Allison Brown and Aaron Caverly

Unit 3: Theory of the Business Firm Vocab

Economic Cost: A payment that must be made to obtain and retain the services of
a resource.

Explicit Cost: The monetary payment a firm must make to an outsider to obtain a
resource.

Implicit Cost: The monetary income a firm sacrifices when it uses a resource it
owns rather than supplying the resource in the market; equal to what the resource
could have earned in the best-paying alternative employment; includes a normal
profit.

Short Run Time: a period of time in which the quantity of at least one input is
fixed and the quantities of the other inputs can be varied

Long Run: a period of time in which the quantities of all inputs can be varied.

Law Of diminishing returns: The tendency for a continuing application of effort

or skill toward a particular project or goal to decline in effectiveness after a certain
level of result has been achieved.

Total Product: The total output of a particular good or service produced by a firm
(or a group of firms or the entire Economy)

Marginal Product: Output that results from one additional unit of a factor of
production (such as a labor hour or machine hour), all other factors remaining
constant. Whereas the marginal cost indicates the added cost incurred in producing
an additional unit of output, marginal product indicates the added output accruing
to an additional input. Since marginal product is measured in physical units
produced, it is also called marginal physical product.

Average Product: The total output produced per unit of a resource employed.

Average Variable Cost: Variable cost divided by number of units produced.

Formula: Variable costs ÷ total output.

Average Total Cost: Average total cost is the sum of all the production costs
divided by the number of units produced.

Total Revenue: Total sales revenue and other revenue for a particular period.

Marginal revenue: Increase in the gross revenue of a firm produced by selling one
additional unit of output.

Profit Maximizing: The monopolist's profit maximizing level of output is found by

equating its marginal revenue with its marginal cost, which is the same profit
maximizing condition that a perfectly competitive firm uses to determine its
equilibrium level of output. Indeed, the condition that marginal revenue equal
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Unit 3: Theory of the Business Firm Vocab

marginal cost is used to determine the profit maximizing level of output of every
firm, regardless of the market structure in which the firm is operating.

Breakeven Point: Point in time (or in number of units sold) when forecasted
revenue exactly equals the estimated total costs; where loss ends and profit begins
to accumulate. This is the point at which a business, product, or project becomes
financially viable

Close-Down (Shutdown?): Period during which an equipment, machine, or plant

is out of service.

MR (P) = MC Rule:

Constant Cost Industry: A perfectly competitive industry with a flat, or perfectly

elastic long-run industry supply curve that results because expansion of the
industry has no effect on production cost or resource prices. For a constant-cost
industry the entry of new firms, prompted by an increase in demand, has no effect
on the long-run average cost curve of each firm nor its minimum efficient scale of
production.

Increasing Cost Industry: A perfectly competitive industry with a positively-

sloped long-run industry supply curve that results because expansion of the
industry causes higher production cost and resource prices. For an increasing-cost
industry the entry of new firms, prompted by an increase in demand, causes the
long-run average supply curve of each firm to shift upward, which increases the
minimum efficient scale of production.

Marginal Cost: Increase or decrease in the total cost of a production-run, from

making one additional unit of an item. It is computed in situations where breakeven
point has been reached: the fixed costs have already been absorbed by the already
produced items and only the direct (variable) costs have to be accounted for.
Marginal costs are variable costs comprising of labor and material costs, plus an
estimated portion of fixed costs (such as administration overheads and selling
expenses). In firms where average costs are fairly constant, marginal cost is usually
equal to average cost. However, in industries that require heavy capital investment
(automobile plants, airlines, mines) and have high average costs, it is comparatively
very low. The concept of marginal cost is of critical importance in resource
allocation because, for optimum results, the management must concentrate its
resources where the excess of marginal revenue over the marginal cost is
maximum. Also called choice cost, differential cost, or incremental cost

Economies of Scale: refers to the cost advantages that a business obtains due to
expansion. There are factors that cause a producer’s average cost per unit to fall as
the scale of output is increased. "Economies of scale" is a long run concept and
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Unit 3: Theory of the Business Firm Vocab

refers to reductions in unit cost as the size of a facility and the usage levels of other
inputs increase

Diseconomies of Scale: Opposite of Economies of Scale

Perfect Competition: Theoretical free-market situation where (1) buyers and

sellers are too numerous and too small to have any degree of individual control over
prices, (2) all buyers and sellers seek to maximize their profit (income), (3) buyers
and seller can freely enter or leave the market, (4) all buyers and sellers have
access to information regarding availability, prices, and quality of goods being
traded, and (5) all goods of a particular nature are homogeneous, hence
substitutable for one another. Also called perfect market or pure competition.

Perfect Monopoly: Market situation where one producer (or a group of producers
acting in concert) controls supply of a good or service, and where the entry of new
producers is prevented or highly restricted. Monopolist firms (in their attempt to
maximize profits) keep the price high and restrict the output, and show little or no
responsiveness to the needs of their customers. Most governments therefore try to
control monopolies by (1) imposing price controls, (2) taking over their ownership
(called 'nationalization'), or (3) by breaking them up into two or more competing
firms. Sometimes governments facilitate the creation of monopolies for reasons of
national security, to realize economies of scale for competing internationally, or
where two or more producers would be wasteful or pointless (as in the case of
utilities). Although monopolies exist in varying degrees (due to copyrights, patents,
access to materials, exclusive technologies, or unfair trade practices) almost no firm
has a complete monopoly in the era of globalization.

Monopolistic Competition: Market situation midway between the extremes of

perfect competition and monopoly, and displaying features of the both. In such
situations firms are free to enter a highly competitive market where several
competitors offer products that are close (but not perfect) substitutes and,
therefore, prices are at the level of average costs (a feature of perfect competition).
Also, some consumers have a preference for one product over another that is
strong enough to make them keep buying it even when its price increases, thus
giving its producer a small amount of market power (a feature of monopoly).
Monopolistic situation is a common situation in all free markets.

Oligopoly: Market situation between, and much more common than, perfect
competition (having many suppliers) and monopoly (having only one supplier). In
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Unit 3: Theory of the Business Firm Vocab

oligopolistic markets, independent suppliers (few in numbers and not necessarily

acting in collusion) can effectively control the supply, and thus the price, thereby
creating a seller's market. They offer largely similar products, differentiated mainly
by heavy advertising and promotional expenditure, and can anticipate the effect of
one another's marketing strategies. Examples include airline, automotive, banking,
and petroleum markets. Mirror image of oligopsony.

Imperfect Competition: Real world' competition that is less effective in lowering

price levels nearer to the cost levels than the theoretical perfect competition.
Conditions that help cause imperfect competition include (1) restricted flow of
information on costs and prices, (2) near monopoly power of some suppliers, (3)
collusion among sellers to keep prices high, and (4) discrimination by sellers among
buyers on the basis of their buying power.

Price Maker: A seller (or buyer) of a product or resources that is able to affect the
product or resource price by changing the amount it sells (or buys)

Price Taker: A seller (or buyer) of a product or resources that is unable to affect
the product or resource price by changing the amount it sells (or buys)

Average Revenue: Total revenue divided by the number of units sold.

Decreasing Cost Industry: A decreasing cost industry is one where costs

decrease as the industry expands.

Collusion: Improper secret agreement between two or more entities, to defraud or

deprive others of their property or rightful share, or to otherwise indulge in a
forbidden, illegal, or illegitimate activity.

Cartel: Group of firms or nations who attempt to control price or supply of a

commodity (such as oil) through mutual restraint on production. Although such
collusion among sovereign countries (such as in OPEC) is grudgingly accepted, it is
illegal among corporations. See also oligopoly.

Normal Profit: Minimum profit necessary to attract and retain suppliers in a

perfectly competitive market (see perfect competition). Only normal profit could be
earned in such markets because, if profit was abnormally high, more competitors
would appear and drive prices and profit down. If profit was abnormally low, firms
would leave the market and the remaining ones would drive the prices and profit
up. Markets where suppliers are making normal profits will neither expand nor
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Unit 3: Theory of the Business Firm Vocab

shrink and will, therefore, be in a state of long-term equilibrium. Normal profit

typically equals opportunity cost.

Accounting Profit: Profit before tax.

Socially Optimal Price:

Game Theory: is a branch of mathematics that uses models to study interactions

with formalized incentive structures ("games"). It has applications in a variety of
fields, including economics, evolutionary biology, political science, and military
strategy. Game theorists study the predicted and actual behavior of individuals in
games, as well as optimal strategies. Seemingly different types of interactions can
exhibit similar incentive structures, thus all exemplifying one particular game.

Nash Equilibrium: A concept of game theory where the optimal outcome of a

game is one where no player has an incentive to deviate from his or her chosen
strategy after considering an opponent's choice. Overall, an individual can receive
no incremental benefit from changing actions, assuming other players remain
constant in their strategies. A game may have multiple Nash equilibrium or none at
all.