What determines the Lerner index? The proper interpretation of inverse elasticity rule

Abstract

Inverse elasticity rule is one of the best known equations in economics, but its interpretations are often erroneous and lacking. They posit that the price is set closer to the cost when the demand is more elastic with regard to price. Such interpretation, by focusing only on demand elasticity, ignores other important determinants of price-cost margin (i.e. Lerner index). It also fails to identify and distinguish the different effects of many features of demand and cost. This paper addresses these problems by showing that Lerner index is affected by the cost side as much as by the demand side of the market. The two sides interact with each other to determine Lerner index together. The important features are the (relative) heights of the demand and the marginal cost curves as well as their (relative) slopes. These results lead to more direct prediction of Lerner index and proper interpretation of the inverse elasticity rule.