Economics Letters 3 (1979) 275-279

0 North-Holland Publishing Company

THE LERNER INDEX AND MEASURES OF CONCENTRATION

V.A. DICKSON
University of New Brunswick, Fredericton, N.B. E3B 5A3, Canada

Received 17 July 1979

The paper investigates the relationship between price-cost margins (the Lerner index) and
measures of seller concentration. It shows that previous disparate conclusions on the appropri-
ate concentration measure are special cases that can be reconciled in a more general formulation.

1. Introduction

Economists have made frequent use of measures of seller concentration in

studies of interindustry variation in price-cost margins. However little has been
written regarding the most appropriate specification of concentration to be used in
these studies. One exception are Cowling and Waterson (1976) who have established
a link between the Lerner index @) and the Herfindahl-Hirschman (fl measure of
concentration. Other exceptions are Saving (1970) who in a dominant firms model
established a relationship between L and the k-firm concentration ratio, and Hause
(1977) who also in a dominant firms model, found a link between L and H.
This paper reconciles the Hause, Saving and Cowling-Waterson (C-W) conclu-
sions by showing that their models are special cases belonging to a more general
formulation as represented by the (C-W) model. In doing so it clearly shows that,
depending on how rivals recognize their interdependence, many concentration
measures can be the most appropriate in terms of a link between L and concentra-
tion.

2. The C-W model

An industry of n firms produces a homogeneous product. Firm i maximizes

profit, rri =pxi - ci(xJ - Fi, where xi, c&xi), and Fi are firm i’s output, variable
cost and fixed cost, and p =f(x) = f(Z$r Xi) is industry price. The first-order con-
dition for a profit maximum is

.’. Li = -Si(l + X[)/q. (1)

215
216 VA. Dickson / The Lcrrwr index and wwasures of concentration

In (1) TJis the industry price elasticity of demand, si is i’s market share, Xi/X, Li is
i’s Lemer index, and hi is i’s conjectural variation (cv), Cj+i dxj/dxi, the output
response of other firms anticipated by firm i to a change in Xi. The industry Lerner
index is

C-W obtain from (2) L =H(l + x)/(-n), where x= (C $ Xi)/H. This for them pro-
vides a link between L and H and suggests H as the ‘relevant’ index. Our point of
departure will be to examine the value of Xi in (2) for all firms in the industry.

3. Extensions

We set the stage with what can be viewed as two extreme cases of oligopoly -
the Cournovian and perfect collusion cases. In the former Xi = 0 for all i and L =
(-H/q). ’ In the latter each firm expects its competitors will protect their market
share SO that Zj+ziXj/((Zi+iXj) + xi) = c = (1 - si) where c is a constant. Differ-
entiating Ej+iXj with respect to Xi gives hi = (1 - Si)/Si and inserting into (2) yields
L = (-l/n), the perfect collusion or monopoly solution.

Dominant firms models. Consider a fringe of the (n - k) smallest firms who act as
price takers and a group of the k largest dominant firms who perfectly collude
among themselves. The following variables are introduced:

Xk = the output of the k largest dominant firms,

Qd = market demand,
Q,f = the output supplied by the fringe of (n - k) firms,
nS,- = the supply elasticity of the competitive fringe,
nk = the price elasticity of demand for the k largest firms,
Ck = Xk/X = the k-firm concentration ratio,
di = xi/Xk = Si/Ck = dominant firm i’s share of dominant firm output,
Hk = the H index for the dominant firms sub-group.

The cv for each of the competitive fringe firms will be - 1, since each expects
that an extra unit of output by it will not affect price and hence industry output. *
The cv for each dominant firm will have two parts, one because each expects other
dominant firms to protect their share of dominant firm output and another because

’ Besides C-W, other writers have recently become aware of the H-L link in Cournot equi-
librium. For a list see Hause (1977, p. 80).
’ This conclusion is established in Fama and Laffer (1972).
 V.A. Dickson / The Lerner index and measures of concentration 217

each large firm also expects fringe firms to behave as price takers. Accordingly for
the dominant firm i we can derive
1 -di (1 - ck)%f
hi=--- + (3)
di dt{g + (ck - I)rlsf! *
In (3) the first term represents the anticipated response of i’s dominant firm rivals.
Its derivation for the perfectly colluding dominant firms sub-group is analogous to
the derivation of (1 - si)/si for the perfectly colluding market as a whole. The
second term in (3) measures the anticipated response of the competitive fringe to
a change in i’s output. It is obtained by setting Q,f = Qd - Xk and deriving d&/
dwi. Accordingly,

dQsf @d - dxk = 77& - qkxk

-=
(4)
&i (di) ak di?)kXk ’
Saving (1970, p. 140) has established that nk = {n + (Ck - 1) nsf} /Ck. 3 Substitut-
ing for nk in (4) will yield the second term in (3). Having obtained hi for the fringe
and dominant firms, and letting (n - k + 1) = m, we can compute L as follows:
n-k

Rewriting H in terms of Si, substituting sj/Ck for di, and separating terms for the
last term in (5) gives

(1-ck)%f 2 Sick. (6)

n{n + (ck - l>%fi m

After separating the third term in (6) and cancelling, and since C”, sick = Cl we

G
obtain

(l -
Q{vf(Ck-l)Qf}
Ck)%f
1
=-'?f(Ck-lhsf .
(7)

The result in (7) is exactly that obtained by Saving (1970) in his modelling of a
dominant firms oligopoly.
The dominant firms model of Hause can similarly be case as a variant of C-W.
Unlike Saving, Hauses’ conclusion is that even in the dominant firm industries, H
is the preferred index since he shows that L = -H/(77 f (ck - l)nsf}. The differ-
ent conclusions occur because while Hause’s dominant firms do take into account
the competitive fringe as in Saving’s model, they do not recognize their own inter-
dependence since each dominant firm makes the Cournot assumption about other

3 Saving set Xk = Qd - Q,f, differentiated with respect to industry price and converted to elan
ticities.
278 V.A. Dickson / The Werner index and measures of concentration

dominant firms. 4 Hence the cv of a dominant firm is (1 - Ck) nsf/ {q f (Ck - l)~,~},
where unlike the Saving case, no di appears in the denominator because each dom-
inant firm anticipates that the fringe will respond only to its expansion, since the
expansion of other firms is thought by the Cournot assumption not to occur. In the
framework of expression (2) we have

(8)
Since si = diCk, we can Write (sk + . . . + s’,) = (d&C; + . . . + diC$ = C,$HI,. Inserting
CiHk in place of (s& +... + si) in (8) we can obtain after factoring out C’iHk and
cancelling

(9)

This is identical to Hause’s result if we assume, as he does, that the fringe makes a
negligible contribution to H, i.e. that Hk = H/C:.

4. Conclusion

This paper has shown that the disparate conclusions of Hause and Saving concern-
ing the ‘best’ index for the dominant firms model can be reconciled within a more
general formulation. It has also shown, more clearly than before, how the correct
index varies with the pattern of cv’s in an industry. 5 Because the plausible cv pat-
terns are many, it highlights the futility of declaring one index preferable to another
in studies of price-cost margins. 6

4 Hause started with the dominant firms only and established that in Cournot equilibrium,
their L index is -Hk/qk. After introducing the fringe he obtains the result in the text. In con-
trast, Saving set xk = Qd - Qsf, differentiated with respect to price, converted to elasticities
and after further manipulation obtained (7).
5 The importance of different patterns of cv’s across industries has been emphasized in a differ-
ent context by Dansby and Willig (1979). They show that, depending on the pattern of cv’s
in an industry, different concentration indices can be related to measures of the change in
welfare resulting from locally optimum changes in industry output.
6 For example one should not criticize the use of a k-firm concentration ratio instead of H as
an ‘error of commission’ as is done in Cowling (1976). In fact Ck is directly suggested if we
assume a fringe of (n - k) firms each with hi = - 1, and a group of k larger firms each oblivi-
ous of the fringe but expecting full retaliation for expansion beyond its historical share, so
that Ai = (1 - s$/si. In this case then, L = -Ck/n.
 VA. Dickson f The Werner index and measures of‘concentratior~ 279

References

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Fama, E.R. and A. Laffer, 1972, The number of firms and competition, American Economic
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