Appendix I. Elasticities of Demand and Economic Models of Market Power

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APPENDIX I

ELASTICITIES OF DEMAND AND ECONOMIC

MODELS OF MARKET POWER

Understanding the role of market definition requires an

understanding of the economic analysis of market power. To that end,

this Appendix examines the determinants of market power in the context

of simple economic models. Section A.1 begins with the classic

economic model of monopoly and the roles of the own-price and cross-

price elasticities of demand in the analysis of market power. In Section

A.2, the discussion turns to the application of these concepts to the

analysis of market power when there are multiple suppliers of a product.

Using three different models of multi-firm competition, the discussion

demonstrates how the relationship between market power and market

shares can vary depending on the nature of the firms and the way in

which they compete.

A. The Classic Monopoly Model

1. The Definition of Market Power

Economists define market power as the ability of a firm or group of

firms acting jointly to raise price above the competitive level without

losing enough sales to render the price increase unprofitable. A common

measure of market power is the Lerner index. The Lerner index (L) is

equal to the difference between the profit-maximizing price and marginal

cost, expressed as a percentage of the price—that is, the monopolist’s

percentage profit-maximizing price-cost margin. The mathematical

expression is:

(1)

p

cp

L



where p is price and c is short-run marginal cost.1

1. See DENNIS W. CARLTON & JEFFREY M. PERLOFF, MODERN INDUSTRIAL

ORGANIZATION 254 (4th ed. 2005).