DEFINITIONS A 42. Benjamin Disraeli. I hate definitions.

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1 DEFINITIONS I hate definitions. Benjamin Disraeli adverse selection: opportunism characterized by an informed person s benefiting from trading or otherwise contracting with a less informed person who does not know about an unobserved characteristic of the informed person. (19)* asymmetric information: situation in which one party to a transaction knows a material fact that the other party does not. (19) average cost (AC): the total cost divided by the units of output produced: AC = C/q. (7) average fixed cost (AFC): the fixed cost divided by the units of output produced: AFC = F/q. (7) average product of labor (AP L ): the ratio of output, q, to the number of workers, L, used to produce that output: AP L = q/l. (6) average variable cost (AVC): the variable cost divided by the units of output produced: AVC = VC/q. (7) bad: something for which less is preferred to more, such as pollution. (4) barrier to entry: an explicit restriction or a cost that applies only to potential new firms existing firms are not subject to the restriction or do not bear the cost. (9) Bertrand equilibrium: a Nash equilibrium in prices; a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. (13) best response: the strategy that maximizes a firm s profit, given its beliefs about its rivals strategies. (13) budget line (or budget constraint): the bundles of goods that can be bought if the entire budget is spent on those goods at given prices. (4) bundling (package tie-in sale): a type of tie-in sale in which two goods are combined so that customers cannot buy either good separately. (12) *Numbers refer to the chapter where the term is defined. A 42 cartel: a group of firms that explicitly agree to coordinate their activities. (13) certification: a report that a particular product meets or exceeds a given standard level. (19) cheap talk: unsubstantiated claims or statements. (19) common property: resources to which everyone has free access. (18) comparative advantage: the ability to produce a good at a lower opportunity cost than someone else. (10) competitive fringe (or fringe): small, price-taking firms that compete with a dominant firm. (11) constant returns to scale (CRS): property of a production function whereby all inputs are increased by a certain percentage, output increases by that same percentage. (6) consumer surplus (CS): the monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs. (9) contingent fee: a payment to a lawyer that is a share of the award in a court case (usually after legal expenses are deducted) if the client wins and nothing if the client loses. (20) contract curve: the set of all Pareto-efficient bundles. (10) cost (total cost, C): the sum of a firm s variable cost and fixed cost: C = VC + F. (7) Cournot equilibrium: a Nash equilibrium in quantities; a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity. (13) credible threat: an announcement that a firm will use a strategy harmful to its rival that the rivals believe because the firm s strategy is rational in the sense that it is in the firm s best interest to use it. (14) cross-price elasticity of demand: the percentage change in the quantity demanded in response to a given percentage change in the price of another good. (3)

2 Definitions deadweight loss (DWL): the net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium. (9) decreasing returns to scale (DRS): property of a production function whereby output increases less than in proportion to an equal percentage increase in all inputs. (6) demand curve: the quantity demanded at each possible price, holding constant the other factors that influence purchases. (2) discount rate: a rate reflecting the relative value an individual places on future consumption compared to current consumption. (16) diseconomies of scale: property of a cost function whereby the average cost of production rises when output increases. (7) dominant firm: a price-setting firm that competes with price-taking firms in a competitive fringe. (11) dominant strategy: a strategy that strictly dominates (gives higher profits than) all other strategies, regardless of the actions chosen by rival firms. (13) duopoly: an oligopoly with two firms. (13) durable good: a product that is usable for years. (7) economic cost (opportunity cost): the value of the best alternative use of a resource. (7) economic profit: revenue minus economic cost. (8) economically efficient: minimizing the cost of producing a specified amount of output. (7) economies of scale: property of a cost function whereby the average cost of production falls as output expands. (7) economies of scope: situation in which it is less expensive to produce goods jointly than separately. (7) efficiency in production: situation in which the principal s and agent s combined value (profits, payoffs), π, is maximized. (20) efficiency in risk bearing: a situation in which risk sharing is optimal in that the person who least minds facing risk the risk-neutral or less riskaverse person bears more of the risk. (20) efficiency wage: an unusually high wage that a firm pays workers as an incentive to avoid shirking. (20) efficient contract: an agreement with provisions that ensure that no party can be made better off without harming the other party. (20) efficient production (technological efficiency): situation in which the current level of output cannot A 43 be produced with fewer inputs, given existing knowledge about technology and the organization of production. (6) elasticity: the percentage change in a variable in response to a given percentage change in another variable. (3) endowment: an initial allocation of goods. (10) Engel curve: the relationship between the quantity demanded of a single good and income, holding prices constant. (5) equilibrium: a situation in which no one wants to change his or her behavior. (2) essential facility: a scarce resource that a rival must use to survive. (14) excess demand: the amount by which the quantity demanded exceeds the quantity supplied at a specified price. (2) excess supply: the amount by which the quantity supplied is greater than the quantity demanded at a specified price. (2) exhaustible resources: nonrenewable natural assets that cannot be increased, only depleted. (16) expansion path: the cost-minimizing combination of labor and capital for each output level. (7) externality: the direct effect of the actions of a person or firm on another person s well-being or a firm s production capability rather than an indirect effect through changes in prices. (18) fair bet: a wager with an expected value of zero. (17) fair insurance: a bet between an insurer and a policyholder in which the value of the bet to the policyholder is zero. (17) firm: an organization that converts inputs such as labor, materials, energy, and capital into outputs, the goods and services that it sells. (6) fixed cost (F ): a production expense that does not vary with output. (7) fixed input: a factor of production that cannot be varied practically in the short run. (6) flow: a quantity or value that is measured per unit of time. (16) free ride: to benefit from the actions of others without paying. (18) game: any competition between players (firms) in which strategic behavior plays a major role. (13) game theory: a set of tools that economists, political scientists, military analysts, and others use to analyze decisionmaking by players that use strategies. (13)

3 A 44 Definitions general-equilibrium analysis: the study of how equilibrium is determined in all markets simultaneously. (10) Giffen good: A commodity for which a decrease in its price causes the quantity demanded to fall. (5) good: a commodity for which more is preferred to less, at least at some levels of consumption. (4) incentive compatible: referring to a contract s provision of inducements such that the agent wants to perform the assigned task rather than engage in opportunistic behavior. (20) incidence of a tax on consumers: the share of the tax that falls on consumers. (3) income effect: The change in the quantity of a good a consumer demands because of a change in income, holding prices constant. (5) income elasticity of demand (or income elasticity): the percentage change in the quantity demanded in response to a given percentage change in income. (3) increasing returns to scale (IRS): property of a production function whereby output rises more than in proportion to an equal increase in all inputs. (6) indifference curve: the set of all bundles of goods that a consumer views as being equally desirable. (4) indifference map (or preference map): a complete set of indifference curves that summarize a consumer s tastes or preferences. (4) inferior good: A commodity of which less is demanded as income rises. (5) interest rate: the percentage more that must be repaid to borrow money for a fixed period of time. (16) internalize the externality: to bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others). (18) internal rate of return (irr): the discount rate that results in a net present value of an investment of zero. (16) isocost line: all the combinations of inputs that require the same (iso-) total expenditure (cost). (7) isoquant: a curve that shows the efficient combinations of labor and capital that can produce a single (iso-) level of output (quantity). (6) Law of Demand: consumers demand more of a good the lower its price, holding constant tastes, the prices of other goods, and other factors that influence consumption. (2) learning by doing: the productive skills and knowledge that workers and managers gain from experience. (7) Lerner Index: the ratio of the difference between price and marginal cost to the price: (p MC)/p. (11) limited liability: condition whereby the personal assets of the owners of the corporation cannot be taken to pay a corporation s debts if it goes into bankruptcy. (6) long run: a lengthy enough period of time that all inputs can be varied. (6) marginal cost (MC): the amount by which a firm s cost changes if the firm produces one more unit of output. (7) marginal product of labor (MP L ): the change in total output, q, resulting from using an extra unit of labor, L, holding other factors constant: MP L = q/ L. (6) marginal profit: the change in profit a firm gets from selling one more unit of output. (8) marginal rate of substitution (MRS): the maximum amount of one good a consumer will sacrifice to obtain one more unit of another good. (4) marginal rate of technical substitution: the number of extra units of one input needed to replace one unit of another input that enables a firm to keep the amount of output it produces constant. (6) marginal rate of transformation (MRT ): the trade-off the market imposes on the consumer in terms of the amount of one good the consumer must give up to obtain more of the other good. (4) marginal revenue (MR): the change in revenue a firm gets from selling one more unit of output. (8) marginal revenue product of labor (MRP L ): the extra revenue from hiring one more worker. (15) marginal utility: the extra utility that a consumer gets from consuming the last unit of a good. (4) market: an exchange mechanism that allows buyers to trade with sellers. (1) market failure: inefficient production or consumption, often because a price exceeds marginal cost. (9) market power: the ability of a firm to charge a price above marginal cost and earn a positive profit. (11) market structure: the number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals. (8)

4 Definitions microeconomics: the study of how individuals and firms make themselves as well off as possible in a world of scarcity and the consequences of those individual decisions for markets and the entire economy. (1) minimum efficient scale (full capacity): the smallest quantity at which the average cost curve reaches its minimum. (13) model: a description of the relationship between two or more economic variables. (1) monopolistic competition: a market structure in which firms have market power but no additional firm can enter and earn positive profits. (13) monopoly: the only supplier of a good for which there is no close substitute. (11) monopsony: the only buyer of a good in a given market. (15) moral hazard: opportunism characterized by an informed person s taking advantage of a lessinformed person through an unobserved action. (19) multimarket price discrimination (third-degree price discrimination): a situation in which a firm charges different groups of customers different prices but charges a given customer the same price for every unit of output sold. (12) Nash equilibrium: a set of strategies such that, holding the strategies of all other firms constant, no firm can obtain a higher profit by choosing a different strategy. (13) natural monopoly: situation in which one firm can produce the total output of the market at lower cost than several firms could. (11) noncooperative strategic behavior: the set of actions taken by a profit-maximizing firm acting independently of other firms. (14) nonuniform pricing: charging consumers different prices for the same product or charging a single customer a price that depends on the number of units the customer buys. (12) normal good: a commodity of which as much or more is demanded as income rises. (5) normative statement: a conclusion as to whether something is good or bad. (1) oligopoly: a small group of firms in a market with substantial barriers to entry. (13) opportunistic behavior: taking advantage of someone when circumstances permit. (15) A 45 opportunity cost (economic cost): the value of the best alternative use of a resource. (7) opportunity set: all the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint. (4) Pareto efficient: describing an allocation of goods or services such that any reallocation harms at least one person. (10) partial-equilibrium analysis: an examination of equilibrium and changes in equilibrium in one market in isolation. (10) patent: an exclusive right granted to the inventor to sell a new and useful product, process, substance, or design for a fixed period of time. (11) perfect complements: goods that a consumer is interested in consuming only in fixed proportions. (4) perfect price discrimination (first-degree price discrimination): situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it, so prices differ across customers and a given customer may pay more for some units than for others. (12) perfect substitutes: goods that a consumer is completely indifferent as to which to consume. (4) pooling equilibrium: an equilibrium in which dissimilar people are treated (paid) alike or behave alike. (19) positive statement: a testable hypothesis about cause and effect. (1) price discrimination: practice in which a firm charges consumers different prices for the same good. (12) price elasticity of demand (or elasticity of demand, ε): the percentage change in the quantity demanded in response to a given percentage change in the price. (3) price elasticity of supply (or elasticity of supply, η): the percentage change in the quantity supplied in response to a given percentage change in the price. (3) prisoners dilemma: a game in which all players have dominant strategies that result in profits (or other payoffs) that are inferior to what they could achieve if they used cooperative strategies. (13) private cost: the cost of production only, not including externalities. (18) producer surplus (PS): the difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good. (9)

5 A 46 Definitions production function: the relationship between the quantities of inputs used and the maximum quantity of output that can be produced, given current knowledge about technology and organization. (6) production possibility frontier: the maximum amount of outputs that can be produced from a fixed amount of input. (7) profit (π): the difference between revenues, R, and costs, C: π = R C. (6) property right: the exclusive privilege to use an asset. (18) public good: a commodity or service whose consumption by one person does not preclude others from also consuming it. (18) quantity demanded: the amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases. (2) quantity discrimination (second-degree price discrimination): situation in which a firm charges a different price for large quantities than for small quantities but all customers who buy a given quantity pay the same price. (12) quantity supplied: the amount of a good that firms want to sell at a given price, holding constant other factors that influence firms supply decisions, such as costs and government actions. (2) quota: the limit that a government sets on the quantity of a foreign-produced good that may be imported. (2) rent: a payment to the owner of an input beyond the minimum necessary for the factor to be supplied. (8) rent seeking: efforts and expenditures to gain a rent or a profit from government actions. (9) requirement tie-in sale: a tie-in sale in which customers who buy one product from a firm are required to make all their purchases of another product from that firm. (12) reservation price: the maximum amount a person would be willing to pay for a unit of output. (13) residual demand curve: the market demand that is not met by other sellers at any given price. (11) residual supply curve: The market supply that is not met by demanders in other sectors at any given wage. (10) risk: situation in which the likelihood of each possible outcome is known or can be estimated and no single possible outcome is certain to occur. (17) risk averse: unwilling to make a fair bet. (17) risk neutral: indifferent about making a fair bet. (17) risk preferring: willing to make a fair bet. (17) risk premium: the amount that a risk-averse person would pay to avoid taking a risk. (17) screening: an action taken by an uninformed person to determine the information possessed by informed people. (19) separating equilibrium: an equilibrium in which one type of people takes actions (such as sending a signal) that allows them to be differentiated from other types of people. (19) shirking: a moral hazard in which agents do not provide all the services they are paid to provide. (20) shortage: a persistent excess demand. (2) short run: a period of time so brief that at least one factor of production cannot be varied practically. (6) signaling: an action taken by an informed person to send information to an uninformed person. (19) social cost: the private cost plus the cost of the harms from externalities. (18) standard: a metric or scale for evaluating the quality of a particular product. (19) stock: a quantity or value that is measured independently of time. (16) strategic behavior: a set of actions a firm takes to increase its profit, taking into account the possible actions of other firms. (14) strategy: a battle plan of the actions a firm plans to take to compete with other firms. (13) substitution effect: The change in the quantity of a good that a consumer demands when the good s price changes, holding other prices and the consumer s utility constant. (5) supergame: a game that is played repeatedly, allowing players to devise strategies for one period that depend on rivals actions in previous periods. (13) sunk cost: an expenditure that cannot be recovered. (7) supply curve: the quantity supplied at each possible price, holding constant the other factors that influence firms supply decisions. (2)

6 Definitions tariff (duty): a tax on only imported goods. (9) technical progress: an advance in knowledge that allows more output to be produced with the same level of inputs. (6) technological efficiency (efficient production): property of a production function such that the current level of output cannot be produced with fewer inputs, given existing knowledge about technology and the organization of production. (6) tie-in sale: a type of nonlinear pricing in which customers can buy one product only if they agree to buy another product as well. (12) total cost (C): the sum of a firm s variable cost and fixed cost: C = VC + F. (7) total product of labor: the amount of output (or total product) that can be produced by a given amount of labor. (6) transaction costs: the expenses of finding a trading partner and making a trade for a good or service beyond the price paid for that good or service. (2) A 47 two-part tariff: a pricing system in which the firm charges a consumer a lump-sum fee (the first tariff or price) for the right to buy as many units of the good as the consumer wants at a specified price (the second tariff). (12) utility: a set of numerical values that reflect the relative rankings of various bundles of goods. (4) utility function: the relationship between utility values and every possible bundle of goods. (4) variable cost (VC): a production expense that changes with the quantity of output produced. (7) variable input: a factor of production whose quantity can be changed readily by the firm during the relevant time period. (6) vertically integrated: describing a firm that participates in more than one successive stage of the production or distribution of goods or services. (15)