Download Economic Definitions

1. Cost Theory (total, fixed, variable costs; calculating costs)
● Total cost: fixed costs + variable costs
○ Average total cost: total cost / output
● Fixed costs: costs that remain unchanged when output changes (e.g. rent, interest on
loans, insurance)
○ Average fixed cost: Fixed cost / output
● Variable costs: costs that vary directly with the level of output so they change
according to the number produced (e.g. cost of raw materials, packaging costs,
direct labor)
○ Average variable cost: variable cost / output
2. Law of diminishing returns
● As more and more of a variable factor are added to fixed factor, output will rise
initially but will l eventually fall.
● Example: McDonalds hire three new workers that increase output by 10 burgers but
adding another worker would only increase the output by 5. Adding a fifth worker
will only increase output by 2. It gets cramped and there isn't space so it because
inefficient.
● Is a short-run law
● Graph
3. Short-run
● The short run is the period of time in which at least one factor of production is fixed.
Over this time period the firm can only expand production by using more of the
variable factor.
4. Long-run
● The long run is the period of time when all factor inputs, including capital, can be
changed.
● Economies of scale: advantages of increasing in size (e.g. greater revenue)
● Diseconomies of scale: disadvantages of increasing in size (e.g. poor
communication)
● Graph
5. Revenues (TR, AR, MR)
● Total revenue (TR): all the revenue earned by the business. Total revenue = price x
quantity demanded.
● Average revenue (AR): total revenue divided by number sold.
● Marginal revenue (MR): the increase in total revenue as the result of one more sale.
This is not necessarily the same as the price. It is only the same as price, if price
remains constant.
6. Profit, sales & revenue maximization
● Profit maximisation: Companies that are trying to create the biggest gap between
their costs and revenue to increase the profit. (companies like Tiffany don’t want to
increase sales by reducing costs but rather just get the most profit from their good)
A firm will maximize profits where MC=MR.
● Sales revenue maximisation: itmeans earning the maximum possible revenue from
the quantity sold. This will not be the same as profit maximising as the additional
units will have a higher cost and may therefore be less profitable to sell. Sales
revenue is maximised where MR=0.
● Sales volume maximisation: it means selling the maximum possible number of units
without incurring a loss. Sales volume is maximised where AR=AC. The firm might
be able to sell more than this, but the diagram shows that on all units of output
beyond this, AC is greater than AR and, therefore, a loss would be incurred.
● Graph
7. Perfect Competition (elements of)
● Perfect competition is considered as the ideal or the standard against which
everything is judged.
● Perfect competition is characterised as having:
● Many buyers and sellers. Nobody has power over the market.
● Perfect knowledge by all parties. Customers are aware of all the products on
offer and their prices.
● Firms can sell as much as they want, but only at the ruling price. Thus sellers
have no control over market price. They are price takers, not price makers.
● All firms produce the same product, and all products are perfect substitutes
for each other, i.e. goods produced are homogeneous.
● There is no advertising.
● There is freedom of entry and exit from the market. Sunk costs are few, if
any. Firms can, and will come and go as they wish. There are no barriers to
entry such as licenses.
● Companies in perfect competition in the long-run are both productively and
allocatively efficient.
8. Shut down and break-even price
Where MC meets AVC (average fixed cost)- shut down price
They can’t meet their costs therefore must shut down
Where MC meets ATC- break even price
9. Monopoly (elements of, model, theory)
● Model: Monopoly is the opposite of perfect competition. In the literal sense, it exits
when one single firm or a group of firms acting together control the entire market
for that good or service and no substitutes are available. This is a situation of pure
monopoly. Economists focus more on the degree of monopoly power that exists
rather than absolute monopoly power. A market concentration ratio is used to
measure the degree of concentration within that industry or group of industries.
The five firm concentration ratio is used commonly to indicate the proportion of the
industry’s output produced by the five largest firms.
● Theory: In perfect competition, as there are many firms competing against each
other, no one controls the price; therefore they are price takers. However, under
monopoly there is only one firm in the industry. So there is no difference between
the demand curve for the industry and and the demand curve for the firm. As the
monopolist is subjected to the normal demand curve, to sell more, the price must be
lowered. However compared the other markets, the monopolist’s demand curve is
probably more inelastic as close substitutes are not available even at higher prices.
● Assumptions about the Model
○ One firm
○ Price Setter
○ Barriers to entry
○ Some monopolies are considered Natural Monopolies i.e. barriers to entry
are very high and the firm enjoys economics of scale where it can produce at
a lower cost than many small firms combined e.g water supply, gas,
electricity
○ Pros
■ natural monopolies can gain economies of scale
■ abnormal profits used for Research and Development
○ Cons
■ anti-competitive behavior & predatory pricing
■ high prices for lower output
■ productively & allocatively inefficient
10. Oligopoly (elements of, model, theory)
● Definition/Model: Oligopoly is when a few suppliers who provide the same
product dominate a market. Petrol companies and the soap and detergent industry
are good examples. Each firm has to be concerned about what the others in the
industry will do.
● Assumptions (Theory) about the model
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three or four large companies dominate the industry, but small companies do
exist
firms are interdependent, all will watch what the competitors do and act
accordingly
there are barriers to entry, this means it is difficult for other firms to enter
the industry;
non price competition, as companies cannot compete by prices, therefore
they have to compete with the service they offer
the oligopoly must be collusive (collusion)
advertising
11. Monopolistic competition (elements of, model, theory)
Definition: Monopolistic competition is made up of a large number of small firms who
produce goods that are only slightly different from other sellers.
Assumptions
● Large number of firms: Each firm has a small share of the market
● Independence: because of the large number of firms in the market, every firm is
unlikely to greatly affect the other. When making decisions firms do not have to
think about how its rival will react.
● Freedom of entry
● Product differentiation: This makes it different from perfect competition. This is also
why each firm has a down ward sloping demand curve.
Examples
● Petrol stations, restaurants, hairdressers.
Theory
Monopolistic Competition in the short-run
● Graph
● In the short run firms are able to make abnormal profits.
● Profit maximized when MC=MR
● In monopolistic competition the AR and MR curves are more elastic because more
substitutes are available.
Monopolistic Competition in the long-run
● Graph
● In the long run new firms can enter the market. Other firms are attracted by the
abnormal profits and they will be competed away until there are just normal profits.
● This means that the demand for the product of each firm will fall and the AR will
shift to the left.
12. Advertising and Branding
Advertising definition: The presentation of a product, idea or organization to convince
individuals to buy, support, or approve of it.
Branding definition: Creating a name, symbol or design that identifies what differentiates
this produce from others. How consumers perceive a branded product will be enough for
goods to be sold at a very different price.
Multiple branding definition: Marketing two or similar and competing product by the same
firm under different and unrelated brands. This could be effective on the barriers to enter a
market for new firms.
13. Forms of collusion
Formal Collusion
Cartel definition: Limited number of competing firms, which are selling a similar product,
decide to collude rather than compete.
● When the cartel acts like a single monopolist and maximises profits, it is most
successful.
● Profit maximisation for the cartel graph
● To maximize profits, MC is equal to MR and there is a optimum price.
Reasons for a cartel
● geography: productive capacity or pre-cartel market share
● cartel members want non-price competition so that they can gain optimum quantity.
Informal or tactic collusion
Priceleadership definition: This is when one firm sets a price that is accepted as the market
price by the other producers. There is no formal or written agreement.
14. Price discrimination
● Price discrimination: charging different prices for the same/similar good to differnt
consumers
● Price discrimination occurs in an imperfect market, when a sale from the same
supplier, of an identical good or service is charged for a different price for different
consumers. Price discrimination is used to profit the discriminating firms. But, the
price discrimination has to be for different consumers, in different markets.
● Stakeholders:
Winners:
Suppliers (able to set a higher price to those able to buy it at that price)
Poorer consumers (able to buy the good/service at a price they can afford. If
price not that low, they wouldn’t have been able to buy it)
Losers:
Richer consumers (have to pay a higher price for the same good, but not a big
loser because they are still able to pay for the good/service)
15. The kinked demand curve theory
● Asymmetrical reaction : asymmetrical reaction to the change in price by one firm.
● eg. a decrease in price by one firm will lead to a decrease in price by other firms to
protect market share.
● Elastic part of graph (top part of graph) - to increase price at the elastic part of the
graph would not be effective as not many other firms would increase their price
(because price is high)
● Point at kink : point showing discontinuity (how good changes from elastic to
inelastic)
● Inelastic part of graph (bottom part of graph) - Price War! Constant competition of
price (if one firm decreases price, other firms follow)