The Lerner index: something business owners should learn

Just what is in a bottle of water? In true economic fashion, the answer is “it depends”. In the attached photo, there are four different bottles, The Dasani is processed tap water, The Club Soda is carbonated processed tap water. The Perrier and San Pellegrino are naturally carbonated mineralized spring water from France and Italy respectively. At one restaurant in Australia, the owner has installed a system that filters and carbonates water and he is charging A$5 (A$1=C$1.03) with unlimited refills according to a Reuters article.

The question in the article is whether the public will buy it or not. A firm with monopoly power will choose its output by equating its marginal cost with its marginal revenue. This is the point of maximum profits. Having determined the optimal output level, the firm will charge as much as the market will bear.

The ratio of the price to marginal cost is known as the Lerner index and is inversely related to the elasticity of demand. That is, the more elastic the demand, the less the firm will charge for its product.

A product tends to be more elastic if there are substitutes available, and that is in the eye of the consumer. Club Soda is easy to make and there are several available substitutes. A large bottle can be obtained for a relatively low price. The same is true for bottled water like Dasani, Aquafina or Nestlé Pure Life. People pay for the convenience of bottled water more so than just the product itself. Mineralized waters are somewhat different in that they have different flavours depending on the amount and type of mineral salts that they contain. Some people prefer this to regular tap water and are willing to pay more. Perrier and San Pellegrino are more expensive because the demand is less elastic.

If a customer were to pay the A$5 and a normal person would have at least 2-250ml glasses of water at dinner that is A$1/100mL. In order to get (at least in dollar terms) the same value for money as a Dasani bottle, they customer would have to drink about 2 litres (0.2/100mL).

Dasani               0.212/100ml
Canada Dry      0.1095/100ml
Perrier              0.332/100ml
S.Pellegrino      0.358/100ml

The unfortunate Australian restaurant owner must provide regular tap water for free. The marginal cost of the treated water will be slightly higher but unless customers are not willing to substitute between the treated and untreated water the new product will tend to have a relatively elastic demand.

A small marginal cost and a small Lerner index does not suggest that a A$5 price will be acceptable to consumers. Perhaps business owners should learn more about the Lerner index.

Michael S. Leonard
Kwantlen Polytechnic University
Surrey, BC




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