GCE A Level Economics - Microeconomics Key Terms and Definitions

[CPE] What is a positive statement and a normative statement?

A positive statement is a statement of fact whose accuracy can be tested by appealing to facts. On the other hand, a normative statement is a statement of value about something that ought or ought not to be.

[CPE] What is scarcity?

Scarcity is a problem that arises from limited resources and unlimited wants. All societies face the basic problem of scarcity.

[CPE] What is opportunity cost?

Opportunity cost is the forgone benefits/utility of the next best alternative when an individual makes a choice due to scarce resources.

[CPE] What is marginal benefit and marginal cost?

Marginal benefit refers to the additional benefit derived from undertaking an additional unit of an activity. Marginal cost refers to the additional cost derived from undertaking an additional unit of an activity.

[CPE] What is the marginalist principle?

The marginalist principle assumes that all economic agents are rational, where individuals seek to maximize utility, firms seek to maximize profits and the government seeks to maximize societal welfare. The marginalist principle states that economic agents only consume at the margin where the marginal benefit is equal to the marginal cost. Rational decision making dictates that individuals should only undertake an activity when the marginal benefit is at least at great as the marginal cost.

[CPE] What is the law of diminishing marginal utility?

The law of diminishing marginal utility states that as the total number of units of a good consumed increases, the additional utility derived from consuming each additional unit of the good decreases.

[CPE] What is the law of diminishing marginal revenue?

The law of diminishing marginal revenue states that with a given amount of fixed inputs, as the amount of variable inputs increase, there will come a point where each additional unit of the variable input will produce a lower quantity of output than the previous unit of variable input.

[CPE] What is the PPC model?

The production possibility curve (PPC) is a model that shows all the maximum attainable combinations of two goods that a country can produce within a specified time period with all of its resources fully and efficiently employed, at a given state of technology.

[CPE] What is productive efficiency?

Productive efficiency is the situation in which all available resources are fully and efficiently employed.

[CPE] What is allocative efficiency?

Allocative efficiency is the situation in which the society produces and consumes a combination of goods and services that maximizes its total welfare. This means that goods and services wanted by the economy are produced in the right quantities.

[Price Mech] Explain the market adjustment process to market equilibrium.

When price is above the equilibrium price level, there is a surplus in the market since quantity supplied exceeds quantity demanded. This puts downward pressure on prices as producers begin to lower their prices to sell of their surplus. As price falls, consumers become more willing and able to purchase the goods, thus quantity demanded increases. As price falls, producers will also be less incentivized to produce the goods due to lower profitability, thus quantity supplied falls. The fall in price carries on until equilibrium price level is reached.

When price is below equilibrium price level, there is a shortage in the market since quantity demanded exceeds quantity supplied. This puts upward pressure on prices as consumers begin to outbid one another for limited quantities of the good. As price rises, producers become more incentivized to produce the goods due to higher profitability, thus quantity supplied increases. As price rises, consumers will also be less wil1ling and able to purchase the goods, thus quantity demanded decreases. The rise in price carries on until equilibrium price is reached.

[Price Mech] What is demand?

The demand for a good is the quantity of the good that consumers are willing and able to purchase at every given price level.

[Price Mech] What is the law of demand?

The law of demand states that the quantity demanded of a good is inversely related to its price, ceteris paribus

[Price Mech] What is the substitution effect of demand?

The substitution effect is the effect of a change in price of a good on its quantity demanded arising from the consumer switching to or from alternative products, ceteris paribus. When prices fall, quantity demanded rises since the goods are now relatively cheaper than other substitutes.

[Price Mech] What is the income effect of demand?

The income effect is the effect that occurs when a change in the price of the good affects consumers' real income or purchasing power, in turn affecting their ability and willingness to buy a good. When prices fall, consumers have more income, thus their ability and willingness to buy the good increases further, increasing quantity demanded.

[Price Mech] What is supply?

The supply of a good is the quantity of the good that producers are willing and able to offer for sale at every given price level.

[Price Mech] What is the law of supply?

The law of supply states that the quantity of a good supplied is directly related to its price, ceteris paribus

[Price Mech] What is consumer surplus?

Consumer surplus is the difference between the maximum price that consumers are willing and able to pay for a given quantity of a good and what they actually pay.

[Price Mech] What is producer surplus?

Producer surplus is the difference between the minimum price that producers are willing and able to receive for a given quantity of a good and what they actually receive.

[Price Mech] What is society's welfare?

Society's welfare is the sum of consumers' and producers' surplus.

[Price Mech] What are the three main functions of the price mechanism?

The signaling (allocative), rationing (distributive) and incentive function.

[Price Mech] What is the price elasticity of demand (PED)?

PED is a measure of the responsiveness of the quantity of a good demanded to a change in its price, ceteris paribus.

[Price Mech] What is the price elasticity of supply (PES)?

PES is a measure of the responsiveness of the quantity of a good supplied to a change in its price, ceteris paribus.

[Price Mech] What is the cross elasticity of demand (CED)?

CED is a measure of the responsiveness of the quantity demanded of a good to a change in the price of another good, ceteris paribus.

[Price Mech] What is the income elasticity of demand (YED)?

YED is a measure of the responsiveness of the quantity demanded of a good to a change in consumers' incomes, ceteris paribus.

[Price Mech] What are indirect and direct taxes?

Indirect taxes are taxes on goods and services paid to the tax authorities indirectly by the suppliers of the goods and services. Direct taxes are taxes on income and wealth paid to the tax authorities directly by the economic agent who owns the income or wealth.

[Price Mech] What are indirect and direct subsidies?

Indirect subsidies are subsidies granted by the tax authorities indirectly to the suppliers of the goods and services. Direct subsidies are subsidies granted by the tax authorities directly to the economic agent with the income or wealth.

[Price Mech] What is a price floor/minimum price?

A price floor is a legally established minimum price that prevents prices from falling below a certain level, which must be set above the market equilibrium price level.

[Price Mech] What is a price ceiling/maximum price?

A price ceiling is a legally established maximum price that prevents price from rising above a certain level, which must be set below the market equilibrium price level.

[Price Mech] What is a quota?

A quota is a limit on the quantity produced imposed by the government through legislation and regulation.

[Firms] What is the short run time period?

The short run is a time period during which at least one factor of production is fixed. Output can only increase by using more variable factors.

[Firms] What is the long run time period?

The long run is a time period long enough for all inputs to be varied, except for the level of technology.

[Firms] What are explicit costs?

Explicit costs include payments made to outside suppliers of inputs, such as salaries and wages, price of raw materials and rent.

[Firms] What are implicit costs?

Implicit costs are costs which do not involve a direct payment of money to a third party, but involve a sacrifice of some alternative.

[Firms] What is the law of diminishing marginal returns?

The law of diminishing marginal returns states that as more units of a variable factor are applied to a given quantity of a fixed factor, there comes a point beyond which the additional output from additional units of the variable factor employed will eventually diminish.

[Firms] What are fixed costs?

Fixed costs refer to costs that do not vary with output level. They are paid even when production does not take place.

[Firms] What are variable costs?

Variable costs refer to costs that vary with output level. They are not incurred when production does not take place.

[Firms] What are internal economies of scale?

Internal economies of scale are cost savings that occur as a result of the firm's expansion, and have been created by the firm's own policies and actions. These include technical EOS, consisting factor indivisibility, law of increased dimensions and specialization and division of labor, financial EOS, managerial EOS, marketing EOS and risk-bearing EOS.

[Firms] What are internal diseconomies of scale?

Internal diseconomies of scale are increases in costs that occur to a firm as a result of the expansion of the firm, and have been created by the firm's own policies and actions. These include high cost of monitoring and management, and low morale of employees.

[Firms] What are external economies of scale?

External economies of scale are savings in costs that occur to all firms as a result of the expansion of the industry or a concentration of firms in a certain location. These include economies of information and economies of concentration.

[Firms] What are external diseconomies of scale?

External diseconomies of scale are increases in costs that occur to all firms in an industry as a result of the expansion of the industry or a concentration of firms in a certain location. These include an increased strain on infrastructure and a shortage of industry-specific resources.

[Firms] What is the minimum efficient scale (MES)?

The MES is the scale of production where the internal economies of scale have been fully exploited, corresponding to the lowest point on the long run average cost curve.

[Firms] What is the perfect competition market structure?

PC is a market structure whereby there is a large number of small firms relative to market size, its product is homogenous, barriers to entry and exit are absent and information is perfect.

[Firms] What is the monopoly market structure?

A monopoly is a market structure whereby the firm is the only seller of a good or service that has no close substitutes. Its barriers to entry and exit are complete and information is imperfect.

[Firms] What are strategic barriers to entry?

Strategic barriers to entry involves any move by the incumbent firm to keep potential firms out of the market.

[Firms] What are statutory barriers to entry?

Statutory barriers to entry are given by the force of law. The incumbent firm attains legal protection in the form of exclusive rights.

[Firms] What are natural barriers to entry

Natural barriers to entry arise from differences in production and costs between the incumbent firm and potential entrant.

[Firms] What is a natural monopoly?

A natural monopoly is a market in which the market demand is large enough to support only one large firm operating at or near the MES of production.

[Firms] What is the monopolistic competition market structure?

Monopolistic competition is a market structure whereby a relatively large number of small firms that sell similar but differentiated products exist, barriers to entry and exit are low and information is imperfect.

[Firms] What is the oligopoly market structure?

An oligopoly is a market dominated by a few large firms where market concentration is high, hence firms are mutually dependent and rival conscious. This gives rise to price rigidity and preference for non-price competition. Other characteristics include high barriers to entry and exit and imperfect knowledge, and their products can be homogenous or differentiated.

[Firms] What is collusion?

Collusion is a formal or informal agreement among oligopolistic firms on what prices to charge and how to divide the market.

[Firms] What is price discrimination?

Price discrimination occurs when a producer sells the same good at different prices whereby the price difference does not reflect differences in the cost of production. Firms charge consumers differently according to the differences in PED of their customers.

[Firms] What is predatory and limit pricing?

Predatory pricing is the deliberate strategy of driving competitors out of the market and scaring off potential entrants by setting very low prices or selling below its average variable cost in the short run.

Limit pricing is pricing by the incumbent firm to deter entry by setting a price below the profit maximizing price but above the competitive level.

[Firms] What is horizontal integration?

Horizontal integration occurs when a firm combines with or takes over a similar firm at the same stage of production to form a single entity.

[Firms] What is vertical integration?

Vertical integration occurs when a firm combines with or takes over a firm at a different stage of production.

Forward integration occurs when a firm moves into succeeding stages of production and gains ownership over firms that were once customers.

Backward integration occurs when one firm merges with another firm involved in the previous stage of production.

[Firms] What are conglomerates?

Conglomerates are companies that sell goods which are not directly related to one another.

[Firms] What is franchising?

Franchising is the practice of selling the right to use a firm's successful business model and brand for a prescribed period of time.

[Firms] What is productive efficiency?

At a microeconomic perspective, from society's point of view, productive efficiency occurs at the point where the firm's long run average cost is at its minimum.

From the firm's point of view, all points on the long run average cost curve are productively efficient as all points on the long run average cost curve represent the lowest possible average cost of producing each given level of output.

[Firms] What is dynamic efficiency?

Dynamic efficiency is defined as the situation where all firms are technologically progressive.

[MF] What is market failure?

Market failure is defined as the inability of the free market to achieve efficient allocation of resources that maximizes the society's welfare, and to achieve social goals such as equity.

[MF] What are externalities?

A positive externality is an external benefit that is enjoyed by third parties who are not directly involved in the production or consumption of a good or service.

A negative externality is an external cost that is imposed on third parties who are not directly involved in the production or consumption of a good or service.

[MF] What is a demerit good?

A demerit good is a good that is deemed socially undesirable by the government, and are overconsumed when left to the free market price mechanism.

[MF] What is a merit good?

A merit good is a good that is deemed socially desirable by the government, and are underconsumed when left to the free market price mechanism.

[MF] What is a public good?

A public good is one that is non-excludable and non-rivalrous. A good is non-excludable when it is impossible or very costly to exclude non-payers from consuming and benefitting from the good once it is provided. A good is non-rivalrous in consumption when the consumption of the good by one person does not reduce the amount of benefits available to others.

[MF] What is asymmetric information?

Asymmetric information occurs when one party involved in a trade has more or better information compared to another when making decisions and transactions.

[MF] What is adverse selection?

Adverse selection can come about when the profit-seeking seller knows more about the attributes of the good sold than the buyer.

[MF] What is moral hazard?

Moral hazard is a situation in which economic agents take greater risks than they normally would, because the costs that result from their riskier behaviours would not be solely borne by themselves.

[MF] What is government intervention?

Government intervention occurs when the market fails to achieve social goals and achieve the efficient distribution of resources in the economy.

[MF] What are anti-trust laws?

Anti-trust laws seek to promote or maintain market competition by regulating anti-competitive conduct by companies.

[MF] What is nationalization?

Nationalization refers to a transfer in ownership of a firm away from the private sector and towards government ownership.

[MF] What are consumer protection laws?

These are used to address adverse selection in markets, where consumers can make claims for a defective product within a few months of purchase.

[MF] What are co-payment schemes?

These are used to address the moral hazard problem, where the buyer of insurance will have to pay for part of the cost of damages or make partial payments for healthcare bills.

[MF] What is government failure?

Government failure refers to situations where government intervention in the free market increases market distortions and reduces economic efficiency and welfare, leading to an even worse allocation of resources.

[Firms] What is a Merger / Acquisition?

A merger occurs when a firm combines with one or more existing firms to form an entirely new enterprise or by buying over another firm.