts increasing.