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6EC03 – key definitions

Allocative

efficiency

Occurs when resources cannot be reallocated to produce a

different combination of goods that will increase economic welfare;

i.e. economic welfare is maximised and the sum of consumer and

producer surplus is maximised (P=MC).

Average cost The cost per unit – total costs divided by quantity of output.

Average revenue The average selling price – total revenue divided by the number of

units of output sold.

Backward vertical

integration

Where a firm merges or takes over a business that is one stage

further away from the consumer in the production process.

Barriers to entry Anything that prevents new firms entering a market such as brand

loyalty, economies of scale, technical know-how and patents.

Cartel A group of firms that agree to act together as though they were a

monopoly in order to raise profits.

Competition

Commission

The government body responsible for investigating markets that

may have experienced a diminution of competition. Also charged

with the investigation of mergers that may result in reduced

competition in a market.

Competition policy Policies designed to restrict the acquisition and exercise of

monopoly power by firms.

Competitive tendering

When several firms bid for a contract, providing the buyer with lower cost and higher quality choices.

Concentration

ratio

The percentage of total market sales controlled by a specific

number of the industry’s largest firms (3, 5 and 7 firm ratios

commonly used).

Conglomerate

merger

When firms producing unrelated products merge.

Contestable

markets

A perfectly contestable market is one where the sunk costs of

entry are zero and therefore the incumbent firms will only make

normal profits.

Corporate

objectives

The range of targets a firm may have: it is often assumed in

economics that a firm aims to maximise profits.

De-merger Where a firm is divided up into separate businesses.

Diminishing

marginal returns

An economic law stating that if increasing quantities of a variable

factor are applied to a given quantity of a fixed factor, the marginal

product of the variable factor will eventually decrease.

Diseconomies of

scale

A situation where increasing the scale of production further leads

to an increase in the long run average costs of production.

Economic

efficiency

Occurs when output is produced at the lowest cost in terms of

resources used (productive) and in the quantity that reflects the

best possible use of those resources given the relative value

consumers place on the output (allocative).

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Explicit collusion When firms agree to co-operate rather than compete in order to

raise profits.

External

economies of scale

Cost savings that arise from sources outside the firm due to the

growth of the industry as a whole.

First-mover

advantage

The advantages that accrue to a firm by being the first to enter a

market such as market power or supernormal profit.

Fixed costs Costs that do not vary with output and exist only in the short run.

Forward vertical

integration

Where a firm merges or takes over a business that is one stage

closer to the consumer in the production process.

Game theory Game theory is used to predict a firm’s decision when faced with a

set of choices whose payoffs are influenced by the choices of other

firms in the market.

Homogeneous

products

A product is homogeneous when consumers perceive each unit to

be identical.

Horizontal

integration

The joining of two firms together which produce similar products at

the same stage of production.

Imperfect

competition

Where firms have some price setting market power and thus face a

downward sloping demand curve; e.g. duopoly, oligopoly and

monopolistic competition.

Incumbent firms Firms that are established in a market and therefore do not face

sunk costs.

Indivisibility Where a firm would not use a resource to its full capacity and

therefore will not achieve the lowest unit costs of production –

expanding the scale of production allows firms to utilise more

efficient, larger machines and therefore reduce average costs.

Interdependence Where the outcome from a decision is dependent upon the

decisions of other rival firms.

Internal

economies of scale

A situation where increasing the scale of production leads to a

decrease in the long run average costs of production.

Limit pricing Where a firm sets its price below the average cost of potential

entrants in order to discourage entry.

Long run The period of time required for all input costs to be variable.

Marginal cost The additional cost of producing one more unit of output.

Marginal revenue The additional revenue from selling one more unit of output.

Market share A firm’s percentage share of the total market, normally measured

using sales.

Merger When two formerly independent firms unite.

Monopolistic

competition

A market structure in which there are many buyers and sellers, free

entry and exit but heterogeneous products giving each individual

firm some price setting power.

Monopoly A pure monopoly is one where the market has only one supplier. In

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the UK, the legal definition of a monopoly is when a firm has 25%

or more market share.

Monopoly power Monopoly power exists when a single seller in a market has the

ability to set prices.

Monopsony A market with only one purchaser.

Multinational A firm that has operations in more than one country (MNC).

New entrants New firms in a market normally attracted by the existence of

supernormal profits.

Non-price

competition

Competitive activity that doesn’t involve reducing prices such as

brand promotion, product differentiation, innovation and customer

service.

Normal profit The level of profit that represents the opportunity cost of the

resources used to achieve it. If normal profits are not attained,

resources will leave the market to be used more productively in an

alternative market.

OFT The Office of Fair Trading oversees competition policy in the UK,

often referring suspected reductions in competition to the

Competition Commission for investigation. It can bring criminal

charges on business leaders and fine firms who are found to breach

competition law e.g. formation of a cartel.

Oligopoly An oligopoly is a market where there are a few interdependent

firms dominating the market.

Patent The legal right to be the sole user of a particular process or

producer of a unique product.

Perfect

competition

A market structure in which there are many buyers and sellers, free

entry and exit, perfect information and homogeneous products thus making all firms price takers.

Predatory pricing Predatory pricing occurs when a firm incurs short-term losses with

the intention of removing a rival and/or deterring other potential

competitors. It is considered anti-competitive by the OFT.

Price

discrimination

The sale of the same good or service to different consumer groups

at different prices. Three conditions are necessary: effective

separation of markets to prevent resale, different PEDs for the

separated markets and a degree of monopoly power.

Price elasticity of

demand

The responsiveness of quantity demanded to a change in price.

Price leader A firm with sufficient market power to decide on a price change

which its competitors will tend to follow.

Price taker A firm that can alter its output without having any effect on the

price of the product it sells.

Prisoner’s

dilemma

A model used to help show how two interdependent firms may

rationally produce where both firms are worse off if collusion does

not take place.

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Privatisation The transferring of economic activity out of the public sector and

into the private sector in order to improve the productive

efficiency of provision, improve innovation and increase investment.

Product

differentiation

The existence of close substitutes within a market as firms try and

establish a degree of price setting power.

Productive

efficiency

Where a firm produces at the lowest point on its average cost

curve and thus minimises the use of resources per unit produced.

Profit

maximisation

Profit maximisation is achieved at the level of output where

MR=MC. It is often assumed that this is the primary objective of

firms.

Public-private

partnerships

(PPPs)

The use of private firms by the government to improve the

provision of public services through higher and more efficient

investment. Private Finance Initiatives (PFIs) uses private capital and

private sector companies to finance and operate infrastructure that

was previously publicly funded and managed.

Revenue

maximisation

An alternative objective in order to increase market share – it is the

level of output where MR=0.

Sales

maximisation

An alternative objective in order to achieve the highest level of

sales whilst only making normal profit – it is the level of output

where P(AR)=AC.

Satisficing A business that pursues other objectives once a satisfactory level of

profit has been attained.

Short run The period of time over which the inputs of some factors cannot be

varied and thus the quantity of firms in a market is constant.

Shutdown point The level of output where total revenue is equal to total variable

costs – below this point a firm would choose zero output to

minimise the loss made.

Shutdown price The price that is equal to average variable cost, below which a firm

would choose zero output to minimise the loss made.

Sunk costs A sunk cost of entry is a cost that a firm must incur to enter a market and that cannot be recovered if the firm subsequently exits.

Supernormal

profit

A level of profit that is higher than the required level of profit to

keep the firm in the market. The existence of such excess profits

will attract the entry of firms in the long run.

Tacit collusion When firms behave in each other’s mutual interest and restrict

their competitive actions without any agreement in place.

Takeover bid The offer made by the potential buyer for the shares of another

firm in order to achieve control of the business.

Variable costs Costs that vary directly with output.

X-inefficiency The failure of a firm to minimise costs at a given level of output and

thus produce above its own average cost curve.

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Cost & Revenue Concepts

Fixed cost

A cost which does not vary with output in the short-run (e.g. rent, insurance, etc).

Variable cost

A cost which varies with output in both the short and long-run (e.g. raw materials, direct labour,

etc).

Sunk cost

A cost which is irrecoverable upon exiting the industry (e.g. advertising, R&D, etc).

Total cost

TC = TFC + TVC

Average cost

Cost per unit of output.

AC =

Marginal cost

The addition to TC from producing one more unit of output.

MC =

Total Revenue

The total income gained from selling the firm’s output.

TR = P Q

Average revenue

Revenue per unit of output.

AR =

Marginal revenue

The addition to TR from selling one more unit of output.

MR =

Q

TC

Q

TC

Q

TR

Q

TR

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Economies of scale

A fall in long-run average costs as output increases.

Diseconomies of scale

A rise in long-run average costs as output increases.

Allocative efficiency

Where society gets the optimum mix of goods and services in the highest possible quantities, at

which point P = MC.

Productive efficiency

Any level of output at which LRAC is minimised; occurs where LRAC = LRMC.

Minimum efficient scale

The level of output at which LRAC stops falling (i.e. the smallest level of output at which the firm is

productively efficient).

Normal profit

The minimum (accounting) profit which the entrepreneur needs to remain in long-term production

(i.e. the opportunity cost of capital and enterprise). Occurs at the level of output where AR = AC.

Supernormal profit

Any profits in excess of normal profits. Occurs at any level of output where AR > AC

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Market Structures

Monopoly

A market dominated by a single seller (alternatively, the legal definition: where a single firm has

>25% market share).

Assumptions: single seller, many buyers; profit-maximisation; no substitutes for the good; existence of entry

barriers; hence the firm is a price maker earning supernormal profits in both the short and long-run.

Natural monopoly

Where the economies of scale are so great that there is only room for one firm in the market.

Assumptions: very high FC, usually sunk costs, and AC falling continuously with output. Negligible MC, which

also falls continuously with output.

Perfect competition

A market with many buyers, many sellers and a homogenous good, such that each firm is a price

taker.

Assumptions: many buyers and many sellers; profit-maximisation; homogenous good; perfect information; no

entry barriers; hence the firm is a price taker earning normal profits in the long-run.

Oligopoly

A market dominated by a few firms (hence a high concentration ratio).

Monopolistic competition

A market with a large number of firms selling slightly differentiated products.

Assumptions: many sellers and many buyers; product differentiation; no entry barriers.

Concentration ratio

A measure of the combined market share held by the largest n firms in an industry.

Contestability

A market with no entry / exit barriers due to an absence of sunk costs. This leads to ‘hit and run’

competition whenever there are supernormal profits to be made.

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Strategies of the Firm

Profit maximisation

The level of output where TR is furthest apart from TC. Occurs where MR = MC.

Revenue maximisation

The level of output where the TR curve is flat. Occurs where MR = 0.

Sales maximisation

The highest level of output that can be attained without incurring a loss. Occurs where TR = TC, or

AR = AC.

Cost-plus pricing

Where price is set at average cost plus a certain percentage mark-up.

Predatory pricing

Where P < AVC, in order to eliminate existing competition in the market.

Limit pricing

Where price is set below the AC of potential rivals, in order to prevent new firms entering the

market.

Non-price competition

Where the firm aims to attract new customers through branding, quality and innovation.

Cartel

A formal agreement between two or more firms to fix prices and / or output, thereby avoiding a

price war.

Collusion

A secret and informal agreement between two or more firms to fix prices and / or output, thereby

avoiding a price war.

Tacit collusion

Where firms refrain from price competition, but without any communication or formal agreement.

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The Growth of Firms

Internal growth (aka organic growth)

Where the firm increases the sales and TR of its existing businesses.

External growth

Where the firm grows through mergers and acquisitions.

Horizontal integration

The merging of two firms in the same industry and at the same stage of production.

Vertical integration

The merging of two firms operating at different stages of production. Backward / upstream vertical integration (taking over a firm in a preceding stage of production)

Forward / downstream vertical integration (taking over a firm in the next stage of production)

Conglomerate integration

The merging of two firms from completely unrelated markets.

Government Intervention

OFT / Competition Commission / Competition policy

Aim: to promote competition, thereby protecting consumer interests in the form of lower prices

and greater quality, variety and choice.

RPI – X

A method of price-capping where the firm is only permitted to raise price by the level of inflation

(RPI) minus the expected efficiency gain (the ‘X’ value).

RPI + K

A method of price-capping where the firm is permitted to raise price by the level of inflation (RPI)

plus an allowance made for capital investment purposes (the ‘K’ value).

Regulatory capture

Where the regulator begins to sympathise with the regulated firm, leading to lenient price caps and

performance targets.

Deregulation

Where the government removes or simplifies restrictions on entering an industry, with the aim of

stimulating new competition.