Glossary

Adverse selection
An outcome caused by asymmetric information where a product is selected only by the people who’ll make the worst returns for a supplier — for example, only people with risky lifestyles buying life insurance. The typical effect is that the market fails.
Agent
(1) Anyone who acts in an economic model. (2) In the principal-agent model, anyone who acts on behalf of the principal.
Allocative efficiency
When a firm produces up to the point where price equals marginal cost. As a result, when firms are allocatively efficient, no deadweight loss exists because the price paid by consumers equals the marginal cost incurred.
Asymmetric information
A situation in which one side of a trade knows more relevant information than the other — for example, when sellers know more about the quality or performance of their product than buyers.
Auction
A way of selling a good where an auctioneer calls out prices and solicits bids from potential buyers. The good being auctioned goes to one buyer — usually the highest bidder.
Average cost
Total cost divided by the number of units of output produced — in other words, costs per unit output.
Backward induction
A method of solving dynamic games by starting at the end payoffs and working backwards, eliminating any move that would yield a lower payoff.
Barriers to entry
Anything that significantly raises the irrecoverable or sunk cost to a firm of entering a market and thus deters one from entering.
Bertrand oligopoly
A model of oligopoly where firms compete in price and react to each other’s decisions on price.
Cartel
A group of firms acting together to maximize their collective profits. Cartels try to secure monopoly profits for their members and therefore impose deadweight losses on everyone else.
Coordination game
A type of game theory model where the best outcome depends on participants being able to coordinate their actions. The stag hunt is one such game.
Cournot oligopoly
A model of oligopoly where firms compete in quantities and react to each other’s decisions on quantity.
Deadweight loss
A loss of welfare (producer plus consumer surpluses) that occurs because production isn’t allocatively efficient. Deadweight losses are lost to producers and consumers and therefore to society as a whole.
Demand curve
In the supply and demand model, relates the quantity purchased to the price of the good — holding income, prices of other goods, and tastes constant. It generally slopes downwards: As price rises, quantity demanded goes down.
Demand function
Any mathematical description of quantity purchased in terms of prices.
Deterrence
In game theory, deterrent strategies are those whose purpose is to deter a rival from taking an action by signaling that the rival’s payoffs will be lower if it takes that action. The word is often used in terms of preventing a firm from entering a market.
Dominant strategy
A strategy that gives higher payoffs no matter what the opponent does.
Duopoly
Any market supplied by only two firms.
Dutch auction
Where the auctioneer calls out descending prices until a bidder determines that the price is low enough to buy and calls “mine.”
English auction
Where the auctioneer starts at a low price and in successive rounds of bidding raises the price until only one bidder is left.
Externality
A benefit or cost that falls on a third party not included in a transaction. Externalities can be negative — costs — or positive — benefits.
External cost
A cost that falls on a third party. If A and B trade and C, who isn’t involved in the trade, gets burdened with some cost, C is experiencing an external cost.
Factor of production
The basic inputs of a firm — land, labor, and capital. The firm combines them using a technology to produce its output.
Fixed cost
Costs that don’t depend on how many units of output a firm produces. For example, for a football team, the cost of constructing a stadium is a fixed cost, because it costs the same to build no matter how many games are played there. It is also a sunk cost if it has no resale value.
Game theory
A branch of mathematics relevant to understanding strategic interaction, modeling what strategy each player will take given the payoff to that strategy, given the strategies of other players, and investigating an equilibrium outcome for all players.
General equilibrium
A concept used to define an equilibrium in all markets in an economy. In a general equilibrium, all markets are simultaneously in equilibrium; in a partial equilibrium, only one market is in equilibrium.
Hotelling’s law
An observation that under certain conditions, firms will in equilibrium choose to market products that are minimally differentiated from each other.
Indifference curve
Different bundles of goods that yield the same level of utility to an individual.
Isocost
A cost curve where the cost is the same at all combinations of inputs along the curve.
Isoquant
A curve that shows all the combinations of inputs that produce the same output at all points along the curve.
Iterated elimination of dominant strategies
A method for solving games by eliminating at each step strategies that a rational player motivated to maximize his or her payoff would never choose.
Marginal cost
The cost incurred by a firm for producing one additional unit of output.
Marginal revenue
The revenue a firm earns from selling one additional unit of a product.
Marginal social cost
The cost incurred to society (including the firm) when an additional unit of output is produced.
Mixed strategy
A strategy in which the player assigns a probability to each of the pure strategies available to the player. For instance, a mixed strategy in Rock, Paper, Scissors is playing rock, paper, and scissors each about 1/3 of the time.
Monopolistic competition
A type of market structure with free entry and exit but where competing firms each attempt to differentiate their brand of product. It yields some welfare losses because firms do not produce at the minimum of average cost.
Monopoly
A market served by only one firm and as a result the firm is able to set price higher than marginal cost and, if there are barriers to entry, can earn profit.
Moral hazard
A feature of a market in which there is asymmetric information, and someone takes on more risk because she knows that someone else will bear the costs of those risks — for instance, leaving your door unlocked because you have generous home insurance.
Nash equilibrium
In game theory, any outcome where each player is doing the best they can do, given other players’ strategies. At a Nash equilibrium, no party has an incentive to change strategy.
Oligopoly
A market served by few firms with some barriers to entry and exit. Firms in an oligopoly interact strategically given each other’s strategies.
Pareto efficiency
A distribution where making one party better off without making another party worse off is not feasible.
Partial equilibrium
An equilibrium where supply and demand are equal in a particular market, as opposed to general equilibrium where they’re equal in all markets.
Payoff
The benefit or loss a player receives in the outcome of a game.
Perfect competition
An idealized market structure where a large number of producers are making the same product, each is small relative to the market, and their decisions cannot influence price. The result is that profit-maximization leads to price equal to marginal cost.
Pooled equilibrium
This occurs in a market with asymmetric information in which there are two types of traders with different characteristics, but in equilibrium choose the same action so that their uninformed trading partner cannot distinguish between them.
Prisoners’ Dilemma
A game theory model where the two players rationally choose a strategy that leads them to an outcome that only could be achieved if the players can commit to cooperation.
Productive efficiency
Productive efficiency is achieved when firms are producing output at the lowest possible cost, at the minimum of the long-run average cost curve.
Profit
The residual left over after all relevant costs have been taken away from a firm’s revenue.
Pure strategy
A strategy chosen by a player with probability equal to one. As a result, pure strategy equilibrium is a deterministic description of how a game will be played. In contrast, the outcome of a mixed strategy equilibrium is probabilistic.
Reaction function
A description of what is the profit-maximizing strategy of one firm in an oligopoly in reaction to its competitor’s strategy.
Separating equilibrium
This occurs in a market with asymmetric information in which there are two types of traders with different characteristics, but in equilibrium they choose different actions so that their uninformed trading partner can by their actions distinguish between them.
Signal
The term used in a game with asymmetric information in which the action of a player reveals information to the other uninformed players.
Stackelberg oligopoly
A model of an oligopoly where one firm is the leader and moves first and in so doing is able to anticipate the reactions of other firms and take them into account when making its decision. A Stackelberg oligopoly outcome leads to more output produced than a Cournot oligopoly.
Stag hunt
A type of coordination game with two Nash equilibria, one that maximizes the payoffs to players and one that minimizes risk of a low payoff.
Strategy
A set of actions that describes how a player will move at each turn in a game. A strategy must describe each action at each possible point in the game regardless of whether that point will be arrived at in the course of the game.
Sunk costs
Costs that are unrecoverable after being incurred.
Supply curve
A curve that describes how much output will be produced in a perfectly competitive firm or industry at each possible price.
Supply and demand
A model macroeconomists use to look at prices and quantities in a perfectly competitive market. The equilibrium in the model is where supply equals demand, which is where the supply and demand curves cross.
Switching cost
The cost incurred by a consumer changing from one product to another — for example, in switching from one type of word processor to another. Switching costs may come from the sunk cost of learning how to use a product, from having to give up complements, or from loss of opportunities to trade with other consumers.
Technology
Any method for transforming inputs into outputs, most often used to describe the mix of capital and labor a firm chooses.
Tragedy of the Commons
A situation where a common resource is overexploited because no one owns it and access can’t be controlled.
Transactions costs
The costs incurred by a firm using a market to make a trade, including the costs incurred searching for people to deal with, negotiating a trade with a partner, and enforcing a deal when made.
Trust game
A type of game where one player has to decide whether to trust another player, and if she does, the other player has to decide whether or not to betray that trust.
Utility function
A description of the utility a consumer gains from consuming a bundle of goods. Utility functions depend on consumers’ preferences.
Variable cost
A cost that depends on the number of units of output that a firm produces.
Vickrey auction
A type of auction where the highest (or lowest) bidder gets the good (the contract) for the price bid by the second-highest (or second-lowest) bidder. Vickrey auctions are designed to avoid the incentive to overbid (or underbid).
Welfare
A measure of the value created across all consumers and producers in a market equilibrium. In a partial equilibrium model, it’s the sum of consumer and producer surpluses. In a general equilibrium model, it’s the sum of all utility and profits gained by all agents in the model.
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