Theory of the firm (U2) concepts & definitions

Last updated July 2026. Should be mostly good.

Total revenue

The aggregate revenue gained by a firm from the sale of a particular quantity of

output (equal to price times quantity sold).

Marginal revenue

The addition to total revenue resulting from the sale of an additional unit of output.

Short run

Time period where some factors of production are fixed

Long run

The time period where all factors of production are variable

Marginal costs

Marginal costs are the additional costs of producing one more unit of output.

Total costs

 The sum of all costs associated with a particular level of output

Fixed costs

The costs associated with the fixed factors (only exists in the short run)

Variable costs

the cost associated with the variable factors of production

Perfect competition

A market structure where there are a very large number of small firms,

producing identical products that are incapable of affecting the market supply

curve. Because of this, the firms are price takers. There are no barriers to entry

or exit and all the firms have perfect knowledge of the market.

Functions of profit (3)

Investment, High profit firms expand + firms with losses shrink, Reward to risk

Normal profit

The minimum profit firms need to earn to remain in a particular market, when TR=TC.

Abnormal/supernormal profits

The firm has higher revenue (AR) than costs (AC), encourages new firms to enter market

Losses

The firm has higher costs (AC) than revenue (AR), encourages firm to leave market

Profit maximising point

MR=MC

Socially optimal point

MC=AR

Productive efficiency

When output is produced at the lowest average cost (also allocatively efficient) 

Allocative efficiency

all goods and services are optimally distributed—when price of output reflects the marginal cost of production

Technological efficiency

a firm's ability to produce the maximum possible output from a given set of resource inputs (such as labor, capital, and raw materials)

Dynamic efficiency

an economy or firm's ability to adapt and improve its productivity over time

Monopolistic competition

A market structure where there are many buyers and sellers, producing

differentiated products, with no barriers to entry or exit.

Market power

The ability of a firm (or group of firms) to raise and maintain price above the

level that would prevail under perfect competition.

Monopoly

A market structure where there is only one firm in the industry, so the firm is

the industry. Monopolies may, or may not, have barriers to entry.

Natural monopoly

When a single firm can supply the entire market demand at a lower average total cost (ATC) than two or more firms, due to significant economies of scale and high fixed infrastructure costs

X-inefficiencies

a lack of effective competition in an industry means that average costs are higher than they would be if the market was more contestable.

Price discrimination

The practice of selling the same product or service at different prices to different consumers, not based on differences in production costs, but on varying willingness to pay.

Mergers

When firms combine and join; can be vertical (different parts of production process/sectors) or horizontal (same part of production process)

Anti-monopoly regulations

Policies that are intended to regulate the market share of an individual

company in order to enforce competition

Windfall taxes

An one-off tax levied by governments against certain industries when economic conditions allow those industries to experience above-average supernormal profits

Nationalisation

The process by which the government takes ownership of a private company or industry

Trade liberalisation

Removing barriers to trade between different countries and encouraging free trade.

Oligopoly

A market structure where there are a few large firms that dominate the market.

Non-collusive oligopoly

This is where firms in an oligopoly do not resort to agreements to fix prices or

output. Competition tends to be non-price. Prices tend to be stable.

Collusive oligopoly

This is where a few firms act together to avoid competition by resorting to

agreements to fix prices or output in an oligopoly.

Concentration ratio

Functions showing the percentage of market share (or output) held by the

largest X firms in an industry, expressed in the form CRX

, where X represents the

number of the largest firms. Most commonly, it is expressed as CR4

Price war

when firms suspect they can beat the competitor (eg. insider information), temporary, may lose money