4.1 Individuals, firms, markets and market failure DEFINITIONS

according to AQA's subject specific vocabulary list including extras

positive statement

a statement that does not include a value judgement and can be tested against the facts or evidence

normative statement

a statement that includes a value judgement and cannot be refuted just by looking at data or evidence

value judgement

a view about what is right or wrong, good or bad in a moral sense

statements that include value judgements often, but not always, contain the words 'should' or 'ought'

economic activity

the production, consumption, exchange and distribution of goods and services

economic resources (factors of production)

the inputs into the production process that are needed to produce the goods and services that satisfy people’s wants

they are usually classified as land, labour, capital and enterprise

land

the factor of production that includes all the natural resources that are available on the earth

it includes the land and sea

capital

the human-made factor of production.

examples of capital include machines, tools, lorries and buildings

labour

the human resource.

the contribution made by people to the production of goods and services

entrepeneur

the person or group of people who organise the other economic resources to allow goods and services to be produced

enterprise

enterprise involves making decisions and taking risks

scarce resource

a factor of production that is limited in supply

there are not enough available to satisfy people’s needs and wants

scaricity

the fundamental economic problem that results from limited resources and unlimited wants.

it means that choices have to be made which have an opportunity cost

opportunity cost

the next best alternative foregone when a choice is made

production possibility diagram

shows the quantities of two goods or services that can be produced with the available resources, given the current state of technology

production possibility boundary (PPB)

the PPB is also known as the production possibility curve (PPC) and the production possibility frontier (PPF)

it shows the various quantities of two goods or services that can be produced, with the current state of technology, when all the available resources are fully employed

resource allocation

how the available factors of production are used to produce different goods and services

the allocation of resources involves determining what is produced, how it is produced and for whom it is produced

rational economic decision making

sing all the available information to select the best option to maximise the welfare of the decision maker

a rational consumer chooses to buy the goods and services that, given their limited income, will maximise their total utility

utility

the satisfaction that is derived from consuming a good or service

marginal utility

the change in total utility that results from the consumption of one more, or one fewer, goods or services

hypothesis of diminishing marginal utility

the proposition that as more of a product is consumed, the additional satisfaction gained from each extra unit declines

imperfect information

when an economic agent does not have all the information needed to make a rational decision, or the information is distorted in some way

asymmetric information

a type of imperfect information where one party to an economic transaction has more information than the other party

behavioural economics

a branch of economics that includes elements of psychology to improve our understanding of how people’s decision making is influenced by biases and emotional factors

bounded rationality

the idea that human limitations mean that people’s decision making is not completely rational

bounded rationality means that when an individual makes a decision, they choose an option that is satisfactory rather than optimal

bounded self-control

the idea that people do not have sufficient willpower or self-discipline to resist choices that may be tempting but are not in their self-interest

rules of thumb

mental shortcuts, based on experience, that enable individuals to make decisions more quickly and easily

anchoring

the idea that when making decisions, people rely too heavily on one particular piece of information, the anchor

the anchor is often the first piece of information they encounter

availability bias

when people’s decision making is unduly influenced by recent events or how easily an event comes to mind

social norms

behaviours that are consistent with what is generally considered acceptable by society at the present time

choice architecture

the way or framework in which choices are presented to people

nudge

something that encourages a particular decision or behaviour without removing freedom of choice

default choice

an option that has been pre-selected for an individual but the individual is able to select a different option if they want to

restricted choice

where the number of choices made available to an individual is limited

this type of choice architecture is often adopted when there is a large number of choices available which makes it hard for individuals to decide which is the best option

mandated choice

a form of choice architecture where the individual must make a decision

mandated choices are usually required by law

demand curve

the relationship between the price and quantity demanded of a good or service, in a given period of time, when other things that affect demand are held constant

price elasticity of demand

a measure of the extent to which the quantity demanded of a product changes in response to a change in the price of the product

income elasticity of demand

a measure of the extent to which the quantity demanded of a product changes in response to a change in income

cross elasticity of demand

a measure of the extent to which the quantity demanded of a product changes in response to a change in the price of a different product

normal good

a product where there is a positive relationship between income and the quantity demanded of the product

eg a rise in income leads to a rise in the quantity demanded

inferior good

a product where there is an inverse relationship between income and the quantity demanded of the product

eg a rise in income leads to a fall in the quantity demanded

supply curve

the relationship between the price and quantity supplied of a good or service, in a given period of time, when other things that affect supply are held constant

price elasticity of supply

a measure of the extent to which the quantity supplied of a product changes in response to a change in the price of the product

equilibrium market price

the price at which the quantity demanded equals the quantity supplied and there is no tendency for the price to change

disequilibrium price

a price at which there is either excess demand, and a tendency for the price to rise, or there is excess supply, and a tendency for the price to fall

excess demand

the amount by which the quantity demanded exceeds the quantity supplied at the current price

excess supply

the amount by which the quantity supplied exceeds the quantity demanded at the current price

joint demand

when two products are demanded together so that the demand for one product is directly related to the demand for the other product

complementary goods such as printers and printer cartridges are in joint demand

competitive demand

when the demand for one product increases the demand for another product decreases

substitute goods such as butter and margarine are in competitive demand

composite demand

when a product has more than one use so that an increase in the demand for one use leads to a fall in the supply of the product that is available to use elsewhere

for example, milk is used to produce cream and cheese

derived demand

when the demand for a product, or factor of production, is determined by the demand for a different product

for example, the demand for steel is derived from the demand for cars, and a number of other products

joint supply

when the output of one product also results in the output of a different product

for example, sheep farming can lead to the supply of both meat and wool

production

whe process of using factors of production to create goods and services

productivity

a measure of how much a factor of production can produce in a given period of time

for example, the productivity of land might be measured by output per hectare per year. It is a measure of efficiency

labour productivity

a measure of how much a worker can produce in a given period of time

for example, output per person per hour

specialisation

where firms, regions, countries or factors of production concentrate on producing a particular good or service, or carrying out a particular task

division of labour

when the production of a good is broken down into many separate tasks and each worker performs one task, or a narrow range of tasks, as part of the production process

short run

the time period when there is at least one fixed factor of production

long run

the time period when all factors of production are variable

the law of diminishing returns

the law states that as more of a variable factor of production is used in combination with a fixed factor of production, both the marginal and average returns to the variable factor of production will initially increase but will eventually decrease

returns

the amount produced, ie the output of a good or service

marginal returns

the change in total output that results from employing one more unit of a variable factor of production when the amount employed of all other factors of production is unchanged

average returns

average returns to a variable factor of production is calculated by dividing total output by the number of units of the variable factor that are employed

total returns

total output

returns to scale

the effect on total output when all factors of production are changed

it relates to the long run when all factors of production are variable

increasing returns to scale

when a given percentage increase in all factor inputs leads to a greater percentage increase in output

constant returns to scale

when a given percentage increase in all factor inputs leads to the same percentage increase in output

decreasing returns to scale

when a given percentage increase in all factor inputs leads to a smaller percentage increase in output

fixed costs

costs that do not change when output changes

variable costs

costs that change when output changes

marginal cost

the change in total cost when one more or one fewer unit of output is produced

average cost

total cost divided by output

total cost

total fixed cost plus total variable cost

internal economies of scale

ehen the growth of a firm results in the firm’s long-run average cost falling

external economies of scale

when the growth of an industry leads to lower average cost for firms in that industry

diseconomies of scale

when the growth of a firm results in the firm’s long-run average cost increasing

long-run average cost curve (LRAC)

shows the minimum average costs of producing any given level of output when all factors of production are variable but technology has not changed

minimum efficient scale of production

the lowest level of output at which a firm’s long-run average cost is minimised

total revenue

the total amount of money a firm receives from selling its output

it is usually calculated by multiplying the price of the product by the quantity sold

TR = P x Q

marginal revenue

the change in total revenue when one more or one fewer unit of output is sold

average revenue

total revenue divided by the quantity sold

TR / Q

profit

the difference between a firm’s total revenue and total cost (TR - TC)

the firm makes a profit when TR > TC

it is the reward for the factor of production enterprise

normal profit

the minimum amount of profit that is required to keep the entrepreneur in business in the long run

it is the opportunity cost of the entrepreneur

if the cost of enterprise is included as one of the firm’s costs of production, normal profit is earned when total revenue equals total cost

TR = TC

abnormal profit (supernormal profit)

when total profit is greater than normal profit

subnormal profit

when total profit is less than normal profit

technological change

the discovery and use of new and improved methods of producing goods and services

the introduction of new, more efficient technologies shifts the LRAC downwards

invention

the discovery of something new

it might, for example, be a new product, process or method of production

innovation

the process of introducing and developing a new product, service or method of production

market structure

the classification of an industry, or market, in respect of its key characteristics including: the number of firms, the nature of the product and ease of entry

divorce of ownership from control

when the people who own a business are not the same set of people who manage, or control, the business

satisficing

a decision-making strategy where people/managers aim to achieve an acceptable, or satisfactory, outcome rather than the optimal outcome

for example, managers might aim to achieve a minimum target level of profit rather than to maximise profit

market share

the percentage of total sales in a given market that is accounted for by a particular firm or product

perfect competition

a market structure that comprises a large number of small firms selling a homogeneous (identical) product to a large number of buyers, none of whom are able to influence the market price

there is perfect knowledge and freedom of entry into the market

homogenous products

products that are identical to each other, they are perfect substitutes

price taker

a firm that is unable to influence the price of the product it sells

when a firm is a price taker, the price is usually determined by market forces, ie the interaction of demand and supply

monopolistic competition

a market structure that comprises a large number of small firms selling differentiated products to a large number of buyers

there is freedom of entry into the market

differentiated products

products that are similar but not identical to each other

they are close but not perfect substitutes

products can, for example, be differentiated by the use of brand names, advertising, design, colour and after-sales service

these are types of non-price competition that firms use to differentiate their products and increase their monopoly power

price maker

a firm that is able to set the price of the product it sells

oligopoly

oligopoly is a market structure that is often defined as ‘competition amongst the few’

it is not a clearly defined market structure, but a few large firms dominate the market and compete with each other

the market may also contain some small and medium-sized firms

firms in oligopolistic markets usually produce differentiated products and there are barriers to entry, although the extent to which entry is restricted varies

concentration ratio

a measure of the combined market share of the largest firms in an industry, usually expressed as a percentage

for example, a three-firm concentration ratio could be calculated as follows: combined sales of the three largest firms / total sales in the market x 100.

collusion

where rival firms work together for their mutual benefit often to the detriment of consumers