The Degree of Market Power
The price elasticity of demand tells us how sensitive the quantity demanded is to price. If the price elasticity of demand is 1, a1 per cent increase in price will result in a 1 per cent decrease in the quantity demanded.
When the price elasticity of demand is large, the quantity demanded is very sensitive to price. A small percentage reduction in price causes a large increase in the quantity demanded. If the price elasticity of demand were 5, a reduction in price of only 1/5th of 1 per cent would be needed to bring about a 1 per cent increase in the quantity demanded.
In the someway, when the price elasticity of demand is small, the quantity demanded is insensitive to price. If the price elasticity of demand is 1/5, it will take a 5 per cent reduction in price to produce a 1 per cent increase in the quantity demanded.
Using this notion of sensitivity of demand to price, we obtain the Lerner index of the degree of market power from Equation. A monopolist will maximize its profit by picking the output that makes its marginal cost equals to its marginal revenue.
Recall that the source of the welfare loss under monopoly is the restriction of output, which raises the price above marginal cost. It seems natural to measure degree of market power by the extent to which the monopolist can hold the price above marginal cost.
Even for a monopolist, there is a limitation on control over price: the extent to which customers leave when the price is increased. If the quantity demanded is very sensitive to price, the price elasticity of demand will be large. The right-hand side of equation will be small, and the profit-maximizing price will be close to marginal cost. In such a market the profit-maximizing monopolist will restrict output only slightly below the competitive level.
On the other hand, if the price elasticity of demand is small, the monopolist has more leeway to raise the price. When the quantity demanded does not decline very much as the price rises, the profit maximizing monopolist will be able to raise the price above marginal cost without suffering substantial losses in patronage.
