Measuring Market Power - The Lerner Index

The Lerner Index is a measure of market power in an industry.

The Lerner index measures the price-cost margin - it is measured by the difference between the output price of a firm and the marginal cost divided by the output price

Under conditions of perfect competition, output prices equal marginal costs (leading to an electively efficient equilibrium output) while prices move increasingly above marginal cost as market power increases and we head towards an oligopoly, duopoly or monopoly.

We can interpret the index by saying that the Lerner index lies between zero (perfect competition) and one (strong market power)

The chart below tracks the estimated Lerner Index for the UK commercial banking industry and suggests that the industry was becoming more concentrated in the years leading up to the Global Financial Crisis.

Whether or not the entry of a number of challengers banks eventually causes the retail banking sector in the UK to become significantly more competitive remains to be seen. Most of the challenger banks are very small relative to the existing established commercial banks. Some including Metro Bank have already run into significant financial difficulty.

When we calculate the assets of the three largest commercial banks as a share of total commercial banking assets in the UK we find that the leading banks have nearly 70 per cent of assets - a clear indication of an oligopoly.