1. Price System & Microeconomy

Utility

The satisfaction gained from the consumption of a product.

Total Utility

The satisfaction from consuming all units of a product over a particular period.

Marginal Utility

The satisfaction gained from consuming one more unit of a product over a particular period. Tends to fall as consumption increases.

Law of Diminishing Marginal Utility

The fall in marginal utility as consumption of a product rises. Assumes limited income, rational behaviour, and a goal to maximise total utility.

Equi-Marginal Principle

Consumers maximise their utility where the marginal utility per unit of price is equal across all goods consumed. MU(A)/P(A) = MU(B)/P(B) = MU(C)/P(C).

Budget Line

The combination of two products obtainable with a given income and set of prices.

Substitution Effect

Following a price change, a consumer substitutes the more expensive product for the one that is now relatively cheaper. Shown as a movement along the indifference curve (E1 to E2).

Income Effect

The change in demand for a good caused by a change in a consumer's purchasing power or real income. Positive for normal goods; negative for inferior goods. Shown as a shift to a new indifference curve (E2 to E3).

Normal Good (Income Effect)

A good where demand increases as income rises. The income effect is positive, causing a rightward shift in the budget line.

Inferior Good (Income Effect)

A good where demand decreases as income rises. The income effect is negative, causing a leftward shift in the budget line.

Price Effect

The total change in quantity demanded following a price change. Price Effect = Substitution Effect + Income Effect.

Indifference Curve

A curve showing the different combinations of two goods that give a consumer equal satisfaction. A higher curve indicates greater utility.

Marginal Rate of Substitution

The rate at which a consumer is willing to substitute one good for another. Determines the slope of the indifference curve.

Consumer Equilibrium (Indifference Curve)

The optimal point where the budget line is tangent to the highest indifference curve, showing the combination that maximises satisfaction.

Giffen Good

A sub-category of inferior goods where consumption increases as price increases. The strong negative income effect dominates the substitution effect.

Price Effect on Normal Good (Price Fall)

Both substitution and income effects increase demand. Overall demand rises.

Price Effect on Inferior Good (Price Fall)

Substitution effect increases demand; income effect reduces demand. Substitution effect is larger, so overall demand still rises.

Price Effect on Giffen Good (Price Fall)

Substitution effect increases demand; income effect reduces demand. Income effect dominates, so overall demand falls.

Price Effect on Normal Good (Price Rise)

Both substitution and income effects reduce demand. Overall demand falls.

Price Effect on Inferior Good (Price Rise)

Substitution effect reduces demand; income effect increases demand. Substitution effect is larger, so overall demand still falls.

Price Effect on Giffen Good (Price Rise)

Substitution effect reduces demand; income effect increases demand. Income effect dominates, so overall demand rises.

Economic Efficiency

Where scarce resources are used most efficiently to produce maximum output. Consists of productive efficiency and allocative efficiency.

Productive Efficiency

When a firm produces at the lowest possible average cost. Achieved at the minimum point of the average total cost curve.

Allocative Efficiency

Where price equals marginal cost (P = MC). Firms produce the goods most wanted by consumers with no waste.

Pareto Optimality

A state where it is impossible to make one person better off without making someone else worse off. Any improvement requires compensation to those negatively affected.

Dynamic Efficiency

A long-run productive efficiency where resources are reallocated so output increases relative to the increase in resources. Achieved by introducing new production processes in response to competitive pressure.

Market Failure

When a free market fails to make the optimum use of scarce resources, failing to achieve productive and/or allocative efficiency.

Social Costs

The total costs of an action borne by all of society. Social Costs = Private Costs + External Costs.

Private Costs

Costs incurred by the individual or firm that produces a good or service.

External Costs

Costs incurred and paid for by third parties not involved in the production or consumption decision.

Marginal Social Costs (MSC)

The total cost to society of producing one more unit. MSC = Marginal Private Cost + Marginal External Cost.

Social Benefits

The total benefits arising from a particular action. Social Benefits = Private Benefits + External Benefits.

Private Benefits

Benefits that accrue to the individuals who produce and consume a particular good.

External Benefits

Benefits received by third parties not involved in the production or consumption decision.

Marginal Social Benefits (MSB)

The total benefit to society from consuming one more unit. MSB = Marginal Private Benefit + Marginal External Benefit.

Externalities

Side effects on third parties from the actions of producers or consumers, also called spillover effects. Can be negative (costs) or positive (benefits).

Negative Externality

A side effect that negatively impacts third parties and imposes costs on them. Examples: pollution from production, passive smoking from consumption.

Positive Externality

A side effect that positively benefits third parties. Examples: R&D spillovers from production, vaccination benefits from consumption.

Deadweight Welfare Loss

A cost to society created by market inefficiency when supply and demand are out of equilibrium. Occurs with both over- and underproduction.

Asymmetric Information

When one party to an economic transaction possesses greater material knowledge than the other, leading to market failure.

Moral Hazard

The tendency for insured or otherwise protected people to take greater risks, arising from asymmetric information. The more informed party may exploit the less informed.

Adverse Selection

Where an insurance company faces extreme loss due to risks not disclosed at the time of a policy's sale. Arises from information being deliberately withheld or inaccurately presented.

Cost-Benefit Analysis (CBA)

A method for assessing the desirability of a project by identifying, valuing, and comparing all relevant costs and benefits including intangible ones.

Short-Run Production Function

Defines the relationship between one variable factor of production and output while other factors are fixed. Formula: Q = AF(K, L).

Total Product

The total output a firm produces within a given period using given inputs.

Average Product

Output per unit of variable factor input. Formula: Total Product ÷ Labour.

Marginal Product

The addition to total output from employing one more unit of a variable factor. Formula: Change in Output ÷ Change in Input.

Law of Diminishing Returns

Where adding more of a variable factor to fixed factors eventually leads to a fall in marginal product. Also called the law of variable proportions.

Fixed Costs

Costs that do not change with output in the short run. Represented as a horizontal line on a cost curve graph.

Variable Costs

Costs that vary directly with output. All costs become variable in the long run.

Total Cost

Total Fixed Cost + Total Variable Cost.

Average Fixed Cost (AFC)

Total Fixed Cost ÷ Output. Falls continuously as output rises.

Average Variable Cost (AVC)

Total Variable Cost ÷ Output.

Average Total Cost (ATC)

Total Cost ÷ Output. U-shaped curve; the minimum point is the optimum output.

Marginal Cost (MC)

Change in Total Cost ÷ Change in Quantity. Cuts the AVC and ATC curves at their minimum points.

Isoquant

A curve showing all combinations of inputs that produce a given level of output. Similar in concept to an indifference curve.

Optimum Output

The most efficient output at the lowest unit cost; where MC meets the minimum point of ATC. Not the same as profit maximisation.

Increasing Returns to Scale

Where output increases proportionately faster than the increase in factor inputs in the long run.

Decreasing Returns to Scale

Where factor inputs increase at a proportionately faster rate than the increase in output in the long run.

Minimum Efficient Scale (MES)

The lowest level of output at which long-run average costs are minimised. Low MES leads to a fragmented market; high MES can lead to a natural monopoly.

Economies of Scale

The reduction in long-run average costs as the scale of output increases. Can be internal (firm-level) or external (industry-level).

Internal Economies of Scale

Cost advantages gained by a single firm as it increases its scale of production. Types: technical, purchasing, marketing, managerial, financial, risk-bearing economies.

External Economies of Scale

Cost savings available to all firms in an industry as the industry grows. Types: economies of concentration, technology, and skills.

Diseconomies of Scale

Where long-run average cost increases as the scale of output increases. Types: technical, organisational, purchasing, competitive, financial diseconomies.

Total Revenue (TR)

Price × Quantity.

Average Revenue (AR)

Total Revenue ÷ Output. Equals the demand curve (price).

Marginal Revenue (MR)

Change in Total Revenue ÷ Change in Output. The additional revenue from selling one more unit. Always below AR in imperfect competition.

Normal Profit

The minimum level of profit needed to keep a firm operating in the same industry; a cost of production.

Subnormal Profit

Any profit less than normal profit (P < AC). If persistent, the firm will leave the industry.

Supernormal Profit

Any profit in excess of normal profit (TR > TC). Only exists in the short run except in monopoly.

Market Structure

The way a market is organised in terms of the number of firms and barriers to entry.

Barriers to Entry

Any restriction that prevents new firms from entering an industry. Examples: high capital costs, sunk costs, patents, brand loyalty, economies of scale.

Concentration Ratio

The combined market share of the largest firms in an industry. A higher ratio indicates a more monopolistic or oligopolistic market.

Perfect Competition

An ideal market structure with many buyers and sellers, homogeneous products, perfect knowledge, and no barriers to entry. Firms are price takers (P = AR = MR).

Shutdown Price (Short Run)

When P = AR = AVC. If price falls below AVC, the firm makes an operating loss and should shut down in the short run.

Shutdown Price (Long Run)

When price falls below minimum ATC, the firm cannot cover all costs and must permanently exit the market.

Contestable Market

Any market where potential entrants can freely and costlessly enter, regardless of the number of existing firms. Only normal profit can be earned in the long run.

Monopolistic Competition

A market structure with many firms, differentiated products, and few barriers to entry. Firms have some price-setting ability. Normal profit in the long run with excess capacity.

Oligopoly

A market structure dominated by a few firms with high barriers to entry. Firms are interdependent; decisions depend on rivals' reactions.

Price Rigidity (Oligopoly)

The tendency for prices to remain stable in an oligopoly because price rises lose customers to rivals and price cuts trigger retaliatory price wars.

Kinked Demand Curve

A model of oligopoly behaviour showing that demand is price elastic above the equilibrium price (rivals don't follow rises) and price inelastic below it (rivals match cuts).

Price Leadership

A situation where one dominant firm in a market sets prices that competitors then follow.

Cartel

A formal agreement between firms to limit competition by fixing prices, dividing markets, or restricting output. Illegal in most jurisdictions.

Nash Equilibrium

In game theory, the outcome where no player can improve their result by unilaterally changing their strategy. Firms end up in a suboptimal equilibrium.

Dominant Strategy

The optimal choice for a player regardless of what their rivals do.

Prisoners' Dilemma

A game theory scenario where two rational players both choose a strategy that leads to a worse collective outcome than if they had cooperated.

Principal-Agent Problem

When a principal hires an agent but cannot ensure the agent acts in the principal's best interest due to information failure and differing objectives.

Monopoly

A market with a single seller, no close substitutes, and very high barriers to entry. The firm is the price maker and earns long-run supernormal profit.

Natural Monopoly

Where a single supplier has such substantial cost advantages that competition would raise costs and duplicate resources inefficiently. Often regulated or run as a public utility.

X-Inefficiency

When a firm's costs exceed those in a more competitive market due to lack of competitive pressure and incentive to minimise costs. Common in monopolies.

Internal Growth

A firm expands by retaining profit and reinvesting it into the business. Achieves economies of scale and diversity of product range over time.

External Growth

A firm expands by merging with or taking over other firms. Types: horizontal, vertical (forward/backward), conglomerate integration.

Horizontal Integration

A firm merges with or takes over another firm in the same industry and at the same stage of production.

Vertical Integration

A firm merges with or takes over firms at different stages of the supply chain. Forward integration moves toward the consumer; backward integration moves toward raw materials.

Conglomerate Integration

A firm merges with or acquires a business in an unrelated industry. Reduces risk through diversification.

Profit Maximisation

The firm produces where MC = MR, the level of output that generates the greatest profit. Long-term profit maximisation may conflict with other objectives.

Survival Objective

The most basic firm objective; ensuring the firm covers its total costs and continues operating, regardless of profit. Common for startups and firms in decline.

Profit Satisficing

A firm aims to earn a satisfactory level of profit to meet the expectations of all shareholders, rather than the maximum possible profit.

Sales Maximisation

A firm's objective to maximise the volume of sales, sometimes using cross-subsidisation to cover losses from high output.

Revenue Maximisation

A firm's objective to maximise total revenue, producing where MR = 0. Often uses penetration pricing to gain market share.