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). The cost per unit – total costs divided by quantity of output. The average selling price – total revenue divided by the number of units of output sold. Where a firm merges or takes over a business that is one stage further away from the consumer in the production process. Anything that prevents new firms entering a market such as brand loyalty, economies of scale, technical know-how and patents. A group of firms that agree to act together as though they were a monopoly in order to raise profits. 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.

Average cost Average revenue Backward vertical integration Barriers to entry Cartel Competition Commission

Competition policy Policies designed to restrict the acquisition and exercise of monopoly power by firms. Competitive tendering Concentration ratio Conglomerate merger Contestable markets Corporate objectives De-merger Diminishing marginal returns Diseconomies of scale Economic efficiency When several firms bid for a contract, providing the buyer with lower cost and higher quality choices. 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). When firms producing unrelated products merge. A perfectly contestable market is one where the sunk costs of entry are zero and therefore the incumbent firms will only make normal profits. The range of targets a firm may have: it is often assumed in economics that a firm aims to maximise profits. Where a firm is divided up into separate businesses. 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. A situation where increasing the scale of production further leads to an increase in the long run average costs of production. 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).

Prepared by St Paul’s School

Where the outcome from a decision is dependent upon the decisions of other rival firms. Firms that are established in a market and therefore do not face sunk costs. A product is homogeneous when consumers perceive each unit to be identical. A firm’s percentage share of the total market. When two formerly independent firms unite. The joining of two firms together which produce similar products at the same stage of production.g. 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. Costs that do not vary with output and exist only in the short run. The additional cost of producing one more unit of output.Explicit collusion External economies of scale First-mover advantage Fixed costs Forward vertical integration Game theory When firms agree to co-operate rather than compete in order to raise profits. The advantages that accrue to a firm by being the first to enter a market such as market power or supernormal profit. duopoly. Where a firm sets its price below the average cost of potential entrants in order to discourage entry. A situation where increasing the scale of production leads to a decrease in the long run average costs of production. Where firms have some price setting market power and thus face a downward sloping demand curve. A market structure in which there are many buyers and sellers. e. Cost savings that arise from sources outside the firm due to the growth of the industry as a whole. The additional revenue from selling one more unit of output. free entry and exit but heterogeneous products giving each individual firm some price setting power. 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. larger machines and therefore reduce average costs. In Homogeneous products Horizontal integration Imperfect competition Incumbent firms Indivisibility Interdependence Internal economies of scale Limit pricing Long run Marginal cost Marginal revenue Market share Merger Monopolistic competition Monopoly Prepared by St Paul’s School . Where a firm merges or takes over a business that is one stage closer to the consumer in the production process. normally measured using sales. oligopoly and monopolistic competition. The period of time required for all input costs to be variable. A pure monopoly is one where the market has only one supplier.

The responsiveness of quantity demanded to a change in price. It can bring criminal charges on business leaders and fine firms who are found to breach competition law e. often referring suspected reductions in competition to the Competition Commission for investigation. A firm that has operations in more than one country (MNC). An oligopoly is a market where there are a few interdependent firms dominating the market. It is considered anti-competitive by the OFT. A market with only one purchaser. different PEDs for the separated markets and a degree of monopoly power. free entry and exit. OFT Oligopoly Patent Perfect competition Predatory pricing Price discrimination Price elasticity of demand Price leader Price taker Prisoner’s dilemma Prepared by St Paul’s School . resources will leave the market to be used more productively in an alternative market. A market structure in which there are many buyers and sellers. If normal profits are not attained. The legal right to be the sole user of a particular process or producer of a unique product. A firm with sufficient market power to decide on a price change which its competitors will tend to follow. Three conditions are necessary: effective separation of markets to prevent resale. Monopoly power Monopsony Multinational New entrants Non-price competition Normal profit Monopoly power exists when a single seller in a market has the ability to set prices. formation of a cartel. The Office of Fair Trading oversees competition policy in the UK. product differentiation. perfect information and homogeneous products thus making all firms price takers. the legal definition of a monopoly is when a firm has 25% or more market share. The level of profit that represents the opportunity cost of the resources used to achieve it. New firms in a market normally attracted by the existence of supernormal profits. innovation and customer service. 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. A firm that can alter its output without having any effect on the price of the product it sells. Competitive activity that doesn’t involve reducing prices such as brand promotion. Predatory pricing occurs when a firm incurs short-term losses with the intention of removing a rival and/or deterring other potential competitors.the UK.g. The sale of the same good or service to different consumer groups at different prices.

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. 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. The use of private firms by the government to improve the provision of public services through higher and more efficient investment. The price that is equal to average variable cost. The offer made by the potential buyer for the shares of another firm in order to achieve control of the business. The existence of such excess profits will attract the entry of firms in the long run. It is often assumed that this is the primary objective of firms. When firms behave in each other’s mutual interest and restrict their competitive actions without any agreement in place. Where a firm produces at the lowest point on its average cost curve and thus minimises the use of resources per unit produced. A business that pursues other objectives once a satisfactory level of profit has been attained.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. The failure of a firm to minimise costs at a given level of output and thus produce above its own average cost curve. Profit maximisation is achieved at the level of output where MR=MC. Private Finance Initiatives (PFIs) uses private capital and private sector companies to finance and operate infrastructure that was previously publicly funded and managed. 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. An alternative objective in order to increase market share – it is the level of output where MR=0. Product differentiation Productive efficiency Profit maximisation Public-private partnerships (PPPs) Revenue maximisation Sales maximisation Satisficing Short run Shutdown point Shutdown price Sunk costs Supernormal profit Tacit collusion Takeover bid Variable costs X-inefficiency Prepared by St Paul’s School . below which a firm would choose zero output to minimise the loss made. Costs that vary directly with output. A level of profit that is higher than the required level of profit to keep the firm in the market. improve innovation and increase investment. The existence of close substitutes within a market as firms try and establish a degree of price setting power. 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.

AC = TC Q Marginal cost The addition to TC from producing one more unit of output.g. Variable cost A cost which varies with output in both the short and long-run (e. etc). direct labour. rent. etc).Cost & Revenue Concepts Fixed cost A cost which does not vary with output in the short-run (e. AR = TR Q Marginal revenue The addition to TR from selling one more unit of output. etc). R&D. raw materials.g. Sunk cost A cost which is irrecoverable upon exiting the industry (e.g. insurance. MR = TR Q Prepared by St Paul’s School . MC = TC Q Total Revenue The total income gained from selling the firm’s output. advertising. Total cost TC = TFC + TVC Average cost Cost per unit of output. TR = P Q Average revenue Revenue per unit of output.

Occurs at the level of output where AR = AC. the opportunity cost of capital and enterprise). Occurs at any level of output where AR > AC Prepared by St Paul’s School . Allocative efficiency Where society gets the optimum mix of goods and services in the highest possible quantities. occurs where LRAC = LRMC. Minimum efficient scale The level of output at which LRAC stops falling (i. Normal profit The minimum (accounting) profit which the entrepreneur needs to remain in long-term production (i.e. the smallest level of output at which the firm is productively efficient). at which point P = MC. Diseconomies of scale A rise in long-run average costs as output increases.e. Productive efficiency Any level of output at which LRAC is minimised.Economies of scale A fall in long-run average costs as output increases. Supernormal profit Any profits in excess of normal profits.

Assumptions: single seller. Natural monopoly Where the economies of scale are so great that there is only room for one firm in the market. no substitutes for the good. many buyers. no entry barriers. such that each firm is a price taker. Perfect competition A market with many buyers. profit-maximisation. and AC falling continuously with output. the legal definition: where a single firm has >25% market share). Monopolistic competition A market with a large number of firms selling slightly differentiated products. profit-maximisation. Assumptions: very high FC. many sellers and a homogenous good. hence the firm is a price maker earning supernormal profits in both the short and long-run. Prepared by St Paul’s School . Concentration ratio A measure of the combined market share held by the largest n firms in an industry. usually sunk costs. Oligopoly A market dominated by a few firms (hence a high concentration ratio). which also falls continuously with output. Assumptions: many buyers and many sellers. Contestability A market with no entry / exit barriers due to an absence of sunk costs. homogenous good. no entry barriers. perfect information. existence of entry barriers. This leads to ‘hit and run’ competition whenever there are supernormal profits to be made. Negligible MC.Market Structures Monopoly A market dominated by a single seller (alternatively. product differentiation. Assumptions: many sellers and many buyers. hence the firm is a price taker earning normal profits in the long-run.

Cartel A formal agreement between two or more firms to fix prices and / or output. Revenue maximisation The level of output where the TR curve is flat. Cost-plus pricing Where price is set at average cost plus a certain percentage mark-up. Occurs where MR = 0. Prepared by St Paul’s School . in order to eliminate existing competition in the market.Strategies of the Firm Profit maximisation The level of output where TR is furthest apart from TC. Occurs where MR = MC. Tacit collusion Where firms refrain from price competition. Sales maximisation The highest level of output that can be attained without incurring a loss. Limit pricing Where price is set below the AC of potential rivals. Occurs where TR = TC. thereby avoiding a price war. Collusion A secret and informal agreement between two or more firms to fix prices and / or output. or AR = AC. but without any communication or formal agreement. Non-price competition Where the firm aims to attract new customers through branding. in order to prevent new firms entering the market. quality and innovation. thereby avoiding a price war. Predatory pricing Where P < AVC.

External growth Where the firm grows through mergers and acquisitions. with the aim of stimulating new competition. Horizontal integration The merging of two firms in the same industry and at the same stage of production. thereby protecting consumer interests in the form of lower prices and greater quality. leading to lenient price caps and performance targets.The Growth of Firms Internal growth (aka organic growth) Where the firm increases the sales and TR of its existing businesses. 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. 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). 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). Regulatory capture Where the regulator begins to sympathise with the regulated firm. variety and choice. Government Intervention OFT / Competition Commission / Competition policy Aim: to promote competition. Deregulation Where the government removes or simplifies restrictions on entering an industry. Prepared by St Paul’s School .

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