Theme 3 Economic Definitions
Theme 3 Economic Definitions
THEME 3 – A LEVEL – DEFINITIONS
Allocative Efficiency
Occurs where P=MC and is where the right quantity is being produced at the right price
There is maximum social welfare and maximum utility
Productive Efficiency
Occurs on the lowest point of the average cost curve and firms are most productive where their average costs are at the lowest
Here, competitive firms make normal profits – just enough to keep their resources employed
X-inefficiency
This usually occurs in imperfectly competitive markets and when firms do not have incentives to cut costs
Dynamic Efficiency
This involves the introduction of new technology and working practices to reduce costs over time
Perfect Competition
A market structure in which firms are price takers and produce homogeneous goods
The demand curve is a straight horizontal line, there are low barriers to entry and many firms exist in the market
Monopolistic Competition
A market structure similar to perfect competition, however the products being sold ate slightly differentiated
Firms therefore possess a downward sloping demand curve and have some market power over the price
Oligopoly
A market structure where there are a small number of large firms dominating the market
Examples: supermarkets, mobile phone networks, retail banks
Monopoly
A market structure where one firm dominates the market – a firm which possesses 25% or more of the market share in a particular industry
Natural Monopoly
This occurs where the industry can only support one firm
Collusion
Occurs when firms agree to work together by setting a higher price or restricting the quantity they produce
There are two main types of collusion: tacit collusion and overt collusion
Cartels
A formal collusive agreement where firms agree to mutually set prices
Interdependent
They make price and output decisions based on each others
Contestability
This refers to the ease at which firms can enter or exit a market
A perfectly contestable market consists of zero entry or exit costs
Profit Maximisation
Firms profit maximise at the point MR=MC where the marginal revenue of selling one extra unit is equal to the marginal cost of producing one more unit
For firms to profit maximise, marginal profit must also be zero
Revenue Maximisation
Occurs when firms want to achieve the most amount of sales revenue from selling a larger amount of their products at a lower price
Firms aim to produce at MR=0
Sales Maximisation
Occurs when a firm aims to sell as much of a product / service as possible, ensuring a loss is not made
Occurs at the point AC=AR
Satisficing
When a firm generates enough profit allowing managers to aim for other business objectives and ensure shareholders are kept happy
Instead of aiming for an optimal solution, it aims for a satisfactory one
Principal Agent Problem
Agent is inclined to act in their own interest which may cause conflict regarding which business objectives to prioritise
Sunk Costs
Sunk Costs are costs a firm cannot recover if it shuts down
Examples of Sunk Costs include: marketing costs, research, rent, and investment into new capital/equipment
Barriers to Entry
Are factors that prevent new firms from entering a market or an existing firm from expanding into other markets
Barriers to Exit
Are factors that make it more difficult for a firm to leave a market
Economies of Scale
As output increases there is a fall in long run average costs
Internal Economies of Scale – arise when there is a decrease in long run average costs within a firm
External Economies of Scale – this occurs due to a change in the industry. This would lower the entire LRAC curve of all the firms in this industry.
Diseconomies of Scale
Diseconomies of scale occur when output increases, long run average costs also increase.
Examples: communication, managerial, and coordination
Demergers
A business strategy in which a single business is broken into 2 or more components either to operate on their own to be sold or to be dissolved
Example of a demerger: Pepsi announced a demerger with Pizza Hut. Taco Bell is then to focus on competition with Coca Cola and was welcomed by shareholders as the restaurants had failed to live up to expectations
Organic Growth
Organic growth is where the firm grows by increasing their output. For example, increased capital investment or more labour. It may involve opening new stores or increasing their range of products.
Example of a firm who grew through organic growth is Lego. They even introduced new products such as lego friends and board games to expand their customer base
External Growth
Occurs through a merger or takeover. A merger is where two or more firms join under common ownership and an acquisition which is where a firm takes over another firm
Vertical Integration
The integration of firms in the same industry but at different stages in the production process
Forward vertical integration occurs when a firm integrates with another firm in the next stage of the production process closer to the final consumer
Backward vertical integration occurs when a firm merges with another firm in the previous stage of the production process closer to the raw materials
Horizontal Integration
Firms in the same industry at the same stage of production integrate
Conglomerate Integration
Where firms in different industries with no obvious connections integrate or one buys the other one out
Total Revenue
The amount of money generated from selling a certain amount of output and is calculated by: price x quantity sold
Average Revenue
Revenue per unit and is calculated by: total revenue / quantity sold. Also referred to as the ‘demand’ for a good / service
Marginal Revenue
The revenue generated from selling one extra unit of good / service and can also be known as the difference between total revenue at different levels of output
Average Fixed Costs
The fixed cost which remains the same regardless a change in the goods / services being produced
Average Variable Costs
The variable cost per unit of total output produced
Marginal Costs
The cost of producing one extra unit of output. They are derived from variable costs and are not affected by changes in the fixed costs
Marginal Profit
The additional profit gained from producing one extra unit
Normal Profit
The minimum amount of profit needed for a firm to operate successfully
Normal Profit occurs when AC = AR or TC = TR , which can also be known as the ‘break-even point’ in a perfectly competitive market
Supernormal Profit
When firms make a profit above the level of Normal Profit
Supernormal Profit is usually made by monopolies as they have the price making power to charge higher prices at a restricted level of output
Loss
A firm makes a loss when its TC > TR or the average cost of production is greater than the price per unit
Constant Returns to Scale
Output will increase by the same proportion as inputs increase by
Decreasing Returns to Scale
Output will increase by a smaller proportion than inputs increase by
Increasing Returns to Scale
Output will increase by a larger proportion than inputs increase by
Deregulation
Private enterprises are able to compete in a previously protected market due to the removal of legal barriers
Derived Demand
The demand for one good is related to the demand for another similar good
For e.g, labour is a derived demand which means the quantity of labour firms hire is obtained from the demand for the product produced
Game Theory
Is the study of interactions based off strategic thinking, where one player’s decision is dependent upon the moves of its opponent.
Economists use Game Theory to understand the behaviours in an oligopoly firm
Prisoner’s Dilemma
Is a model used to establish whether two independent parties choose to collaborate in a given situation or act as opponents.
Usually, the highest reward for each party is gained when both parties choose to cooperate.
Pay-off Matrix
This is a table displaying the options available to players of a game. It is a two-firm, two-outcome model.
Price Wars
This occurs when one firm reduces their prices to maximise the amount of products sold, leading to greater profit being made.
This results in the competitor firm losing market share and making less profit as they will make less sales due to their prices being higher.
Consequently, they want to also cut their prices. This starts a price war as now the original firm wants to reduce their prices further.
Price Leadership
In a market where a dominant firm exists, they will act to change prices as they know other firms will follow.
This is because price wars and other forms of retaliation are likely to occur within this market. As a result, the dominant firm becomes the established leader.
Predatory Pricing
This is usually a short-term measure which involves a firm cutting prices below the average cost of production to push its competitors out of the market.
Once the other firms have been forced out of the market, it will raise its prices again to make supernormal profits.
Limit Pricing
This occurs when firms cut prices to deter entry of other firms into the market. Competitors looking to enter the market will be discouraged as they would not be able to compete with the higher-cost firms already existing within the market.
Nash Equilibrium
Occurs when each player will gain nothing by changing strategy, given the choices of its opponent. It is possible that at Nash Equilibrium, both players could gain from co-operation.
Dominant Strategy
Is when one choice yields a better result than the other options available
Marginal Revenue Product
Marginal Physical Product x Marginal Revenue of a good. This refers to the level of consumer demand for the product being made and is a key determinant of wages.
A higher MRP will increase the demand for labour
Demand for Labour
The price firms are willing to pay to hire a specific number of workers at a given wage rate and is determined by the marginal revenue product
Worker Productivity
If the productivity of a worker increases, they appear more ‘attractive’ to an employer, encouraging them to be hired. Employers are more likely to invest workers they know will produce high quality work
Supply of Labour
Is depicted by an upward sloping supply curve and is the number of workers available and willing to work at any given wage.
Geographical Immobility of Labour
Workers experience difficulty in moving from one job to another due to the cost of movement and new location
Occupational Mobility of Labour
Workers experience difficulty in moving from one job to another due to the lack of transferable skills they have
National Minimum Wage
The National Minimum Wage is the lowest level of hourly pay that an employer is allowed to pay an employee
The national minimum wage was introduced by the government to ensure workers were not exploited with unfair low wages.
Monopsony
When there is only a single buyer in the market
N-firm Concentration Ratio
This ratio measures the percentage of the total market that a particular number of firms possess. The N-firm concentration ratio indicates the concentration of supply in the industry
Minimum Efficient Scale
The Minimum Efficient Scale is the lowest point on the graph and depicts when average costs are the lowest and Economies of Scale are fully utilised
Third Degree Price Discrimination
Monopolists charge different prices to different groups of people for the same good / service
Privatisation
The selling of government assets / equity in nationalised industries to private investors
Nationalisation
Government gain control of an industry and the private sector assets are sold to the public sector
E.g the railway network was nationalised in 1945
Regulatory Capture
This occurs when regulators start to act in the interest of the company, rather than the consumers’, as a result of impartial information
Private Sector
The part of the economy which is owned by individual people
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