Glossary
Allocative Inefficiency
A situation where resources are not distributed to produce the goods and services that society values most, typically occurring when the price (P) does not equal marginal cost (MC).
Example:
If a city has too few public parks relative to what its citizens desire, it might be due to allocative inefficiency in the allocation of public funds.
Barriers to Entry
Obstacles that prevent new firms from easily entering a market, allowing existing firms to maintain market power and potentially earn long-run economic profits.
Example:
The immense capital required to build a new car manufacturing plant acts as a significant barrier to entry for aspiring automotive companies.
Collusion
An illegal agreement among competing firms to cooperate, typically by fixing prices or limiting output, to increase their collective profits.
Example:
If several major oil companies secretly agree to limit oil production to drive up prices, they are engaging in illegal collusion.
Consumer Surplus
The difference between the maximum price a consumer is willing to pay for a good or service and the actual price they pay.
Example:
If you were willing to pay 30, your consumer surplus for that ticket is $20.
Deadweight Loss
The loss of economic efficiency that occurs when the equilibrium quantity of a good or service is not achieved, resulting in a reduction of total surplus (consumer plus producer surplus).
Example:
A government imposing a tax on a product can create deadweight loss by reducing the number of transactions that would have otherwise occurred, thus reducing overall societal welfare.
Differentiated Products
Products that are similar but not identical, allowing firms to have some control over their price due to perceived differences in quality, features, or branding.
Example:
While all smartphones perform similar functions, Apple's iPhones and Samsung's Galaxies are differentiated products due to their unique operating systems, designs, and brand loyalties.
Dominant Strategy
A strategy that yields the best outcome for a player regardless of what strategies other players choose.
Example:
In a pricing game, if lowering prices always leads to higher profits for Company A, regardless of what Company B does, then lowering prices is Company A's dominant strategy.
Economic Profit
The difference between total revenue and total economic costs, which include both explicit (out-of-pocket) and implicit (opportunity) costs.
Example:
If a small business owner earns 60,000 in explicit costs and 10,000.
Game Theory
A mathematical framework used to analyze strategic interactions between rational decision-makers, often applied to understand firm behavior in oligopolies.
Example:
Businesses use game theory to predict how competitors might react to a new product launch or a significant price change.
Game Theory Matrix
A visual tool used in game theory to represent the possible strategies for each player and the resulting payoffs or outcomes for every combination of strategies.
Example:
A game theory matrix can illustrate the potential profits for two competing fast-food chains based on whether they choose to advertise heavily or not.
Imperfect Competition
Market structures where individual firms have some control over the price of their products due to relaxed assumptions of perfect competition, often characterized by barriers to entry.
Example:
The market for smartphones, dominated by a few large companies like Apple and Samsung, is an example of imperfect competition.
Interdependence (in Oligopoly)
A key characteristic of oligopolies where each firm's actions significantly affect and are affected by the decisions and strategies of its competitors.
Example:
If one major airline lowers its ticket prices, other airlines will likely feel the interdependence and respond by lowering their own prices to remain competitive.
MR = MC (Profit Maximization Rule)
The fundamental rule for all firms, regardless of market structure, stating that profit is maximized at the quantity of output where marginal revenue equals marginal cost.
Example:
A streaming service will continue to add new subscribers as long as the marginal revenue from each new subscriber is greater than or equal to the marginal cost of providing the service to them.
Monopolistic Competition
A market structure characterized by many firms selling differentiated products, low barriers to entry, and significant non-price competition.
Example:
The market for fast-food restaurants, with many brands like McDonald's, Burger King, and Wendy's offering slightly unique menus, is a classic example of monopolistic competition.
Monopoly
A market structure characterized by a single firm that produces a unique product with no close substitutes, facing high barriers to entry.
Example:
If a single company owned all the diamond mines in the world, it would effectively operate as a monopoly in the global diamond market.
Nash Equilibrium
A stable state in a game where no player has an incentive to unilaterally change their strategy, given the strategies chosen by the other players.
Example:
If two rival companies both decide to invest heavily in research and development, and neither would benefit from stopping their investment if the other continues, they have reached a Nash Equilibrium.
Natural Monopoly
A type of monopoly that arises when a single firm can produce the entire market output at a lower average cost than multiple firms due to extensive economies of scale.
Example:
A local water company is often a natural monopoly because the cost of building and maintaining one extensive pipeline network is far lower than having multiple competing networks.
Non-Price Competition
Strategies used by firms to attract customers through means other than lowering prices, such as advertising, branding, or product differentiation.
Example:
Different brands of soft drinks engage in intense non-price competition by sponsoring major events and featuring celebrities in their advertisements.
Oligopoly
A market structure dominated by a few large firms that are highly interdependent, facing high barriers to entry.
Example:
The global automobile industry, dominated by a handful of major manufacturers like Toyota, Volkswagen, and General Motors, is a classic oligopoly.
Patents
Government-granted exclusive rights that give an inventor or firm the sole authority to produce, use, and sell a new invention for a specified period.
Example:
A pharmaceutical company holding a patent for a new drug can be the sole producer, allowing them to set prices without direct competition for a time.
Perfect Competition
A theoretical market structure characterized by many buyers and sellers, identical products, free entry and exit, and perfect information, leading to firms being price takers.
Example:
The market for agricultural commodities like wheat or corn often approximates perfect competition, as many farmers sell nearly identical products.
Price Discrimination
A pricing strategy where a monopolist charges different prices to different customers for the same product or service, based on their willingness to pay.
Example:
Airlines often practice price discrimination by charging business travelers higher fares for the same seat than leisure travelers who book far in advance.
Price Makers
Firms that have some degree of control over the price of their products, unlike firms in perfect competition who are price takers.
Example:
A local utility company, being the sole provider of electricity in an area, acts as a price maker because consumers have no alternative suppliers.
Productive Inefficiency
A situation where a firm is not producing its output at the lowest possible average total cost, indicating that resources are not being used optimally.
Example:
A factory using outdated machinery and inefficient processes might suffer from productive inefficiency, producing goods at a higher cost per unit than necessary.