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 industrys 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).

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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. Cost savings that arise from sources outside the firm due to the growth of the industry as a whole. The advantages that accrue to a firm by being the first to enter a market such as market power or supernormal profit. Costs that do not vary with output and exist only in the short run. Where a firm merges or takes over a business that is one stage closer to the consumer in the production process. Game theory is used to predict a firms decision when faced with a set of choices whose payoffs are influenced by the choices of other firms in the market. A product is homogeneous when consumers perceive each unit to be identical. The joining of two firms together which produce similar products at the same stage of production. Where firms have some price setting market power and thus face a downward sloping demand curve; e.g. duopoly, oligopoly and monopolistic competition. Firms that are established in a market and therefore do not face sunk costs. 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. Where the outcome from a decision is dependent upon the decisions of other rival firms. A situation where increasing the scale of production leads to a decrease in the long run average costs of production. Where a firm sets its price below the average cost of potential entrants in order to discourage entry. The period of time required for all input costs to be variable. The additional cost of producing one more unit of output. The additional revenue from selling one more unit of output. A firms percentage share of the total market, normally measured using sales. When two formerly independent firms unite. 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. A pure monopoly is one where the market has only one supplier. 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

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the UK, the legal definition of a monopoly is when a firm has 25% or more market share. 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. A market with only one purchaser. A firm that has operations in more than one country (MNC). New firms in a market normally attracted by the existence of supernormal profits. Competitive activity that doesnt involve reducing prices such as brand promotion, product differentiation, innovation and customer service. 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. 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. An oligopoly is a market where there are a few interdependent firms dominating the market. The legal right to be the sole user of a particular process or producer of a unique product. 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 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. 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. The responsiveness of quantity demanded to a change in price. A firm with sufficient market power to decide on a price change which its competitors will tend to follow. A firm that can alter its output without having any effect on the price of the product it sells. 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.

OFT

Oligopoly Patent Perfect competition Predatory pricing

Price discrimination

Price elasticity of demand Price leader Price taker Prisoners dilemma

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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. The existence of close substitutes within a market as firms try and establish a degree of price setting power. 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 is achieved at the level of output where MR=MC. It is often assumed that this is the primary objective of firms. 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. An alternative objective in order to increase market share it is the level of output where MR=0. 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. A business that pursues other objectives once a satisfactory level of profit has been attained. 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 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. The price that is equal to average variable cost, below which a firm would choose zero output to minimise the loss made. 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. 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. When firms behave in each others mutual interest and restrict their competitive actions without any agreement in place. The offer made by the potential buyer for the shares of another firm in order to achieve control of the business. Costs that vary directly with output. The failure of a firm to minimise costs at a given level of output and thus produce above its own average cost curve.

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

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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 =

TC Q

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

MC =

TC Q

Total Revenue
The total income gained from selling the firms output. TR = P Q

Average revenue
Revenue per unit of output.

AR =

TR Q

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

MR =

TR Q

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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.

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