Micro Glossaryofallterms IB 05

8/13/2019 Micro Glossaryofallterms IB 05

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Constantine H . Zi ogasThe IB at the Moraiti s School (0346)

Athens, Greeceziogas11@yahoo.com

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Social SciencesSocial Sciences are those disciplines that deal with the study of society in general, the factorsmotivating behavior of humans within that society, and the results of such behavior. (verbatimfrom: http://web.alfredstate.edu/records/LibArts&Scicourses.pdf )

EconomicsEconomics is the science which studies human behavior as a relationship between given ends andscarce means which have alternative uses (Lionel Robbins) Or, t he scientific study of howindividuals and society make choices in regard to the alternative uses of scarce resources which areemployed to satisfy unlimited wants. Or, ‘Economists is what economists do’ (Jacob Viner)(for a collection of definitions check the site

http://www.geocities.com/hmelberg/papers/981123.htm )

MicroeconomicsThe study of how individuals, firms and industries make decisions related to economic choices.

Norwegian Nobel prize economist Ragnar Frisch was the first to use the terms microeconomics andmacroeconomics (see http://www.econlib.org/library/Enc/bios/Frisch.html )

MacroeconomicsMacroeconomics refers to the study of aggregate economic variables such as total output (not theoptimal level of output for a firm), the price level (not the price of a good or of a service) and thelevel of total employment (not the number of workers a firm will choose to hire). It thus examines

economy-wide phenomena such as growth, inflation and unemployment.

GrowthThe term refers to the increase in the volume of output that an economy registers through time.More precisely it is said that an economy has grown if real GDP has increased over the previous

period. This is often referred to as actual growth in contrast to potential growth where the production possibilities of an economy have expanded through time (the curve has shifted outward).The percentage by which real GDP has changed on an annual basis is referred to as the growth rate.If this is a negative number it implies that economic activity (real GDP) has shrunk, has decreased.Technically, if this decrease in real GDP lasts for at least two consecutive quarters the economy isin recession. Note that defining when the US economy has officially entered a recession takes morethan inspecting the change in real GDP. Check on this the NBER site at http://www.nber.org/ andmore specifically http://www.nber.org/cycles/recessions.html#faq

Economic DevelopmentA sustainable increase in living standards that encompass material consumption, education,health and environmental protection (i.e., a multidimensional quantitative and qualitative

process) ( World Bank definition)

Human development:The process of expanding people's choices and the level of well being they achieve are at the coreof the notion of human development. Such choices are neither finite nor static. But regardless ofthe level of development, the three essentials include the ability to lead a long and healthy life, to

acquire knowledge, and to have access to the resources needed for a decent standard of living.Human development does not end there, however. People also highly value political, economic andsocial freedom, opportunities for being creative and productive, self-respect and guaranteed humanrights. Income is a means, with human development the end

Sustainable DevelopmentUN 1987 definition: “development that meets the needs of the present without compromising theability of future generations to meet their own needs”World Bank definition: “a process of managing a portfolio of assets to preserve and enhance theopportunities people face”

Positive (economic) statementA statement that can, at least in principle, be falsified; it can, in other words, be subjected toempirical verification; it can be tested against data.

Normative (economic) statement

A statement that is not subject to falsification and thus reflects a value judgment, an opinion;usually spotted by words such as ‘ought to be’, ‘fair’, ‘unfair’ etc.

Ceteris paribusLatin expression meaning ‘all else remaining constant’; in examining, for example, the relationship

between two economic variables x 1 and y, and finding that when x 1 rises then y tends to decrease, itis assumed that all other economic variables such as x 2, x3, x4,…x n that may also affect variable yremain constant. As an example, we say that if the price per unit of a good rises then quantitydemanded per period of time decreases, ceteris paribus, meaning, in this case, that the level ofincome, consumer preferences, the prices of other related goods etc remain unchanged.

ScarcityThe fundamental concept of economics on which the whole discipline rests: it summarizes the ideathat human wants exceed the ability to produce goods and services from our limited (scarce)resources to satisfy these wants. It points to the clash between unlimited wants and limited meansto satisfy them. Definitely a relative concept as one will find it hard to claim that the term meansthe same in Denmark as it means in Rwanda. Diagrammatically, one can claim that if scarcity wasnot an issue then the idea of a production possibilities frontier would be nonsensical as allcombinations would be feasible.

UtilityThe pleasure, satisfaction (from consuming a good); a philosophical concept (Bentham,utilitarianism etc)

Marginal UtilityThe extra satisfaction from consuming an extra unit of a good; thus, the change in utility from achange in the level of consumption or, the rate of change of total utility.

LandAlso referred to as natural resources; refers to the land itself, the minerals, forests, water resources,the climate etc that an economy is endowed with.

LaborThe human, mental and manual (physical), efforts used in the production of goods and services.

Human CapitalThe education, training and experience embodied in the labor force of an economy.

CapitalMan-made aids to production or produced means of production; includes tools, machines,

equipment, factories as well as all goods that firms use as inputs such as the mozzarella that PizzaHut buys to make pizzas (distinction between fixed and working capital).

EntrepreneurshipThe willingness and ability of certain individuals to organize the other 3 factors of production (land,labor and capital) and, most importantly, to undertake risks. The reward of entrepreneurship is notcontracted out (as wages and salaries are) but is a residual which may be negative. As such, it is adistinct concept from that of managers who belong in the labor category. The value ofentrepreneurship as a separate factor was made painfully clear in certain transition economies in theearly 1990’s.

RentThe reward of the factor of production land (the income accruing to the owner for the services of a

piece of land; Dictionary of Economics, The Economist Books)

ProfitsThe reward of the factor of production entrepreneurship. This reward is not contractually agreedand may thus be even negative. (see economic profit further down)

WagesThe reward of the factor of production labor.

InterestThe reward of the factor of production capital; the rate of return on capital invested; the paymentmade for using over a period of time borrowed money; related to the concept of ‘time preference’;(a charge made for the use of borrowed money levied as a percentage of the amount of the debt;Economist)

Opportunity cost (of an action)The value of the next best alternative sacrificed; in a production possibilities diagram theopportunity cost of producing more units of one of the goods, say of ‘X’, is defined as the numberof units of the other good, say of ‘Y’, that need to be sacrificed (as resources are scarce and willhave to be diverted away from ‘Y’ production into ‘X’ production);

Free good vs. economic goodEconomic goods are goods whose production involves sacrificed factors of production i.e. anopportunity cost. (according to the Economist Dictionary: ‘any physical object or service renderedthat could command a (positive) market price’). Free goods do not entail an opportunity cost of

production; or, alternatively, goods for which there is excess supply at zero price. (“commoditieswith a zero price because they do not use up scarce factors of production to create them”). Veryfew goods may be considered free. Typically, examples include the air, sunshine and sea water.

Rationing System

A mechanism that may be employed to allocate good to consumers. The price mechanism is anexample of a rationing system. In a free from government intervention competitive market the

market price ensures that whoever is willing and able to pay the market price will enjoy the good.Alternative rationing systems (devices) include a ‘first-come, first-served’ system whereby whoeveris their ‘first’ enjoys the good (often the case in price controlled markets), seller’s preferences,coupons etc.

Basic Economic QuestionsThe reality of scarcity necessitates that all societies answer the so-called three fundamental (basic)questions of economics: what, how and for whom.

Mixed EconomyA mixed economy is an economy in which basic economic decisions (concerning, for example, the

production and the consumption of products) are determined by both market forces and the state.Of paramount importance is the degree to which the state is involved. The involvement of the statehas changed dramatically through time (see the “Commanding Heights” DVD and the site athttp://www.pbs.org/wgbh/commandingheights/ for an excellent treatment of the shifting roles of thestate and the market)

Centrally Planned (command) economyAn economy in which the state determines prices, output and production.

Free Market EconomyAn economy in which markets, in other words the interaction of buyers and producers, determine

prices, output and production.

Public sectorThe state, the government (federal and state; national and local)

Private sectorHouseholds and businesses

Production possibilities curve (or, frontier or boundary)(a model, a diagram that..).. refers to an economy with a fixed amount of resources and a givenlevel of technology producing two goods or two classes of goods, X and Y: The locus of points thatdepict the maximum amount of Y an economy is able to produce for each amount of X it chooses to

produce if it fully and efficiently employs all of its scarce resources with its given level oftechnology. Useful in the sense that a number of fundamental economic concepts may be easilyillustrated and visualized such as the idea of scarcity, opportunity cost, actual and potential growth,choice, feasible and non-feasible production sets, (productive) efficiency and inefficiency, theeffects of the choice between present and future consumption (between producing consumption andcapital goods; between consumption and investment) etc.

Actual and potential growthActual growth refers to an increase in real GDP or real per capita GDP (or GNP); potential growthrefers to an expansion of the production possibilities of an economy (a shift outwards of the

production possibilities boundary)

MarketA process through which potential buyers and sellers of a product interact

Expected variablesThe future value of a variable as perceived presently; for example, in order to estimate the realinterest rate agents should subtract from the nominal interest rate the expected value of the inflationrate next period.

ExpectationsThe present perception of decision making units concerning the future state of affairs in aneconomy, a market or the value of an economic variable.

Perfect competitionA market structure characterized by a very large number of small firms (infinitely large number;this implies that increasing returns to scale are ruled out; it also means that the type of competition

present is ‘atomistic’ and ‘impersonal’; contrast this with the ‘rivalry’ present in oligopolisticmarkets), a homogeneous product , no entry or exit barriers and, in addition, perfect information shared by all parties involved and perfect factor mobility (implying that for example, labor does notsuffer from neither occupational not geographical immobility). As a model it may be highly

unrealistic but, given its efficiency results, it is highly useful since it serves as a benchmark againstwhich real world market structures can be judged.

Monopolistic competitionA model introduced independently at roughly the same time by Ed Chamberlain in CambridgeMass. and by Joan Robinson in Cambridge, UK. A monopolistically competitive market ischaracterized by very many small firms (so strategic behavior is ruled out) and free entry (exactly asin perfect competition) but the product is assumed to be differentiated . Advertising is expected insuch an environment. Excess capacity also characterizes long run equilibrium in monopolisticcompetition: a firm has excess capacity if unit costs could be reduced by raising output levels; itcould be reduced also if less variety was present in the market. Some claim that this excesscapacity is a price worth paying if consumers value greater variety (a comparison of perfect andmonopolistic competition can be found at:http://student.maxwell.syr.edu/xliang/101_13_monopolisticcom1.ppt or athttp://www.econ.rochester.edu/eco108/ch15/micro15/micro15.ppt

MonopolyA structure characterized by one firm , a ‘unique’ product (as the distinction between homogeneousand differentiated makes no sense with one, single-product, firm present) and high entry barriers isconsidered as a pure monopoly; rare in the real world with certain utilities -and cable TV in the US-serving as examples. Whether Microsoft should be considered as a typical example of monopoly issubject to debate. Bear in mind also that the definition of the relevant market (how narrowly or

broadly the product is defined as well as geographic considerations) is instrumental in assessing thedegree of monopoly power a firm enjoys.

OligopolyA market characterized by few firms , either a homogeneous or a differentiated product and entrybarriers . ‘Fewness’ is thus the defining characteristic of oligopolies and the resultinginterdependence (which exists if the outcome an action of a firm depends crucially on the reactionof rival firms) that exists. Note that interdependence can be illustrated with a firm facing twodemand curves, one being more elastic than the other at the intersection price which is drawn withthe assumption that rivals do not follow any price change and the other demand curve less elastic

(more inelastic) assuming that they do follow a price change. This evolves into the kinked demand

curve diagram if it is further assumed that price increases are NOT followed whereas price cuts areindeed followed.

Homogeneous productIt is defined as a product that consumers consider identical across all firms. It makes no difference

to them from which of the ‘n’ firms present they will purchase the product from. Products that otherfirms offer are perfect substitutes. Note that firms have the incentive to seek even slight orimaginary differentiation as it grants them at least a slight degree of monopoly power permittingthem to raise price without losing all customers. Good examples of homogeneous products can befound only in the primary sector e.g. agricultural -food and non-food- products, metals etc. Foreignexchange is also considered an example of a homogeneous ‘product’ in the sense that a dollar is adollar whether it’s sold in NY or in London or in Frankfurt.

Differentiated productThese are similar but not identical products. Cross-price elasticity is a very high positive number

but not infinite. Product differentiation may be real, e.g. in terms of characteristics, or imaginary

e.g. Bayer and no-name aspirin both sell the exact same chemical compound (acetylsalicylic acid).Product differentiation confers to a firm a degree of monopoly power in the sense that the demandcurve it faces for its product will be negatively sloped and as a result it becomes a price searcher

being able to set price above its marginal cost. Product differentiation can be considered aneffective firm created entry barrier if it results in brand name creation.

Barrier to entryIt is defined as anything that deters entry into a market; a cost advantage that the incumbent firmenjoys. Could be distinguished into state created (e.g. licenses, patents and proprietary technologyetc), natural (massive scale economies that permit the profitable operation of only a few or even justone firm -case of natural monopoly, favorable access to raw materials, favorable geographiclocation etc) or firm created (brand name creation, product proliferation, product differentiation andinnovation, maintaining excess capacity, limit pricing, learning cost advantages etc)

Resource allocationThe appointment of scarce resources to different uses for the production of different goods andservices. Once the first of the three fundamental problems of economics is answered, namely the“what” question, a specific resource allocation has emerged. If the resulting allocation is optimalfrom society’s point of view then allocative efficiency has been achieved.

DemandDemand is defined as the relationship between various possible prices and the correspondingquantities that consumers are willing and able to purchase per time period, ceteris paribus. If theLaw of Demand holds it is illustrated as a negatively sloped curve. Can be read ‘horizontally’(showing at each price the quantity demanded per time period, ceteris paribus) or ‘vertically’(showing how much at the most consumers are willing to pay for each extra unit of a good; themarginal valuation of each good by consumers.

Law of demandIt states that as the price of a product rises, quantity demanded per time period decreases, ceteris

paribus; that there is a negative (inverse) relationship between the two variables, price per unit andquantity demanded. It follows from the law of diminishing marginal utility and the optimizing

condition for the typical consumer has to satisfy to maximize utility. This result can be brokendown into the substitution effect (that as the price of product ‘x’ rises then all other goods

automatically become relatively cheaper so consumers will tend to substitute other goods for ‘x’)and the income effect (that as the price of ‘x’ rise consumers’ real income -the purchasing power oftheir money income- decreases so they will tend to buy less of ‘x’, assuming that ‘x’ is not ‘ very’inferior and that expenditures on it represent a large chunk of total consumer expenditures in whichcase the income effect may dominate the substitution effect resulting in a ‘Giffen’ good situation)

Veblen goodsOne of the two exceptions to the Law of Demand: as the price rises, quantity demanded also risesresulting in an upward sloping demand curve. It is a good viewed as a status symbol (snob good),valued because its high price is beyond other individuals; Veblen goods thus appeal to consumers

because of the high price and resulting prestige and status. Beluga caviar, large diamonds and largeluxury cars may be examples. Raising the price for these goods may not decrease quantitydemanded; conspicuous, ostentatious consumption. (Thorstein Veblen, The Theory of the LeisureClass, 1899). In this case the substitution effect is perverse and greater in size than the incomeeffect.

Giffen goodsGiffen goods, together with Veblen goods, are an exception to the law of demand. If the price ofsuch goods increases, quantity demanded will increase, giving rise to a positively sloped demandcurve. Giffen goods have the following characteristics: they are very strongly inferior goods , theyare consumed by the very poor and expenditures on these goods must represent a very significant

proportion of total consumer expenditures . The income effect runs opposite the substitution effectand dominates it. Mentioned in 1895 by A. Marshall in his Principles, the original example was

bread in Sir Robert Giffen’s time (19 th century) consumed by the very poor in London. The typicaltextbook example has been potatoes consumed by the very poor Irish farmers during the 1845famine. Both examples have been refuted by historical data. A recent paper (Giffen Behavior:Theory and Evidence, Jensen, R.; available online) using detailed panel data has shown that inChina, where 30% of the population still survives on less than a dollar a day per person, noodles inthe north and rice in the south exhibit such Giffen behavior.

Normal goodsIf a rise in income leads to a rise in the demand for x, then x is considered a normal good (and ischaracterized by a positive income elasticity of demand). In an (income - quantitydemanded/consumption) space the resulting curve is upward sloping and is often referred to as anEngels curve.

Inferior goodsIf a rise in income leads to a decrease in the demand for x, then x is considered an inferior good(and is characterized by a negative income elasticity of demand)

Luxury goodsUsually the term refers to goods with a high income elasticity of demand (greater than 1)

SupplyThe relationship between various possible prices and the corresponding quantities that a firm(s) is(are) willing to offer per period of time, ceteris paribus; the curve in a diagram depicting such arelationship; the supply curve is the marginal cost curve above average variable costs in the shortrun and above average costs in the long run. Note that only perfectly competitive firms have a

supply curve (there is no one-to-one relationship between prices and quantities for firms facing anegatively sloped demand curve). A supply curve can be read ‘horizontally (i.e. it shows at each

price, how much a firm is willing to offer) or, ‘vertically’ (showing for each extra unit the minimumthat a firm would be willing to accept to offer it). The latter is very useful in welfare analyses. Thearea under a supply curve from some q 1 to some q 2 shows the value of resources sacrificed to

produce the amount of output q 1q2.

Law of supplyAs the price increases, the quantity that a firm is willing to offer per period, ceteris paribus, rises.This holds in the short run as a result of the law of diminishing marginal returns which gives rise toan upward sloping marginal cost curve. In the long run this positive relationship may not hold. Itcould be that firms are willing to offer ever greater quantities at the same price (if they face aconstant returns to scale technology) or that they will be willing to offer ever increasing quantitiesat lower and lower prices (if they are characterized by increasing returns to scale).

Indirect taxationA tax on goods or on expenditure on a per unit or a percentage of price / expenditure basis.

SubsidyA payment by the government to producers usually on a per unit of output basis aiming at raising

production / consumption of the product, lowering the market price and/or increasing producers’income.

EquilibriumA state of rest. A system (a market, a firm, a consumer, an economy etc) is considered to be inequilibrium if there is no inherent (endogenous) tendency for change. The term is borrowed fromthe hard sciences. Note that there is nothing necessarily good about equilibrium. For example amonopolist achieving his profit maximizing goal is in equilibrium even though allocativeinefficiency is the case. Or, the natural rate of unemployment is known as equilibrium’unemployment: ask those unemployed if there is anything good about it.

Market clearing priceThat price which leads to quantity demanded being equal to quantity supplied; where neither excessdemand nor excess supply exist.

Comparative staticsA typical way of studying economic phenomena: an initial equilibrium is assumed, an external‘disturbance’ (a ‘shock’) occurs, a new equilibrium is somehow reached and we compare theeventual with the initial equilibria. It’s as if we compare two ‘still’ pictures (instead of examining a‘movie’ which is what dynamic analysis attempts to perform)

Maximum price (price ceiling)A price set by the government (administrative price; a price control) below the equilibriumdetermined price in order to protect (low income) consumers. If it is set below equilibrium and thusis effective it leads to shortages.

Minimum price (price floor)A price set by the government (administrative price; a price control) above the equilibriumdetermined price, usually in order to protect producers. If it is set above equilibrium and thus iseffective it leads to surplus.

Price supportSame as minimum price.

Buffer stocksA policy often employed in agriculture for non–perishables aiming at smoothing out price volatility

often observed in such markets. A target price (or a target range) is chosen and the buffer stockmanager (usually, but not necessarily the government) buys and stocks the good if the price tends tofall (below the lower level) or sells from stocks if the price tends to rise (above upper limit). Seecommodity agreements.

CommoditiesPrimary products, such as cocoa, coffee, tin, tobacco and copper traded in international markets

Commodity agreementsThese are agreements between producers/exporters (and sometimes buyers/importers ofcommodities) to co-operate in order to stabilize prices. If a production (export) quota system is

operated (such as the International Coffee Agreement which operated between 1962 and 1989 bythe International Coffee Organization; also for sugar and tin) then producers (exporting countries)agree to limit the amount exported effectively forming a ‘cartel’. Alternatively, a buffer stocksystem (cocoa, rubber etc) may be operated by a ‘buffer stock authority’ (that may include

producing and importing countries) which sets a target price or a target price band (a range with anupper and lower limit). Commodity agreements have all collapsed usually because of financing

problems.

ElasticityThe responsiveness of a variable to a change in some other variable

Price elasticity of demandThe responsiveness of demand (quantity demanded) to a change in price.

Price elastic demandDemand is considered price elastic if a change in price (in the neighborhood of the current price)leads to a proportionately greater change in quantity demanded.

Price inelastic demandDemand is considered price inelastic if a change in price (in the neighborhood of the current price)leads to a proportionately smaller change in quantity demanded.

Cross price elasticity of demandThe responsiveness of the demand of good X to a change in the price of good Y. A positive CPEimplies that the two goods are substitutes (in competitive consumption) whereas a negative numberimplies that they are complements (jointly consumed). The closer to zero from either direction theCPE is, the weaker the relationship between the two goods.

Income elasticity of demandThe responsiveness of demand to a change in income. If positive, then the good is a normal good.If negative, then the good is an inferior good. If positive and greater than one, then we say demandis income elastic, implying that a change in income will lead to a proportionately greater change in

demand (expenditures) in the same direction. If IED is between zero and +1, then demand is

income inelastic (staple / basic goods, food; Engels’Law: expenditure on food as a proportion oftotal consumer expenditures drops as incomes rise – an empirically derived law)

Price elasticity of supplyThe responsiveness of supply (of quantity supplied) to a change in price.

Total, average and marginal revenuesTotal revenues are the product of the price per unit times the number of units sold. Average revenuefrom selling a given quantity q is defined as total revenues of selling these q units divided by q, soAR(q) = TR(q)/q = pq/q = p

Primary/ secondary/ tertiary sectorThe primary sector refers to agriculture, mining, forestry and fishing; the secondary sector refers tomanufacturing (industry) and construction whereas the tertiary sector refers to services.

Flat rate tax

A tax (usually on income) that is a constant percentage of the tax base

Ad valorem taxAn indirect tax expressed as a percentage of the price (expenditure) of (on) a product. A sales taxsuch as the value added tax.

Indirect taxationTaxes on goods or expenditures (VAT, tariffs, excise duties on alcohol and fuel etc)

Direct taxation Taxation on income and wealth (income tax, profit / corporation tax, inheritance tax etc)

Incidence (burden) of taxationRefers to who ends up paying a tax (tax shifting). An indirect tax imposed on a firm mayeventually be partially or wholly paid by consumers.

Production costsThe value of resources sacrificed for the production of a good or service. Those taken intoconsideration by the firm are private costs. If there are no external costs involved than the privatecosts are equal to the social costs.

Economic costsEconomic costs are always opportunity costs, in other words they include the value of all resourcessacrificed whether the firm does or does not explicitly pay for them. Thus economic costs include‘explicit’ costs (costs for which a firm makes explicit payments by writing, say, a check), ‘implicit’costs (including the value of resources, say a building, owned by the firm for which no explicit

payment is made) as well as ‘normal’ profits (defined as the minimum required to secure the scarceresource entrepreneurship)

Total, average, marginal costsTotal costs are the costs incurred for the production of ‘n’ units; average costs are the costs incurredwhen producing ‘n’ units expressed on a per unit basis; marginal costs are the extra (additional; the

increment in) costs when producing an extra unit, thus it is the change in costs as output changes in

other words the slope of the total cost curve, the rate of change of total costs, the 1 st derivative ofthe cost function.

Short runIn economics it is the time period during which some but not all adjustments are possible. For

example, in production theory this requires that at least one factor remains fixed. In macro (say inthe Phillips curve analysis) it requires that expectations have not fully adjusted (i.e. money illusionis still present). In finance , the short run refers to instruments with a maturity of less than a year.

Long runWhen all adjustments are possible; in production, when all factors are considered variable, when nofixed factors exist.

Law of diminishing marginal returnsA technological (production) law that states that as more and more units of a variable factor areadded to a fixed factor there is a point beyond which total output will continue to rise but at a

decreasing rate or, equivalently, that marginal product will decrease.

Accounting costsCosts that a firm makes explicit monetary payments for.

Total, average and marginal productTotal product is the output derived from a specific combination of inputs, Average product (oflabor) is defined as output per unit of input (per worker; a commonly used measure of productivity);marginal product of labor is the extra (additional; increment in) output from one more unit of labor;the change in output from a change in labor; the slope of the total product curve etc

IRS, CRS DRSProduction technologies that a firm may face I the long run; Increasing Returns to Scale exist if arise of all inputs by x% lead to a rise in output by more than x%; Constant Returns to Scale exist ifa rise of all inputs by x% lead to a rise in output by exactly x%; Decreasing Returns to Scale exist ifa rise of all inputs by x% lead to a rise in output by less than x%.

EOS, DOSEconomies of Scale are enjoyed by a firm if unit (average) costs decrease as the size (scale) of thefirm increases; roughly the idea that larger in size firms are able for various reasons to produce at alower per unit of output cost. A firm is facing diseconomies of scale if unit costs rise as it expandsin size; roughly, that after a certain size, size may be a (cost) disadvantage; being too large may leadto higher unit costs.

Long run cost curveA locus of points that show the minimum unit costs a firm will incur to produce a certain level of

production when it can alter all factors of production i.e. its size, its scale.

Normal profitsThe minimum return required to secure entrepreneurship (entrepreneurial capital); thus, a(economic) cost of production.

Zero economic profitsImply that total revenues collected from selling a certain level of output is equal to the totaleconomic costs incurred to produce that level of output; as a result a firm making zero economic

profits is making normal profits (the minimum it requires) as these normal profits are included inthe economic costs of production; there is thus no reason for such a firm to exit the industry. It is

making as much as it would make in its next best alternative.

Supernormal (abnormal) profitsAnything above the minimum required to remain in a certain business (normal profits); this impliesthat entrepreneurial capital is making more in this industry than in its next best, equally risky,alternative; as a result, more firms (entrepreneurial capital) will be attracted – entry will occur(assuming no barriers)

Profit maximizationThe working behavioral assumption employed typically when judging firm conduct and

performance. Firms will choose that level of output for which economic profits are maximum.

This requires that marginal revenue is equal to marginal cost and that marginal cost is rising. Notethat if these conditions are satisfied there is no guarantee that the firm is indeed making positive

profits – it could very well be the case it is making minimum losses. Thus these conditions are better to be interpreted as optimizing conditions.

Goals of firmsProfit maximization is the working assumption but several other behavioral assumptions have beenalso proposed by theorists. Sales (revenue) maximization is the leading alternative (it requireschoosing that Q for which MR = 0); long run profit maximization; satisficing (Simon’s boundedrationality) theories; Oliver Williamson’s managerial theories etc.

Sales maximization (sales volume ??)The goal to maximize revenues; it occurs at that output at which MR = 0. (our syllabus mentions Ithink ‘sales volume’ maximization which in my opinion is incomprehensible: it would imply as acondition to choose that level of output for which average revenue (price) is equal to zero);

Shut down ruleA loss making firm in the short run will shut down (exit) only if the price (= average revenue) isless than the average variable cost, i.e. if by producing it can not cover its operating (variable) costs(if TR(q) < VC(q)). For example, assume a cab driver still paying off the bank loan for the

purchase of his vehicle and facing a fare equal to €0.40/km. while gas per km. is €0.45. She shouldshut down; if gas was €0.30/km then she should stay in business even if revenues are insufficient tocover her total (variable and fixed) costs.

Break evenThat level of output for which total revenues are equal to total costs i.e. that q for which (q) = 0.

Allocative EfficiencyHas been achieved if for the last unit of output the price (the marginal valuation by consumers) isequal to the marginal cost of production; this implies that all units which are worth to consumers (tosociety) more that the value of the next best alternative sacrificed are indeed produced up until andincluding that unit for which P = MC. If allocative efficiency is achieved then just the right amount

from society’s point of view has been produced (neither more, nor less) so scarce resources have been allocated in the best possible way. The 1 st fundamental question of economics is answered –

what?) No re-allocation could improve upon this allocation. Social welfare, defined as the sum ofconsumer and producer surplus, is maximum. A few points: remember Schumpeter’s critique ofallocative efficiency (‘…. the powerful lever that in the long run expands output and brings down

prices is in any case made of other stuff’) and also that allocative efficiency is not necessarilydesirable as it is dependent on the underlying distribution of income: demand, as defined, reflects

preferences but also income constraints so if the underlying income distribution in a society ishighly skewed perhaps just the right amount of fur coats and bread is produced but half the population may be dying of hunger.

Productive (technical) efficiencyis achieved if production takes place with minimum average (unit) costs (i.e. at that level of outputat which MC = AC). This implies that production takes place with minimal resource waste. It thusanswers the 2 nd fundamental question of economics (how?).

Dynamic efficiencyThe idea of dynamic efficiency is closely related to the idea of innovations (new products and/or

new processes). It is thus best described through Schumpeter’s defense of large, monopoly powered firms which, if not entrenched, will not only enjoy lower unit costs of production (EOS) but will also lead to faster rates of innovation and technical change.

X-inefficiencyA term coined by Harvey Leibenstein which refers to the ‘internal slackness’ that oftencharacterizes monopoly firms that are highly protected (usually behind legal barriers such as alicense; Howard – Johnson’s in the US was a great example). The firm operates on a set of costcurves that lies above the set derived from usual production theory assumptions. On a diagram drawtwo U-shaped AC curves: their vertical distance at each Q reflects this x-inefficiency.

MonopolyTechnically the case where one firm exists, producing a (unique) product without close substitutesin a market with high entry barriers. Monopoly power is the ability to raise price above marginalcosts. It is measured by the Lerner index, the ratio the difference between price and marginal costas a proportion of the price (if perfectly competitive L = 0 as P=MC; the greater the value of L, thehigher the degree of monopoly power).

Barriers to entryAnything that deters entry into an industry; a cost advantage that incumbent firms enjoy over

potential entrants. Can be distinguished into natural, state created and firm created.

Natural monopolyA natural monopoly is said to exist if the market size in relation to the available productiontechnology is such that two firms can not profitably co-exist. It requires very significant EOS (inrelation to the size of the market given by the position of the demand curve)

Collusive oligopolyWhen (a subset of) oligopolistic firms overtly or tacitly agree to price fixing and other anti-competitive practices.

Non-collusive oligopoly

When oligopolistic firms compete through price or non-price competition.

CartelsOvert collusion of (a subset of) oligopolistic firms; they agree to behave as if they were a monopoly

by restricting output in order to raise price; cartels are inherently unstable structures as the incentiveto cheat exists; the structure is more stable: the greater the proportion of the market the cartelcontrols; the smaller the number of members; the more homogeneous the good is and thus the more

similar production technologies are; if demand is rising etc

Kinked demand curveA theory introduced by Payl Sweezy (1939) in an attempt to explain why the oligopolistic firmseven in the face of cost conditions changing avoid changing price. The behavioral assumption isthat in a duopoly if one firm lowers the price the rival firm will follow (the demand that it thus facesis relatively price inelastic) whereas if it raises price the rival will not follow (thus facing arelatively elastic demand for prices above the current price). Often used to illustrate theinterdependence of oligopolistic firms.

Oligopolistic interdependence

In oligopolistic markets fewness results in interdependence: the outcome of any action of one firmdepends on the reaction of the rival firm(s).

Contestable marketA market characterized by no entry or exit barriers (no sunk costs) thus subject to ‘hit and run’entry; as a result, even if concentration is high with few or only one firm existing incumbents will

be forced to price efficiently because of the fear of ‘hit and run’ entry by potential entrants. Thetheory is an alternative to the Joe Bain “Structure-Conduct-Performance” model of industrialorganization and was introduced in the early 1980’s by William Baumol.

Sunk costsEntry costs that are not recoverable upon exit. Typical example of such non- recoverable costs areadvertising costs.

Exit barriersCosts that a firm incurs upon exit.

Price discriminationA pricing policy that firms with monopoly power may adopt to further increase their profitswhereby two or more different prices are charged in two or more markets as long as the pricedifference does not reflect production or provision cost differences. Necessary conditions inaddition require that markets are separable (no seepage; no arbitrage) and that price elasticities ofdemand differ i.e. that one group of consumers faces fewer alternatives.

Market Success When market forces alone (i.e. demand and supply conditions) lead to efficient outcomes.

Market failureWhen market forces alone (i.e. demand and supply conditions) fail to allocate scarce resourcesefficiently meaning that either too much or not enough of a good is produced / consumed. Typicalcases for our purposes include monopoly power; externalities; public, merit and demerit goods.

Government failureWhen government policies aiming at correcting a market failure fail to do so as a result ofunintended consequences, measurement problems, biases etc

Externalities

When an economic activity creates benefits or imposes costs on 3rd

parties for which these do not pay for or do not get compensated respectively. A market failure, as either too much or not enoughof the good is produced / consumed.

Production, consumption, positive, negative externality… such externalities may result in production or in consumption and if they impose costs they areconsidered negative whereas if they confer benefits they are considered positive.

Public goodsGoods that are non – excludable (if it becomes available to one, it automatically becomes availableto all) and non – rival (consumption by one does not decrease the amount available to others);

typical examples include national defense, law and order, monetary stability, traffic lights,lighthouses etc

Merit goodsGoods that are excludable but non-rival up to a point and whose consumption creates significant

positive externalities. Governments (societies) often as a result want even the poor or the ignorantto consume sufficient amounts of these goods / services. Typical examples include basic education,

basic health care, museums etc

Demerit goodsConsumption of such goods creates significant negative externalities so governments try to decreaseor prohibit their consumption. Typical examples include alcohol, tobacco, drugs etc

Underprovision; overprovisionWhen market forces lead to less than the socially optimal amount being produced / consumed (caseof merit goods); when market forces lead to more than the socially optimal amount being produced /consumed (case of demerit goods)

Tradable (marketable) permitsA market based solution to the problem of pollution emitting firms where an authority (thegovernment) determines the maximum acceptable level of pollution and then issues to firms permits(rights to pollute by a certain amount) which are tradable. Firms have the incentive to engage inactive trading until a new allocation of rights emerges with the total level of pollution the same butwith the minimal amount of goods sacrificed.

Property rightsLegal ownership rights over an asset

Micro Glossaryofallterms IB 05

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