Mamma Mia! Mis-using Abba Lerner’s index to measure market power

In August 2018, the Federal Government released the Final Report of the Productivity Commission’s (PC) inquiry into competition in Australia’s financial system.

One of the main findings of that inquiry was that price competition in the banking system was limited and reinforced by opaque pricing and obfuscation. The basis for this finding was that all banks – large and small in Australia – exhibited pricing power and were able to use that power to keep prices above marginal costs.

That important finding was alleged to be supported by analysis undertaken by the PC using the Lerner index, which it claimed showed that all banks in Australia had market power, but that the major banks were the “dominant force in the market” and, as a result, were able to charge higher premiums above their marginal costs compared with other institutions.

This Brief explains why the use of the Lerner index to determine whether a firm has market power is flawed and casts doubt on the PC’s findings that all banks in Australia possess market power and moreover, that the major banks, in particular, have been able to set prices above competitive levels to the detriment of consumers.