Microeconomics Definitions

A to Z of definitions

Ad valorem tax

An indirect tax based on a percentage of the sales price of a

good or service.

Adverse selection

Where the expected value of a transaction is known more accurately by the buyer or the seller due to an asymmetry of information; e.g. health insurance

Allocative efficiency

Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production.

When a market is allocatively efficient, it means that scarce

resources are allocated optimally.

Allocative efficiency is achieved at the point P=MC.

Asymmetric information

When one party holds more information than another party in the market. This problem can cause market failure as people will not always make efficient decisions due to a lack of information e.g. a buyer buying a used car does not know its history or its faults. However, the seller is likely to have this information.

Automation

Production technique that uses capital machinery / technology to replace or enhance human labour and bring about a rise in productivity.

Average cost

Total cost divided by the total output.  AC = TC / Q

Also, average cost will be the sum of average fixed cost and average variable cost. ATC = AFC + AVC

Average fixed cost

Total fixed cost divided by the total output.  AFC = TFC / Q

Average variable cost

Total variable cost divided by total output. AVC = TVC / Q

Barriers to entry

Factors that make it costly or difficult for new firms to enter a market and compete. For example, a patent on a product will protect a firm from other companies stealing their idea. Another example of a barrier to entry is high start-up costs. This will decrease the level of competition in the market.

 Bartering

The practice of exchanging one good or service for another, without using money.

Basic economic problem

Scarce resources + Unlimited wants.

Unlimited wants coupled with scarce resources with which to satisfy them.

Behavioural economics

Branch of economics that studies the impact of psychological and social factors on economic decision making.

Black market

Also known as a shadow market or hidden market, these are illegal markets which operate outside the government’s control. A black market could be selling illegal goods like drugs or counterfeit products. However, they can also be selling perfectly legal products but kept off the record, so no tax is paid.

Bottlenecks

Any factor that causes production to be delayed or stopped – this may reduce the price elasticity of supply of a product. For example, a shortage of electricians will be a bottleneck for a house building company.

 Buffer stocks

These are used to stabilise market prices (of agricultural products in particular). When there is an abundance of supply (e.g. a good harvest), this excess is bought up and stored in a buffer stock. When supplies are low (e.g. a bad harvest), supply is then released from the buffer stock. This means prices and revenues don’t have to fluctuate so much in the market.

 Capacity utilisation

How much of your factors of production are being used to produce your products. For example, 80% capacity utilisation means that you are not using 20% of your potential capacity, so you are under-utilising your resources.

 Capital goods

Capital goods are the tools/machinery that are used to produce consumer goods. An example of a capital good is a paint brush, used by a painter and decorator. Another example of a capital good is a pizza oven, used by a pizza restaurant to produce pizza.

 Capital-intensive production

When production is capital-intensive, it means that there is a high proportion of capital to labour. Production will generally be capital-intensive if the good is mass produced, or if there is a high degree of precision needed to produce the good.

 Capitalist economy

An economic system which revolves around the allocation of resources from markets via the market price.

 Carbon capture and storage

A process of capturing the waste products from fossil fuels that damage our environment. This limits the negative effects of fossil fuels.

Carbon credits

Carbon credits allow firms to pollute a certain amount of CO2. They incentivise firms to pollute less. If a firm pollutes less than the carbon credit they have, they can sell these in a carbon market to other firms.

Cartel

Cartel member firms mainly agree on prices and quantities to be sold of a particular product. They are illegal under UK and European competition laws as they are anti-competitive. An example of a cartel is OPEC.

Ceteris paribus

An economic term. It means “all other factors remaining constant.”

Collusion

Collusion occurs when firms agree amongst themselves to avoid competition. Without collusion, firms have to compete with one another and second guess their competitors. Collusion is anti-competitive and is regulated by the government. Collusion can either be formal or informal.

 Command and control

These are laws that are backed up by penalties if not followed e.g. regulation and carbon emissions.

Command economy

An economic system where resources are allocated, not by markets, but by a central planner, normally the government.

 Common resources

Goods that are rival, but non-excludable. Therefore, anybody can benefit but there is limited quantity available. This leads to overuse of the resource. This problem relates to the “tragedy of the commons”.

 Competition policy

Government policy to encourage competition in the private sector e.g. investigating firms thought to be colluding.

Competitive market

A market with many firms selling similar products (homogenous). The consumer has plenty of choice. Therefore, competitive markets will output more and the market price will be lower than less competitive markets. Generally, competitive markets lead to an efficient allocation of resources (but not always).

Competitive supply

Firms can produce a variety of products. A food producer could use potatoes and produce mashed potato products or chips. A farmer could grow potatoes on their land, or they could grow carrots instead.

 Composite demand

Where goods and services that have more than one use will lead to a fall in supply of another. For example, an increase in demand for potato chips, will decrease the supply available of mashed potato products.

Consumer sovereignty

A market with consumer sovereignty will be a market where consumers have plenty of choice and low prices. Scarce resources are allocated to satisfy the needs and wants of consumers.

Consumer surplus

It is a measure of consumer welfare. It is the difference between the maximum amount that consumers are willing to pay and the current market price. High consumer surplus means that prices are very low compared to what consumers are able to pay, therefore consumer welfare is higher.

Consumption

The process of buying goods/services to satisfy wants and needs.

Contestable market

A market where there are low/no barriers to entry and exit.

Cost benefit analysis (CBA)

A decision-making tool used to compare the social cost and social benefits of a planned project. It will establish whether or not investment into the project/policy is efficient.

Costs

What firms must pay to produce goods and services.

 Cross price elasticity of demand (XED)

How sensitive the quantity demanded for Good A is, when there is a price change in Good B. It will tell us whether two goods are substitutes or complements to one another.

% change in Qty demand of Good A

/

% change in Price of Good B

Cyclical demand

Demand that is inline with the economic cycle. For example, in a boom, demand will tend to be stronger than in a recession.

Deadweight loss

The loss of welfare due an inefficient level of production/allocation of resources. This is due to market failure or perhaps even government failure.

Demand

Quantity of a good/service that is bought at a given price level at a given point in time.

Demand curve

A curve that shows the willingness and ability of consumers to pay for a good/service in a given period of time. There is an inverse relationship between price and quantity that is assumed.

Demerit goods

Due to misinformation, people overvalue them so there is overconsumption/overproduction of the good. Demerit goods are also goods that emit negative consumption externalities. Without intervention they cause the free market to fail.

Deregulation

The removal of legally enforced rules that restrict or ban specified activities.

Derived demand

When the demand for a factor of production is dependent on the demand for the good/services that it is used to produce.

Diminishing returns

When variable factors are added to fixed factors of production in the short run period, diminishing returns is the result. Marginal product will begin to fall, and this will begin to raise marginal costs.

Diseconomies of scale

When the scale of a firm increases (increases in size) and its long run average costs begin to rise. This could be due to inefficiencies in production such as communication problems, complexity of production on a large scale and managerial problems.

Disequilibrium

A situation where there is a state of imbalance and so a tendency for change. On a demand/supply diagram, disequilibrium will be the case when demand does not equal supply. If demand outweighs supply, then the price will begin to rise to establish an equilibrium in the market, until the point where demand=supply.

Diversification

When total risk is reduced by spreading risk across a number of investments.

 Division of labour

When the production process is divided across the labour force, and each segment focuses on a specific task. This can lead to increases in productivity and is linked with specialisation.

Dominant monopoly

A dominant monopoly is a firm with 40% or more market share.

Economic agent

Economic agents are people within the economy who have to make decisions on how to act. This could be consumers, firms or governments.

Economic efficiency

Making the best use of scarce resources that can be used for alternative uses. Economic efficiency will involve both allocative and productive efficiency.

Economic growth

The increase of productive potential within the economy. This will be shown by an outward shift in the PPF curve.

Economies of scale

When the size of a firm increases, this can lead to a reduction in long run average costs. This can be down to technical, marketing, financial and purchasing (and risk bearing) economies of scale.

Economies of scope

When firms decide to produce a wider range of products instead of one or a few. This can lead to a reduction in costs.

 Elastic demand

When consumers are very sensitive to price changes. Price is a significant factor of demand. Elastic demand will occur when elasticity is greater than 1.

Elastic supply

When firms are very sensitive to changes in the price. Price is a significant factor of supply. If the price rises, firms will be very willing and able to produce more. Elastic supply will occur when PES is greater than +1.

Entrepreneur

A person who takes risks in order to profit.

Equilibrium

When there is a balance in the market. It is achieved at the level where demand=supply.

Equity

Fairness – based on opinion rather than fact. Therefore, equity is based on value judgements rather the positive statements.

Excess demand

When the quantity demand is greater than the quantity supplied at a given price. In the free market, this will tend to increase the market price towards equilibrium.

Excess supply

When the quantity supplied is greater than the quantity demanded at a given price. In the free market, this will tend to decrease the market price towards equilibrium.

Excise duty

Indirect taxes that are placed on spending on goods and services. This could be on alcohol, for example.

Excludability

Where firms are able to prevent specific people from benefitting from their products.

External cost

Costs that are faced by a third party in a transaction. For example, a buyer and seller interact and make a trade. Somebody outside the transaction pays some sort of cost. Passive smoking is an external cost.

Externalities

Third party effects, either positive or negative, and in consumption or production. This causes the free market to fail as they are unaccounted for.

Factor rewards

Reward payments that are paid to the factors of production when they are used. Rewards for land, labour, capital and enterprise are: rent, wage, interest and profit, in that order.

Firm

An organisation that produces products in order to satisfy needs and wants.

First mover advantage

When the person to act first, has an advantage in the market as they are early. For example, a new type of production is launched – a firm who is first to market has the first mover advantage as potential customers will take note of them first.

Fixed costs

Costs that do not vary with output. They have to be paid regardless of customer demand and the amount sold. Even if the firm sell 0 quantity they must be paid. Therefore, fixed costs will involve everything that is needed for the business to run in the first place e.g. rent, salaries of necessary workers, minimum amount of electricity and energy. They are also known as overheads.

Free market

Where forces of supply and demand only are used to allocate scarce resources to satisfy needs and wants. There is no government intervention in a free market.

Geographical immobility

Where units of labour are unable to be used efficiently to barriers that prevent them from moving to where the demand is for their services.

Gini coefficient

An indicator of the distribution of income in an economy. It is calculated using the Lorenz curve. If the Gini coefficient is 0, it will mean perfect equality. If the Gini coefficient is 1, it will mean perfect inequality of the distribution of income. You can work out the Gini coefficient by the following formula. Area A / Area (A + B)

Goods

These are products that are tangible, physical products.

Government Failure

This is when the government intervenes in a market. They do this because they believe there is a market failure and they are trying to correct this with policies. However, when the government intervenes and this causes lower social welfare than without governemnt intervention, then this is deemed government failure. This is because resources have been wasted to correct the market failure, but the government has failed to do so.

Government Spending

When the government spends money on goods and services.

Hedging

Is when somebody protects themselves against risk. This could be by diversification (buying into multiple investments rather than one).

Horizontal equity

When people in the same income group should be taxed at the same percentage rate.

Horizontal integration

When two firms join at the same stage of production in an industry e.g. Tesco and Sainsbury's do a merger.

Incidence of a tax

How tax on a product is shared between the producer and the consumer. It will depend highly on elasticity of demand.

If a product is inelastic, then this means the consumer is less sensitive to price. That means the producer is likely

to pass on the tax to the consumer. Therefore, the consumer will pay more.

If a product is elastic, then we have price sensitive consumers. Producers are likely to absorb the tax and pay itthemselves.

Income

It is the flow of earnings from using factors of production to generate outputs. An example of this is wages and salaries.

Income elasticity of demand (YED)

The relationship between quantity demand and income. If YED is positive, then the good is considered a normal good.

If YED is negative, the good is an inferior good.

It can be calculated by the following formula:

% change of qty demanded / % change of income

Income gap

It is the gap between incomes of various groups. It is used to show how fairly or unfairly income is distributed in the economy.

Incumbent firm

A firm that is already established within a market.

Indirect tax

An indirect tax is a tax on a good or service. This tax is imposed on producers by the government.

Inefficiency

When scarce resources are not being put to the best use possible.

Inelastic demand

When elasticity of demand is between 0 and 1.

Inelastic supply

When elasticity of supply is between 0 and +1

Inferior good

A good which falls in demand when a consumer's income rises.

Information failure

This occurs when information is not perfect in a market. Full details are not known by producers, consumers, governments or all of these. Therefore, this can result in market or government failure because economic agents will not be able to make the best choices possible. This can lead to inefficiency.

Infrastructure

The stock of capital used to support the economic system. Examples would be roads, buildings, telecommunication networks etc.

Innovation

When firms develop and improve existing products.

Inputs

Inputs are used to make outputs. Our inputs are our factors of production: land, labour, capital, enterprise.

Intellectual property

Property rights over somebody's idea that is back up by the law. These could be patents, copyrights, trademarks.

This can be considered a barrier to entry.

Internalising an externality

When an externality is paid for by the consumer or producer responsible for creating it.

The Invisible Hand

The process where resources are allocated efficiently in markets when economic agents act to benefit themselves.

This term was first by Adam Smith.

Joint Supply

When a resource can be used for multiple by-products, they are said to be in joint supply. For example, a reduction in the supply of cows will reduce the supply of leather and beef.

Land

The stock of natural resources available in an economy e.g. livestock, fertile land, water, oil, coal, iron.

Law of Demand

The inverse relationship between price and quantity of a product.

Living Wage

This is different to the National Minimum Wage. The Living Wage is considered to be the wage that people need in order to be able to afford their basic cost of living. The Living Wage can also vary by region e.g. it is higher in London because London is an expensive area to live in.

Long Run

A time period where all factors of production are considered to be variable (they can be changed by the firm).

Manufacturing

The use of tools, machines and labour to create products. Mass manufacturing is when firms manufacture goods/services on a large scale.

Marginal benefit

Additional benefits received by consuming one more of a product.

Marginal cost

Additional cost that must be paid by producing one more product.

Marginal revenue

Additional revenue that the producer receives when they sell an additional product.

Market failure

When the free market mechanism fails to achieve economic efficiency, scarce resources are not being used optimally to satisfy the needs and wants of society. There are several causes of market failure e.g. externalities, public goods, imperfect competition, information failure etc.

Market incentives

The signals in a market that motivate people to act a certain way e.g. high prices in a market will incentivise the producer to produce more due to the profit motive.

Market power

The ability of a firm to influence or control the market. Firms with high market power can influence prices, quantity made and the decisions of competitor firms.

Maximum price

This is a price in a market which firms cannot legally exceed. Maximum prices will be imposed by the government, generally to correct market failure.

Merit Good

This is a product that is underconsumed/underproduced by the free market. Generally, society would want more of this product consumed because there are external benefits from its consumption.

Minimum Price

A minimum price law is when the price in a market cannot go below a certain level. This is imposed by the government in order to correct market failures.

Mixed Economy

An economic system where markets are responsible for allocating resources, however, there is also government intervention in order to correct failures within the free market. This is the most popular economic system in the world.

Monopoly

A single seller in a market.

Monopoly Power

A firm in a market which has 25% or more market share is considered to be a monopoly power.

Moral Hazard

One of the problems arising from information failure in the insurance market. This occurs when people take actions that are less than desirable because they are insured against loss.

An example would be unethical behaviour in the banking industry. Banks realise that they are "too big to fail". Governments are likely to bail them out when they are about to go bankrupt. Therefore, they feel insured when they undergo risky behaviour, so they will take greater risks knowing that they will be insured by the government.

Nationalisation

The transfer of ownership of a firm from the private sector to the public sector.

Needs vs Wants

A need is essential for survival. A want is something that people desire but is not essential for survival.

Negative Externalities

External costs in production or consumption. They impose costs on a third party. They are not taken into account by the

free market. Therefore, they lead to market failure and an inefficient allocation of resources. When negative externalities

are present in a free market, social costs will outweigh private costs.

Niche Market

A section of a market which caters for specific needs and wants by a limited amount of people. An example of a niche market would be handmade candles.

Non Price Competition

When firms compete on factors other than price. Examples could be quality of products, customer service levels, extended warranties and brand strength. This is generally a preferred means of competition in oligopoly markets as price wars can be avoided.

Non-renewable Resources

Resources that are finite and cannot be replaced (at least in our lifetimes). An example of a non-renewable resource is a fossil fuel.

Non-rival

When consumption is non-rival, it means that consumption by one person does not limit the amount available for somebody else. Generally, there will be plenty of supply available and very limited demand relative to supply.

Normal Goods

Goods that increase in demand when there is also an increase in income levels. The YED for normal goods will be positive.

Normative Statement

A statement that is made which expresses an opinion based on a set of values. Normative statements are not necessarily facts. They involve value judgements.

Office of Fair Trading

A UK government agency responsible for competition policy. They try to encourage the market to be fair for consumers as well

as producers.

Off-peak Pricing

When lower prices are charged in periods which are less busy. Off-peak pricing is an example of 3rd degree price discrimination.

Opportunity Cost

The cost of the next best alternative foregone.

Ostentatious Demand

When goods are purchased for the sake of it being expensive e.g. a £1000 handbag made by a luxury designer.

Out-sourcing

When a firm gets another firm to produce something for them, also known as subcontracting.

Overheads

The fixed costs of a business. These must be paid regardless of the output produced. An example would be rent.

Pareto Efficiency

When resources are used at a level where any change in the allocation of resources would mean somebody else is worse off.

Peak Pricing

When higher prices are charged during times of increased demand. Peak pricing is an example of 3rd degree price discrimination.

Penetration Pricing

When firms choose to set an extremely low price in order to gain market share (in order to penetrate the market).

Planned Economy

An economic system where decisions about the allocation of resources are made by central planners rather than the free market mechanism. What to produce, how much and who for - all decided by the central planner.

Polluter pays principle

When a government intervenes in a market to ensure that those who are responsible for creating negative externalities include the costs of these externalities when they make economic decisions.

Positional goods

These goods are demanded because acquiring them may hold some value in terms of boosting a person's social status.

Positive externality

Third party benefits from economic activity. Externalities can be either in consumption or production. When positive externalities are created, it means

social benefits will outweigh private benefits. This won't be accounted for in the free market.

Poverty trap

It is where there is a lack of incentive to look for work or work longer hours because of the failings of the taxation and benefits system.

Price elasticity of demand

% change in qty demand / % change in price. It measures how sensitive consumers are to a change in the price. If PED is elastic, then price is an important factor for consumers. If it is inelastic, then price is not such an important factor of demand.

Price Mechanism

Where the decisions of consumers and businesses determine the allocation of resources via the price in a market. There are 3 functions of the price mechanism, signalling, incentive and rationing.

Price signals

Where changes in the price act as a signal about how resources should be allocated. For example, when prices rise, producers want to make more, however, consumers want to buy less.

Private benefit

It is the benefit to the individual for consuming or producing a good/service. It does not include externalities.

Private costs

The cost to individuals (firms/consumers) of producing or consumer a good/service. These costs do not take into account externalities.

Private goods

Goods which are rival and excludable.

Privatisation

Where state owned firms are sold to the private sector e.g. privatisation of Royal Mail.

Producer surplus

The difference between the minimum cost a producer will sell a product for and the current market price. Larger levels of producer surplus will mean increased welfare for the producer.

Production function

The relationship between a firm's inputs and what it is able to produce as outputs.

Production Possibility Frontier (PPF)

A curve that represents the maximum possible output level in an economy, in which two goods/services are made.

Productive efficiency

When a firm maximises output while minimising levels of average costs. It can be shown as the minimum point on an AC diagram, or alternatively, when the firm produces on the PPF boundary.

Productivity

It is a measure of the efficiency of a factor inputs. Labour productivity will equal the amount that is made per labour unit. Output/units of labour.

Profit

Revenue - Cost = Profit. It is the reward that firms receive for taking risks. Total profit = Total Revenue - Total Cost

Profit per unit = Average Revenue - Average Cost

Property rights

Property rights refer to the legal control/ownership of something. For markets to be efficient, property rights must be clearly defined.

Public bads

Public bads include environmental damage and global warming - the costs of these bads are felt by everybody.

Public goods

Goods which are non-rival and non-excludable. They in a failure of the free market.

Publicly owned firms

Where firms are owned by the state.

Public sector

The sector of the economy in which resources are allocated by firms within the government's control e.g. the NHS, the public education system.

Purchasing Economies of Scale

Where lower levels of average costs are achieved when firms grow in size and they can negotiate better prices on their factor inputs. This can also be referred to as "bulk buying".

Quota

A quota is a quantity restriction - a limit on how much quantity can be supplied to a market.

Rational Decision Making

A rational person will weigh up costs and benefits of an activity in order to make a decision. When benefits outweigh costs, then a rational person will act on that decision.

Redistribution of Income

When the government implements policies to distribute income from richest to poorest.

Regressive Tax

When a tax represents a higher proportion of income for low income earners rather than high income earners. VAT is said to be regressive, because even though the same amount of tax is paid, a low income earner will "feel it" more than a high income earner.

Regulation

Regulations are rules that imposed on a market - it is a type of government intervention.

Regulator

A government agency who is responsible for regulating a market and ensuring that laws are abided by and consumers are protected.

Relative Poverty

Relative poverty is not as extreme as absolute poverty. Relative poverty is when a household's income falls below an average level of income in the economy.

Scarcity

The problem of scarcity is at the heart of economics. Scarce/limited resources mean that we have to make efficient decision about the allocation of those resources.

Shortage

When demand exceeds supply, there is a shortage.

Social Benefit

Social benefit = Private benefit + external benefit. When social benefit is greater than private benefit, it must mean there is a positive externality.

Social Cost

Social cost = Private cost + external cost. When social costs exceed private costs, it must mean there is a negative externality.

Social Optimum

The point where Marginal Social Benefits = Marginal Social Costs  

MSB = MSC. It is the point where no market failure exists, the point of maximum social welfare.

Social Exclusion

When those on the lowest incomes do not have the same opportunities as those on higher incomes e.g. going to school/healthcare.

Specialisation

Where people/firms/economies specialise in producing a particular product. This is in order to gain efficiency in production.

Speculation

Is when people engage in activity in anticipation of a change in the market. For example, if people speculate that the housing market will continue to grow, then people will buy houses today as they think the price of houses will increase.

Stakeholder

A stakeholder is anybody who has an interest or is affected by a business.  This could be shareholders, managers, employees, suppliers, local businesses, local communities, the environment, the government. Stakeholders will often have competing objectives.

State Provision

Where the government provides goods/services through tax revenues.

Static efficiency

Where firms are efficient both allocatively and productively (at a single point in time).

Subsidy

Payment to firms which aim to reduce their costs of business.

This encourages firms to increase their supply and reduces their prices.

Substitution effect

Where a decrease in the price encourages consumers to buy more

of a product and substitute this with spending on a higher priced

substitute product.

Supply

Quantity of a good/service that a producer is willing to produce in

a market at a given price and at a given point in time.

Supply chain

Different stages of production, from raw materials to selling the final

good/service.

Supply shock

When the supply of a product is altered significantly by an unexpected

event. This could be changes in commodity prices, for example. It will shift

the supply curve either to the left or right depending on whether the shock

is positive or negative in its effect.

Time lag

A period of time between the implementing of a policy and when the policy is felt, either in the market or the economy.

Total costs

Total Fixed Cost + Total Variable Cost

Total Revenue

Price x Qty - Price multiplied by the number of units sold

Trade-off

Where a choice has to be made between alternatives  - the trade-off is what you must give up in order to make a choice.

Tragedy of the Commons

When property rights are not perfectly defined, it can lead to resources being overused. For example, fish stocks (over-fishing) and deforestation.

Value judgement

A judgement that is made according to a person's values/opinions. Value judgements make up normative statements.

Variable Cost

A cost which varies with output - when more is produced, variable costs will rise.

Examples will include, increased costs of raw materials, increased wage costs and power consumption.

Welfare Loss

How much welfare is lost due to a market failure. It can be calculated by the difference between social costs and social benefits at a given level of output.

Willingness to pay

The maximum price a consumer is willing to pay for a product.

Zero-Hour Contract

A contract where employees agree to work when work is required rather than agreeing to work a set number of hours, week to week. Zero-hour contracts have been shown to increase labour market flexibility.