Glossary (See related pages) Actuarially fair   An insurance policy is actuarially fair if its expected net payoff is zero. Ad valorem tax   An ad valorem tax is a tax that is stated as a percentage of the good's price. Adverse selection   Adverse selection is present if an informed individual is more willing to trade when trading is less advantageous to an uninformed trading partner. Aggregate surplus   Aggregate surplus equals consumers' total willingness to pay for a good less firms' total avoidable cost of production. It captures the net benefit created by the production and consumption of the good. Anchoring   Anchoring occurs when someone's choices are linked to prominent but plainly irrelevant information. Average cost   A firm's average cost, AC = C/Q, is its cost per unit of output produced. Average product of labor   The average product of labor, denoted APL, equals the amount of output divided by the number of workers employed. Avoidable fixed costs   An avoidable fixed cost is a fixed cost that is not incurred when the firm decides to produce no output. Backward induction   Backward induction is the process of solving a strategic problem by reasoning in reverse, starting at the end of the tree diagram that represents the game, and working back to the beginning. Bad   A bad is an object, condition, or activity that makes a consumer worse off. Benefit   An insurance benefit is the amount of money a policyholder receives if a specific loss occurs. Bertrand model of oligopoly   In the Bertrand model of oligopoly, firms produce homogeneous products and set their prices simultaneously. Best response   A player's best response is a strategy that provides him or her with the highest possible payoff, assuming that other players behave in a specified way. Best response function   A best response function shows the relationship between one player's choice and the other's best response. Best response curve   A firm's best response curve shows its best choice in response to each possible choice by its rival. Bond   A bond is a legally binding promise to make specific future payments. Boundary action   A boundary action is an action at which it is possible to change the activity level in only one direction. Boundary choice   See boundary action. Boundary solution   When the consumer's best choice is a boundary choice, we call it a boundary solution. Boundary solution (for cost minimization)   A least-cost input combination is a boundary solution if it excludes some inputs. Budget constraint   A budget constraint identifies all of the consumption bundles a consumer can afford over some period of time. Budget line   A budget line shows all of the consumption bundles that just exhaust a consumer's income. Bundling   Bundling is the practice of selling several products together as a package. Business stealing   Business stealing arises when some of a new entrant's sales come at the expense of existing firms, whose sales contract after the new firm enters the market. Capitalist economy   A capitalist economy is one in which the means of production are mostly owned and controlled by and for the benefit of private individuals, and the allocation of resources is governed by voluntary trading among businesses and consumers. Captured   Regulators have been captured when they promote the regulated firm's agenda. Cardinal   Information about a consumer's preferences is cardinal if it tells us about the intensity of those preferences. It answers the questions "How much worse?" or "How much better?" Certainty equivalent   The certainty equivalent of a risky bundle is the amount of consumption which, if provided with certainty, would make the consumer equally well off. Choice Principle   The Choice Principle states that among the available alternatives, a consumer selects the one that he ranks the highest. Coase Theorem   The Coase Theorem states that if bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will remedy the market failures associated with externalities and restore economic efficiency. Cobb-Douglas production function   The Cobb-Douglas production function is a production function of the form Q = F(L, K) = ALαKβ. Common property resource   A common property resource is a resource that more than one person is free to use without payment. Communist economy   A communist economy is one in which the state owns and controls the means of production and distribution. Compensated demand curve   A compensated demand curve shows the effect of a compensated change in a good's price on the amount consumed. In other words, it describes the relationship between the price and the amount consumed holding the consumer's well-being fixed and allowing his income to vary. Compensated price change   A compensated price change consists of a price change and an income change which, together, leave the consumer's well-being unaffected. Compensating variation   A compensating variation is the amount of money that exactly compensates the consumer for a change in circumstances. Complements   Two products are complements if, all else equal, an increase in the price of one of the products causes consumers to demand less of the other product. Completeness   The assumption of completeness holds that, in comparing any two alternatives X and Y, the consumer either prefers X to Y, prefers Y to X, or is indifferent between them. Compounding   Compounding refers to the payment of interest on loan balances that include interest earned in the past, a practice that causes the loan balance to grow faster as time passes. Constant elasticity demand function   A constant elasticity (or isoelastic) demand function has the same elasticity at every price. Constant expected consumption line   A constant expected consumption line shows all the risky consumption bundles with the same level of expected consumption. Constant returns to scale   A firm has constant returns to scale if a proportional change in all inputs produces the same proportional change in output. Consumer surplus (total)   (Total) consumer surplus equals the sum of consumers' total willingness to pay less their total expenditure, or equivalently, the sum of their individual consumer surpluses. Consumer surplus   Consumer surplus is the net benefit a consumer receives from participating in the market for some good. It equals her total willingness to pay less her total expenditure. Consumption basket   See consumption bundle. Consumption bundle   A consumption bundle is the collection of goods that an individual consumes over a given period, such as an hour, a day, a month, a year, or a lifetime. Contract curve   The contract curve shows every efficient allocation of consumption goods in an Edgeworth box. Cost function   A firm's cost function describes the total cost of producing each possible level of output. It is a function of the form Total cost = C(Output). Cost-of-living index   A cost-of-living index measures the relative cost of achieving a fixed standard of living in different situations. Coupon   A bond's coupon is the regular, constant payment made by the issuer to the bond's owner. Cournot model of oligopoly   In the Cournot model of oligopoly, firms choose how much to produce (their quantities) simultaneously, and the price clears the market given the total quantity produced. Cross-price elasticity of demand   The cross-price elasticity of demand with another product equals the percentage change in the amount demanded of the product for each one-percent increase in the price of the other product. Cross-subsidization   In an insurance market, cross-subsidization occurs when the policy chosen by one type of customer generates losses, while the policy chosen by another type of customer generates profits, and all policies collectively break even. Deadweight loss   A deadweight loss is a reduction in aggregate surplus below its maximum possible value. Deadweight loss from monopoly pricing   The deadweight loss from monopoly pricing is the amount by which the aggregate surplus attained when a monopolist sets the price of a good to maximize its profit falls short of its maximum possible level, which is attained in a perfectly competitive market. Deadweight loss of taxation   The deadweight loss of taxation is the lost aggregate surplus due to a tax. Declining marginal rate of technical substitution   An isoquant for a production process using two inputs, X and Y, has a declining marginal rate of technical substitution if MRTSXY declines as we move along the isoquant, increasing input X and decreasing input Y (that is, the isoquant becomes flatter as we move along the curve from the northwest to the southeast). Declining marginal rate of substitution   A consumer's indifference curve for consumption bundles involving two good, X and Y, has a declining marginal rate of substitution if MRSXY declines as we move along the indifference curve, increasing good X and decreasing good Y (that is, the indifference curve becomes flatter as we move along the curve from the northwest to the southeast). Decreasing returns to scale   A firm has decreasing returns to scale if a proportional change in all inputs produces a less than proportional change in output. Default   Default on a loan is the failure to pay back borrowed money. Default effect   The default effect refers to the fact that when confronted with many alternatives, people sometimes avoid making a choice and end up with the option that is assigned as a default. Demand curve   A product's demand curve shows how much buyers of the product want to purchase at each possible price, holding fixed all other factors that affect demand. Demand function   A product's demand function describes the amount of the product that buyers wish to purchase for each possible combination of its price and other factors. Deviation   For any distribution of uncertain payoffs, a deviation is the difference between the actual payoff and the expected payoff. Dictator game   In the dictator game, one player (the dictator) divides a fixed prize between himself and another player (the recipient) who is a passive participant. Differentiated products   When consumers do not view similar products as perfect substitutes, those products are called differentiated products. Diminishing sensitivity   The principle of diminishing sensitivity holds that the marginal impact of enlarging a change from the status quo declines with the size of the change. Diseconomies of scale   A firm experiences diseconomies of scale when its average cost rises as it produces more. Diseconomies of scope   Diseconomies of scope occur when producing two products in a single firm is more expensive than producing them separately, in different fi rms. Diversification   Diversifi cation is the practice of undertaking many risky activities, each on a small scale, rather than a few risky activities (or just one) on a large scale. Domestic aggregate surplus   Domestic aggregate surplus is the sum of consumer surplus, domestic producer surplus, and government revenue. Dominant   A strategy is dominant if it is a player's only best response, regardless of other players' choices. Dominated   A strategy is dominated if there is some other strategy that yields a strictly higher payoff regardless of others' choices. Duopoly   A duopoly is a market with two sellers. Dynamically consistent   A person is dynamically consistent if his preferences over the alternatives available at some future date don't change as that date approaches or once it arrives. Dynamically inconsistent   A person is dynamically inconsistent if his preference over the alternatives available at some future date change as that date approaches or once it arrives. Econometrics   Econometrics is the application of statistical methods to empirical questions in the field of economics. Economies of scale   A firm experiences economies of scale when its average cost falls as it produces more. Economies of scope   Economies of scope occur when a single firm can produce two or more products more cheaply than two separate firms. Edgeworth box   The Edgeworth box is a diagram that shows two consumers' opportunities and choices in a single figure. Efficient production method   A production method is efficient if there is no way for the firm to produce a larger amount of output using the same amounts of inputs. Efficient production frontier   A firm's efficient production frontier contains the combinations of inputs and outputs that the firm can achieve using efficient production methods. Efficient scale of production   A firm's efficient scale of production is the output level at which its average cost is lowest. Egalitarianism   According to the principle of egalitarianism, equal division of society's resources among all members of the population is the most equitable outcome. Elastic demand   Demand is elastic at a given price when the elasticity of demand is less than -1. Elastic supply   Supply is elastic at a given price when the elasticity of supply is greater than 1. Elasticity   The elasticity of Y with respect to X, denoted EYX, equals the percentage change in Y divided by the percentage change in X, or equivalently, the percentage change in Y for each one percent increase in X. Emissions standard   An emissions standard is a legal limit on the amount of pollution that a person or company can produce when engaged in a particular activity. Endowment   An endowment is the bundle of goods an individual starts out with before trading. Endowment effect   The endowment effect refers to the observation that people tend to value something more highly when they own it than when they don't. Engel curve   The Engel curve for a good describes the relationship between income and the amount consumed, holding everything else fixed (including prices and the consumer's preferences). Equilibrium price   The equilibrium price is the price at which the amounts supplied and demanded are equal. Equity premium puzzle   The equity premium puzzle suggests that standard economic models can account for the historical equity premium only if investors are absurdly risk averse. Equity premium   The equity premium is the difference between the annual returns on a broad portfolio of stocks, and safe bonds. Equity share   An equity share is a proportional claim on the ownership of a company. Equivalent variation   An equivalent variation is the amount of money a consumer is just willing to accept (positive or negative) in place of a change in circumstances. Exchange economy   In an exchange economy, people own and trade goods, but no production takes place. Exchange efficiency condition   The exchange efficiency condition holds if every pair of individuals shares the same marginal rate of substitution for every pair of goods. Expected payoff   The expected payoff of a risky financial choice is a weighted average of all the possible payoffs, using the probability of each payoff as its weight. Expected utility function   An expected utility function assigns a benefit level to each possible state of nature based only on what is consumed, and then takes the expected value of those benefits. Explicit collusion   Firms engage in explicit collusion when they communicate to reach an agreement about the prices they will change. External benefit   An external benefit is the economic gain that a positive externality provides to others. External cost   An external cost is the economic harm that a negative externality imposes on others. Externality   A decision creates an externality if it affects someone with whom the decision maker has not engaged in a related market transaction. Face value   A bond's face value is the amount paid at maturity by the issuer to the bond's owner, over and above the final coupon payment. Factor market   A factor market is a market for an input. Factor-neutral technical change   Factor-neutral technical change has no effect on the MRTS at any input combination. It simply changes the output level associated with each of the firm's isoquants. Family of indifference curves   A family of indifference curves is a collection of indifference curves that represent the preferences of the same individual. Family of isocost lines   A family of isocost lines contains, for given input prices, the isocost lines for all of the possible cost levels of the firm. Family of isoquants   A firm's family of isoquants consists of the isoquants corresponding to all of its possible output levels. Finitely repeated game   A finitely repeated game is formed by repeating a simpler game a fixed number of times, after which the game ends. First welfare theorem   The first welfare theorem tells us that, in a general equilibrium with perfect competition, the allocation of resources is Pareto efficient. Fixed input   A fixed input cannot be adjusted over the time period being considered. Fixed proportions   Two inputs are used in fixed proportions when they must be combined in a fixed ratio. See also perfect complements. Fixed-weight price index   A fixed-weight price index measures the percentage change in the cost of a fixed consumption bundle. Free entry   There is free entry in a market when technology is freely available to anyone who wishes to start a firm and entry is unrestricted. In that case, the number of potential firms is unlimited. Free market system   In a free market system, the government mostly allows markets to operate as they will, with little regulation or other intervention. See also market economy. Free rider   A free rider contributes little or nothing to a public good while benefiting from others' contributions. Full insurance   With full insurance, the promised benefit equals the potential loss. Gambler's fallacy   The gambler's fallacy is the belief that once an event has occurred, it is less likely to repeat. Game   A game is a situation in which a number of individuals make decisions, and each cares both about his own choice and about others' choices. General equilibrium analysis   General equilibrium analysis is the study of competitive equilibrium in many markets at the same time. Giffen good   A product is called a Giffen good if the amount purchased increases as the price rises. Grim strategies   With grim strategies, the punishment for selfish behavior is permanent. Groves mechanism   A Groves mechanism is a procedure for setting the level of a public good that induces everyone to report their preferences correctly, and that produces a socially efficient outcome. Guaranteed consumption line   The guaranteed consumption line shows the consumption bundles for which the level of consumption does not depend on the state of nature. Hedging   Hedging is the practice of taking on two risky activities with negatively correlated financial payoffs. Hicksian demand curve   See compensated demand curve. Higher productivity   A firm has higher productivity when it can produce more output using the same amounts of inputs. Equivalently, its production function is shifted upward at each combination of inputs. Homogeneous goods   In a market for homogeneous goods, firms sell identical products. Horizontal merger   In a horizontal merger, two or more competing firms combine their operations. Hot-hand fallacy   The hot-hand fallacy is the belief that once an event has occurred several times in a row, it is more likely to repeat. Human capital   Human capital consists of marketable skills acquired through investments in education and training. Incentive scheme   An incentive scheme is a contract or compensation policy that ties rewards or punishments to performance, designed in a manner to induce desirable behavior. Income   A consumer's income consists of the money he receives during some fixed period of time. Income effect of a price change   The effect on consumption of removing the compensation after creating a compensated price change is known as the income effect of a price change. Income effect   An income effect is the change in the consumption of a good that results from a change in income. Income elasticity of demand   The income elasticity of demand equals the percentage change in the amount demanded for each one-percent increase in income. Income-consumption curve   The income-consumption curve shows how the best affordable consumption bundle changes as income changes, holding everything else fixed (including prices and the consumer's preferences). Increasing returns to scale   A firm has increasing returns to scale if a proportional change in all inputs produces a more than proportional change in output. Indifference curve   Starting with any alternative, an indifference curve shows all the other alternatives that a consumer likes equally well. Indifferent   A consumer is indifferent between two alternatives if he likes (or dislikes) them equally. Individual demand curve   An individual demand curve describes the relationship between the price of a good and the amount a particular consumer purchases, holding everything else fixed (including the consumer's income and preferences, as well as all other prices). Individual sovereignty   The principle of individual sovereignty holds that each person knows what's best for him or her. Inelastic demand   Demand is inelastic when the elasticity of demand is greater than -1 (that is, between -1 and 0). Inelastic supply   Supply is inelastic when the elasticity of supply is between 0 and 1. Inferior   If a good is inferior, an increase in income reduces the amount that is consumed. Infinitely repeated Bertrand model   In the infinitely repeated Bertrand model, firms play the Bertrand pricing game over and over, with no definite end. Infinitely repeated game   An infinitely repeated game is formed by repeating a simpler game over and over, with no definite end. Inflation   Inflation refers to the change in the cost of living over time. Informational asymmetry   An informational asymmetry is present when one party to a transaction has more information than another about the characteristics of the good or service to be traded. Inframarginal units   The inframarginal units are the units the firm sells other than the marginal units. Input efficiency condition   The input efficiency condition holds if every pair of firms share the same marginal rate of technical substitution between every pair of inputs. Input efficiency   Input efficiency means that holding constant the total amount of each input used in the economy, there is no way to increase any firm's output of one good without decreasing the output of another good. Inputs   Inputs are the materials, labor, land, or equipment that firms use to produce their outputs. Instrumental variable   An observed factor that shifts the demand curve when one is estimating the supply curve, or the supply curve when one is estimating the demand curve, is called an instrumental variable. Insurance policy   An insurance policy is a contract that reduces the financial loss associated with some risky event, like a burglary, an accident, an illness or death. Interest   Interest is the amount of money a borrower is obliged to pay a lender, over and above the principal. Interest rate   The interest rate is the amount of interest paid on a loan during a particular period (usually a year), stated as a percentage of the principal. Interior action   An interior action is an action at which it is possible to marginally increase or decrease the activity level. Interior choice   See interior action. Interior input combination   An interior input combination uses at least a little bit of every input. Interior solution (for cost minimization)   A least-cost input combination is an interior solution when it is an interior input combination (that is, it contains at least a little bit of every input). Interior solution (for consumer decisions)   When the best affordable choice is an interior choice, we call it an interior solution. Internal rate of return (or IRR)   A project's internal rate of return (or IRR) is the rate of interest at which its net present value is exactly zero. Inverse demand function   The inverse demand function for a firm's product describes how much the firm must charge to sell any given quantity of its product. It takes the form Price = P(Sales Quantity). Investment   Investment refers to up-front costs incurred with the expectation of generating future profits. Isocost line   An isocost line contains all the input combinations with the same cost. Isoelastic demand function   See constant elasticity demand function. Isoquant   An isoquant identifies all the input combinations that efficiently produce a given amount of output. Iterative deletion of dominated strategies   The iterative deletion of dominated strategies refers to the following process. Remove the dominated strategies from a game. Inspect the simplified game to determine whether it contains any dominated strategies. If it does, remove them. Repeat this procedure until there are no more dominated strategies left to remove. Labor supply   Labor supply refers to the sale of a consumer's time and effort to an employer. Laissez-faire   The doctrine of laissez-faire holds that the government should adopt a "hands off " approach to private commerce. Laspeyres price index   A Laspeyres price index is a fixed-weight index that is based on the consumption bundle actually purchased in the base period. It tells us whether the cost of the base-period consumption bundle has risen or fallen, and by how much. Law of Demand   The Law of Demand states that demand curves usually slope downward. Law of Diminishing Marginal Returns   The Law of Diminishing Marginal Returns states the general tendency for the marginal product of an input to eventually decline as its use is increased holding all other inputs fixed. Law of Supply   The Law of Supply says that when the market price increases, the profit-maximizing sales quantity for a price-taking firm never decreases. Lerner Index   A firm's Lerner Index equals the amount by which its price exceeds its marginal cost, expressed as a percentage of its price. (See also markup and price-cost margin.) Liability rule   A liability rule is a legal principle requiring a party who takes an action that harms others to compensate the affected parties for some or all of their losses. Long run   The long run is a period of time over which all inputs are variable. Loss aversion   Loss aversion occurs when the consumer's valuation of an outcome is more sensitive, per dollar, to small losses than to small gains. Loss leader   A loss leader is a product that is sold at a price below its direct marginal cost to encourage sales of a complementary product. Lump-sum transfer   In a lump-sum transfer, the amount of resources received or surrendered by each consumer is fixed; it doesn't depend on the consumer's choices. Marginal benefit of an action   The marginal benefit of an action at an activity level of X units is equal to the extra benefit produced by the marginal units, B(X) - B(X - ΔX), divided by the number of marginal units, ΔX. Marginal change   A marginal change is a small adjustment of a choice. Marginal cost of an action   The marginal cost of an action at an activity level of X units is equal to the extra cost incurred due to the marginal units, C(X) - C(X - ΔX), divided by the number of marginal units, ΔX. Marginal cost   A firm's marginal cost, MC, measures how much extra cost the firm incurs to produce the marginal units of output, per unit of output added. Marginal expenditure   A monopsonist's marginal expenditure, ME, is the extra cost incurred to hire or purchase the marginal units of an input, per marginal unit. Marginal product of labor   The marginal product of labor with L workers, denoted MPL, equals the extra output produced by the ΔL marginal units of labor, per unit of labor added. Marginal rate of substitution for good X with good Y    The marginal rate of substitution for good X with good Y, written MRSXY, is the rate at which a consumer must adjust Y to maintain the same level of well-being when X changes by a tiny amount, from a given starting point. Mathematically, if ΔX is the tiny change in X and ΔY is the adjustment to Y, then MRSXY = -ΔY/ΔX. It equals the slope of the consumer's indifference curve at this consumption bundle, times negative one. Marginal rate of transformation   The marginal rate of transformation from good X to good Y is the additional amount of Y that can be produced by sacrificing one unit of X (where the units involved are very small). Marginal rate of technical substitution (MRTS) for input X with input Y    The marginal rate of technical substitution (MRTS) for input X with input Y, written as MRTSXY, is the rate ( -ΔY/ΔX.) at which a firm must replace units of X with units of Y to keep output unchanged starting at a given input combination, when the changes involved are tiny. It equals the slope of the firm's isoquant at this input combination, times negative one. Marginal revenue   A firm's marginal revenue at Q units equals the extra revenue produced by the ΔQ marginal units sold, measured on a per unit basis. Marginal tax rate   The marginal tax rate is the tax rate applied to the last dollar of income received. Marginal units of labor   The marginal units of labor are the last ΔL units hired, where ΔL is the smallest amount of labor an employer can add or subtract. Marginal units of output   The marginal units of output are the last ΔQ units, where ΔQ is the smallest amount of output the firm can add or subtract. Marginal units   The marginal units of action choice X are the last ΔX units, where ΔX is the smallest amount one can add or subtract. Marginal utility   Marginal utility is the change in the consumer's utility resulting from the addition of a very small amount of some good, divided by the amount added. Market demand curve   Graphically, the market demand curve is the horizontal sum of the individual demand curves. Market demand   The market demand for a product is the sum of the demands of all the individual consumers. Market economy   A market economy allocates scarce resources primarily through markets. See also free market system. Market failure   A market failure is a source of inefficiency in an imperfectly competitive economy. Market power   A firm has market power when it can profitably charge a price that is above its marginal cost. Market supply curve   Graphically, the market supply curve is the horizontal sum of the individual supply curves. Market supply   The market supply of a product is the sum of the supply of all the individual sellers. Market unraveling   Market unraveling occurs in settings with adverse selection when the presence of unattractive trading partners drives attractive trading partners out of the market by altering the prices at which they can trade. Market-clearing curve   The market-clearing curve for a good shows the combinations of prices (both for that good and for other related goods) that bring supply and demand for the good into balance. Markets   Markets are economic institutions that provide people with opportunities and procedures for buying and selling goods and services. Markup   A firm's markup equals the amount by which its price exceeds its marginal cost, expressed as a percentage of its price. (See also Lerner index and price-cost margin.) Marshallian demand curve   See uncompensated demand curve. Maturity   A bond's maturity is the period over which payments are made. Median voter   The median voter is the voter who has the median ideal policy among all voters. Median voter theorem   The median voter theorem states that, if voters have single-peaked preferences, a majority of them prefer the median ideal policy to all other policies. Mixed bundling   Mixed bundling is the practice of selling several products together as a package while also offering those products for sale individually. Mixed strategy   When a player in a game uses a rule to randomize over the choice of a strategy, we say he is playing a mixed strategy. Mixed strategy equilibrium   In a mixed strategy equilibrium, players choose mixed strategies, and the mixed strategy chosen by each is a best response to the mixed strategies chosen by the others. Model   A model is a simplified representation of a phenomenon. Monopolist   A monopolist is the single seller in a monopoly market. Monopolistic competition   Monopolistic competition occurs in a market when there are a large number of firms, each of which produces a unique product, prices above marginal cost, and earns (close to) zero profit net of its fixed costs due to free entry. Monopoly market   A monopoly market is a market with a single seller. Monopsonist   A monopsonist is the single buyer in a monopsony market. Monopsony market   A monopsony market is a market with a single buyer. Moral hazard   Moral hazard is present when one party to a transaction takes actions that a trading partner cannot observe, and that affect the benefits the partner receives from the trade. More-Is-Better Principle, The   The More-Is-Better Principle states that when one consumption bundle contains more of every good than a second bundle, a consumer prefers the first bundle to the second. More productive   A firm is more productive when it can produce more output using the same amounts of inputs. Equivalently, its production function is shifted upward at each combination of inputs. Multiple-stage game   In a multiple-stage game, at least one participant observes a choice by another participant before making some decision. Mutual fund   A mutual fund raises money from investors by selling shares in the fund and then invests the proceeds. Investors share in the fund's gains and losses until they either redeem their shares from the fund or sell them to other investors. Narrow framing   Narrow framing is the psychological tendency to group related items into categories, and, in making a choice, to consider other items in the same category while ignoring items in different categories. Nash equilibrium   In a Nash equilibrium, the strategy played by each individual is a best response to the strategies played by everyone else. Natural monopoly   A market is a natural monopoly when the good is produced most economically by a single firm. Negative externality   A decision creates a negative externality if it harms someone else. Negatively correlated   Two variables are negatively correlated if they tend to move in the opposite direction. Net benefit   Net benefit equals total benefit less total cost. Net cash flow (NCF)   A net cash flow (NCF) is the difference between revenue and cost during a single year of a project's life. Net present value (NPV)   The net present value (NPV) of an investment project is the difference between the present discounted value of the revenue stream and the present discounted value of the cost stream. No Marginal Improvement Principle (for Finely Divisible Actions)   If actions are finely divisible, then marginal benefit equals marginal cost (MB = MC) at any best choice at which it is possible to both increase and decrease the level of the activity a little bit. No Marginal Improvement Principle for Boundary Choices (with Finely Divisible Actions)   If boundary choice X* is a best choice, then: (i) If only a marginal increase in the activity level is possible starting from X*, then marginal benefit is less than or equal to marginal cost at X*; (ii) If only a marginal decrease in the activity level is possible starting from X*,then marginal benefit is greater than or equal to marginal cost at X*. Nominal interest   Nominal interest is the compensation received by the lender over and above the principal, measured in nominal dollars (that is, without adjusting for inflation). Noncooperative outcome   In a setting of repeated competition between firms, the noncooperative outcome is the repetition in each period of the Nash equilibrium outcome that would arise were the firms to compete just once. Nonexcludable   A good is nonexcludable if there is no way to prevent a person from a consuming it (or in the case of a firm, from using it). Nonrival   A good is nonrival if more than one person can consume it (or more than one firm can use it) at the same time without affecting its value to others. Non-satiation principle   See More-Is-Better Principle. No-Overlap Rule for Finding a Consumer's Best Choice   The area above the indifference curve that runs through the consumer's best bundle does not overlap with the area below the budget line. The area above the indifference curve that runs through any other bundle does overlap with the area below the budget line. No-Overlap Rule for Finding a Least-Cost Input Combination   The area below the isocost line that contains the firm's least-cost input combination for producing Q units does not overlap with the area above the Q-unit isoquant. Normal   If a good is normal, an increase in income raises the amount that is consumed. Normative economic analysis   Normative economic analysis addresses questions that involve value judgments. It concerns what ought to happen rather than what did, will, or would happen. See also normative questions. Normative questions   Normative questions require value judgments; they ask what ought to happen. See also normative economic analysis. NPV criterion   The NPV criterion states that an investment project is profitable when its net present value is positive, and unprofitable when its net present value is negative. Objective probability   An objective probability is a measure of the likelihood that a state of nature will occur based on the frequency with which it has occurred in the past, under comparable conditions. Observable customer characteristics   Price discrimination is based on observable customer characteristics when a firm can distinguish, even if imperfectly, consumers with a high versus low willingness to pay. Oligopolists   Oligopolists are firms in an oligopoly market. Oligopoly market   An oligopoly market is a market with a few (but not many) sellers. One-stage game   In a one-stage game, each participant makes all of his choices before observing any choice by any other participant. Opportunity cost   An opportunity cost is the cost associated with forgoing the opportunity to employ a resource in its best alternative use. Opportunity cost of funds   See time value of money. Ordinal   Information about a consumer's preferences is ordinal if it allows us to determine only whether one alternative is better or worse than another. Outcome-oriented   Outcome-oriented notions of equity focus on whether the process used to allocate resources yields fair results. Output efficiency condition   An allocation satisfies the output efficiency condition if, for every pair of goods, every consumer's marginal rate of substitution equals the marginal rate of transformation. Output efficiency   Output efficiency means that, among allocations satisfying exchange efficiency and input efficiency, there is no way to make all consumers better off by shifting production from one good to another. Output expansion path   A firm's output expansion path shows the least-cost input combinations at all possible levels of output for fixed input prices. Outputs   Outputs are the physical products or services a firm produces. Pareto efficient   An allocation of resources is Pareto efficient if it's impossible to make any consumer better off without hurting someone else. Partial equilibrium analysis   Partial equilibrium analysis concerns competitive equilibrium in a single market, considered in isolation. Partial insurance   With partial insurance, the promised benefit is less than the potential loss. Pass-through rate   The pass-through rate is the ratio of the increase in price that occurs in response to a small increase in marginal cost, measured per dollar of increase in marginal cost. Payback period   The payback period is the amount of time required before a project's total inflows match its total outflows. Perfect complements (for inputs)   Two inputs are perfect complements when they must be combined in a fixed ratio. Perfect complements (for consumption goods)   Two products are perfect complements if they are valuable only when used together in fixed proportions. Perfect information   In a game with perfect information, players make their choices one at time, and nothing is hidden from any player. Perfect substitutes (for inputs)   Two inputs are perfect substitutes if their functions are identical, so that a firm can exchange one for another at a fixed rate. Perfect substitutes (for consumption goods)   Two products are perfect substitutes if their functions are identical, so that a consumer is willing to swap one for the other at a fixed rate. Perfectly correlated   Two variables are perfectly correlated if one is simply a multiple of the other. Perfectly elastic demand   Demand is perfectly elastic when the demand curve is horizontal so that the elasticity of demand equals negative infinity. Perfectly elastic supply   Supply is perfectly elastic when the supply curve is horizontal so that the price elasticity of supply is infinite. Perfectly inelastic demand   Demand is perfectly inelastic when the demand curve is vertical so that the elasticity of demand is zero. Perfectly inelastic supply   Supply is perfectly inelastic when the supply curve is vertical so that the price elasticity of supply is zero. Perfect price discrimination   A monopolist can engage in perfect price discriminate if he knows the customer's willingness to pay of each unit he sells, and can charge a different price for each unit. Pigouvian subsidization   Pigouvian subsidization involves the use of subsidies to remedy positive externalities. Pigouvian taxation   Pigouvian taxation involves the use of taxes or fees to remedy negative externalities. Political economy   The field of political economy examines the economic consequences of public sector decision making. Pooling equilibrium   In a pooling equilibrium, people with different information choose the same alternative. Positive economic analysis   Positive economic analysis addresses factual questions usually concerning choices or market outcomes. It concerns what did, will, or would happen. See also positive questions. Positive externality   A decision creates a positive externality if it benefits someone else. Positively correlated   Two variables are positively correlated if they tend to move in the same direction. Positive questions   Positive questions concern factual matters; they ask what did, will, or would happen. See also positive economic analysis. Precommitment   A precommitment is a choice that removes future options. Preferences   Preferences tell us about a consumer's likes and dislikes. Premium   An insurance premium is the amount of money the policyholder pays for the insurance policy. Present bias   Present bias is a form of dynamic inconsistency involving a bias toward immediate gratification. Present discounted value   Present discounted value (or PDV) of a claim on future resources is the monetary value of that claim today. Price   A price is the rate at which someone can swap money for a good. Price discrimination   A firm engages in price discrimination when it charges different prices for different units of the same good. (Price) elasticity of demand   The (price) elasticity of demand at price P, denoted Ed, equals the percentage change in the amount demanded for each one percent increase in the price. (Price) elasticity of supply   The (price) elasticity of supply at price P, denoted Es, equals the percentage change in the amount supplied for each one percent increase in the price. Price taker   A firm is a price taker when it can sell as much as it wants at some given price, but nothing at any higher price. Price-consumption curve   The price-consumption curve shows how the best affordable consumption bundle changes as the price of a good changes, holding everything else fixed (including the consumer's income and preferences, as well as all other prices). Price-cost margin   A firm's price-cost margin equals the amount by which its price exceeds its marginal cost, expressed as a percentage of its price. (See also Lerner index and markup.) Principal   Principal is the amount borrowed when one person (or firm) lends money to another. Private good   A private good is a good for which consumption involves perfect rivalry and that is completely excludable. Probability distribution   The probability distribution of a set of payoffs tells us the likelihood that each possible payoff will occur. Probability   Probability is a measure of the likelihood that a state of nature will occur. Process-oriented   Process-oriented notions of equity focus on the procedures used to arrive at an allocation of resources rather than on the allocation itself. Producer surplus   A firm's producer surplus equals its revenue less its avoidable costs. Producer surplus (total)   (Total) producer surplus equals the sum of firms' revenues less their avoidable costs, or equivalently, the sum of their individual producer surpluses. Production contract curve   The production contract curve shows every efficient allocation of inputs between two firms in an Edgeworth box. Production function   A production function is a function of the form Output = F(Inputs), giving the amount of output a firm can produce from given amounts of inputs using efficient production methods. Production possibilities set   A firm's production possibilities set contains all combinations of inputs and outputs that are possible given the firm's technology. Production possibility frontier   The production possibility frontier shows the combinations of outputs that firms can produce when inputs are allocated efficiently among them, given their technologies and the total inputs available. Production technology   A firm's production technology summarizes all of its possible methods for producing its output. Productive Inputs Principle   Increasing the amounts of all inputs strictly increases the amount of output the firm can produce (using efficient production methods). Profit   A firm's profit is equal to its revenue less its cost. Progressive tax system   In a progressive tax system, the tax rate applied to the last dollar of income rises with the total amount of income received. Projection bias   Projection bias is the tendency to evaluate future consequences based on tastes and needs at the moment of decision making. Property right   A property right is an enforceable claim on a good or resource. Prospect theory   Prospect theory is an alternative to expected utility theory that may resolve a number of puzzles related to risky decisions. Public good   A public good is a good that is nonrival and nonexcludable. Pure strategy   When a player in a game chooses a strategy without randomizing, we say he is playing a pure strategy. Quantity Rule   The quantity rule explains how to determine a firm's best positive level of production. According to the rule, we first identify any positive sales quantities at which maringl revenue equals marginal cost. If more than one positive sales quantity satisfies this condition, we compare the profits they generate. Quantity-dependent pricing   In a quantity-dependent pricing plan, the price a consumer pays for an additional unit depends on how many units the consumer has bought. Quota   A quota directly limits the total quantity of a good that can be imported. Ranking Principle   The Ranking Principle states that a consumer can rank, in order of preference (though possibly with ties), all potentially available alternatives. Rationed good   When the demand for a good exceeds the supply at the prevailing price, and the government or a supplier limits the amount that each consumer can purchase, we say that the good is rationed. Rawlsianism   According to the principle of Rawlsianism, society should place all weight on the well-being of its worst-off member. Reaction function   See best response function. Real income   Real income is the amount of money received in a particular period adjusted for changes in purchasing power that alter the cost of living over time. Real interest   Real interest is the compensation received by a lender over and above the principal, measured in real dollars (that is, adjusted for inflation). Rent seeking   Rent seeking is socially useless effort devoted to securing a monopoly position. Repeated game   A repeated game is formed by playing a simpler game many times in succession. Reputation   A reputation is a widely held belief about a characteristic of a person or company that predisposes them to act in a particular way. Residual demand curve   A residual demand curve shows the relationship between a firm's output and the market price given the outputs of the firm's rivals. Revealed preference approach   The revealed preference approach is a method of gathering information about consumers' preferences by observing their actual choices. Revealed preferred   One consumption bundle is revealed preferred to another if the consumer chooses it when both are available. Risk averse   A person is risk averse if, in comparing a riskless bundle to a risky bundle with the same level of expected consumption, he prefers the riskless bundle. Risk loving   A person is risk loving if, in comparing a riskless bundle to a risky bundle with the same level of expected consumption, he prefers the risky bundle. Risk management   The object of risk management is to make risky activities more attractive by taking steps to moderate the potential losses while preserving much of the potential gains. Risk neutral   A person is risk neutral if he is indifferent between all bundles with the same level of expected consumption. Risk premium   The risk premium of a risky bundle is the difference between its expected consumption and the consumer's certainty equivalent. Risk sharing   Risk sharing involves dividing a risky prospect among several people. Scientific method   The scientific method is the general procedure used by scientists to learn about the characteristics, causes, and effects of natural phenomena. Screening   Screening occurs when an uninformed party establishes a test that induces informed parties to self-select, thereby revealing what they know. Second welfare theorem   The second welfare theorem tells us that every Pareto efficient allocation is a competitive equilibrium for some initial allocation of resources. Self-enforcing agreements   In self-enforcing agreements, every party to the agreement has an incentive to abide by it, assuming that others do the same. Self-selection   Price discrimination is based on self-selection when the firm offers a menu of alternatives, designed so that different customers will make different choices based on their willingness to pay. Separating equilibrium   In a separating equilibrium, people with different information choose different alternatives. Short run   The short run is a period of time over which one or more inputs is fixed. Shut-down rule   The shut-down rule tells us whether a firm should remain in operation. It tells us to check whether the most profitable positive sales quantity results in greater profit than shutting down. If it does, that is the profit-maximizing choice. If not, then selling nothing is the best option. If they are the same, then either choice maximizes profit. Signaling   Signaling occurs when an informed individual undertakes a costly activity to convince others of particular facts. Single-peaked   A voter's preferences are single-peaked if her net benefit from an activity increases with the activity's level until her ideal is reached, and declines thereafter. Slutsky equation   The Slutsky equation is a precise mathematical statement of the principle that the effect of an uncompensated price change equals the effect of a compensated price change (the substitution effect) plus the effect of removing the compensation (the income effect). Social insurance   Social insurance is insurance provided by the government. Social welfare function   A social welfare function summarizes judgments about resource allocations. For each possible allocation, the function assigns a number that indicates the overall level of social welfare. Specific tax   A specific tax is a fixed dollar amount that must be paid on each unit bought or sold. Stable equilibrium   A market equilibrium is stable if market pressures near the equilibrium point tend to push the price toward its equilibrium level. Stackelberg model of quantity competition   In the Stackelberg model of quantity competition, two firms choose their outputs sequentially. Standard deviation   The standard deviation is the square root of the variance. State of nature   A state of nature is one possible way in which events relevant to a risky decision can unfold. Strategic precommitment   A strategic precommitment occurs when a firm commits to some actions before rivals take theirs, with the aim of increasing its future competitive profit. Strategy   A strategy is one player's detailed plan for playing a game. For every situation that might come up during the course of play, it tells us what the player will do. Subjective probability   A subjective probability is a measure of the likelihood that an event will occur based on subjective judgment. Subsidy   A subsidy is a payment that reduces the amount that buyers pay for a good or increases the amount that sellers receive. Substitutes   Two products are substitutes if, all else equal, an increase in the price of one of the products causes buyers to demand more of the other product. Substitution bias   The substitution bias of a Laspeyres price index involves a failure to capture the consumer's tendency to moderate the impact of a price increase by substituting away from goods that have become more expensive. As a result, the index overstates increases in the cost of living. Substitution effect of a price change   The effect on consumption of a compensated price change is known as the substitution effect of a price change. Sunk cost   A sunk cost is a cost that the decision maker has already incurred, or to which she has previously committed. It is unavoidable. Sunk cost fallacy   The sunk cost fallacy refers to the belief that, if you paid more for something, it must be more valuable to you. Supply curve   A product's supply curve shows how much sellers of the product want to sell at each possible price, holding fixed all other factors that affect supply. Supply function   A product's supply function describes the amount of the product that is supplied for each possible combination of its price and other factors. It is a function of the form Quantity Supplied = S(Price, Other factors). Tacit collusion   Firms engage in tacit collusion when they collude without communicating, sustaining a price above the noncooperative price that would arise in a single competitive interaction. Tangency condition (for cost minimization)   An input combination satisfies the tangency condition (for cost minimization) if, at that input combination, the isocost line is tangent to the isoquant. Tangency condition (for consumption decisions)   A bundle on the budget line satisfies the tangency condition if, at that bundle, the budget line lies tangent to the consumer's indifference curve. Tangent   In mathematics, a line is said to be tangent to a curve at a point if its slope equals the rise over the run for very small changes along the curve starting at the point. Tariff   A tariff is a tax on imports. Tax Incidence   The incidence of a tax indicates how much of the tax burden is borne by various market participants. Technological change   Technological change occurs when a firm's production possibilities set changes over time. Theory   A theory is a possible explanation for a natural phenomenon. Time value of money   The time value of money is the opportunity cost associated with the economic benefit an investor could receive by lending money at the prevailing interest rate. Total cost   A firm's total cost of producing a given level of output is the expenditure required to produce that output in the most economical way. Tradable emissions permit   A tradable emissions permit entitles a firm to generate a specified amount of a given pollutant. It is also transferable: one firm can sell it to another. Trade   Trade occurs whenever two or more people exchange valuable goods or services. Transferable   Property rights are transferable if the current owner of a good can reassign those rights to another consenting party. Transitivity   The assumption of transitivity holds that, if an individual prefers one alternative, X, to a second alternative, Y, which he prefers to a third alternative, Z, then he also prefers X to Z. Trust game   In the trust game, one player (the trustor) decides how much money to invest. A second party (the trustee) divides up the principal and earnings. Two-part tariff   With a two-part tariff, consumers pay a fixed fee if they buy anything at all, plus a separate per-unit price for each unit they buy. Ultimatum bargaining   See ultimatum game. Ultimatum game   In the ultimatum game, one player (the proposer) offers to give the second player (the recipient) some share of a fixed prize. The recipient then decides whether to accept or reject the proposal. Uncompensated demand curve   An uncompensated demand curve shows the effect of an uncompensated change in a good's price on the amount consumed. In other words, it describes the relationship between the price and the amount consumed holding the consumer's income fixed and allowing his well-being to vary. Uncompensated price change   An uncompensated price change consists of a price change with no change in income. Uncorrelated   Two variables are uncorrelated if their movements tend to be unrelated. Unstable equilibrium   A market equilibrium is unstable if market pressures near the equilibrium point tend to push the price away from its equilibrium level. Utilitarianism   According to the principle of utilitarianism, society should place equal weight on the well-being of every individual. Utility   Utility is a numeric value indicating the consumer's relative wellbeing. Higher utility indicates greater satisfaction than lower utility. Utility function   A utility function is a mathematical formula that assigns a utility value to each consumption bundle. Utility possibility frontier   The utility possibility frontier shows the utility levels associated with all efficient allocations of resources. Variability   The variability of payoffs is an indication of risk. With little variability, the actual payoff is almost always close to the expected payoff. With substantial variability, the two amounts often differ significantly. Variable cost function   A firm's variable cost function describes the variable cost of producing each possible level of output. It is a function of the form Variable cost = VC(Output). Variability   The variability of payoffs is an indication of risk. With little variability, the actual payoff is almost always close to the expected payoff. With substantial variability, the two amounts often differ significantly. Variable cost function   A firm's variable cost function describes the variable cost of producing each possible level of output. It is a function of the form Variable cost = VC(Output). Variance   The variance is the expected value of a squared deviation. Volume-sensitive pricing   In a volume-sensitive pricing plan, the price a consumer pays for an additional unit depends on how many units the consumer has bought. Voluntary contribution game   In a voluntary contribution game, each member of a group makes a contribution to a common pool. Each player's contribution benefits everyone. Voluntary production reduction   A voluntary production reduction program offers firms inducements to reduce their production voluntarily indicates greater satisfaction than lower utility. Weakly dominated   A strategy is weakly dominated if there is some other strategy that yields a strictly higher payoff in some circumstances, and that never yields a lower payoff regardless of others' choices. Winner's curse   The winner's curse is the tendency, in certain types of auctions, for unsophisticated bidders to overpay whenever they win. Yield to maturity   The internal rate of return associated with an investment in a bond is known as the bond's yield to maturity.
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Course-wide Content Study Guide Glossary Chapter 21 Additional Practice

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Instructor Resources Instructor's Manual (C... Case Studies from Inst... Chapter 21 Test Bank Course-wide Content Study Guide Glossary Chapter 21 Additional Practice

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