Question

6) Two companies sell soda. Company A sells it for $.50 a can and Company B sells it for $.30 a can. The marginal cost for each is $.20 per can.

a) What is the Lerner Index for each of these companies?

b) Which company has more market power? How can you tell?

c) What is the elasticity of demand for Firm A and Firm B?

Answer 1

Answer 6

(a)

Lerner Index = (P - MC)/P where P = price and MC = Marginal cost

Firm A :

Lerner Index = (P - MC)/P = (0.5 - 0.2)/0.5 = 0.6

Firm B :

Lerner Index = (P - MC)/P = (0.3 - 0.2)/0.3 = 0.33

(b)

As Lerner index of Firm A is higher, this means that firm A's ability to charge price above Marginal cost is greater than Firm B.

Hence, Firm A has higher market power.

(c) According to Inverse Price elasticity rule(IEPR). Profit maximizing condition is given by :

Lerner Index = (P - MC)/P = -1/e where e = elasticity of demand

Firm A :

Lerner Index = 0.6

=> -1/e = 0.6

=> e = -1.67

Thus, Firm A elasticity of demand = -1.67

Firm B :

Lerner Index = 0.33

=> -1/e = 0.6

=> e = -3.03

Thus, Firm B elasticity of demand = -3.03