Glossary

absolute advantage: A person or a country has an absolute advantage in the production of a particular good if, given a set of available inputs, they can produce more of it than another person or country.
adverse selection, hidden attributes: A hidden-attributes or adverse-selection problem occurs when some characteristic of a product or service being exchanged is not known to the other parties. For example, someone purchasing health insurance knows their own health status, but the insurance company does not. The lack of information affects the price at which the uninformed party is willing to buy or sell, and this can lead to an ‘adverse selection’ of goods in the market: for example, only the least healthy people wanting to buy health insurance.
aggregate demand: The total of the components of planned spending in the economy: AD = C + I + G + X – M. It is the total amount of demand for (or planned expenditure on) goods and services produced in the economy. See also: consumption, investment, government spending, exports, imports.
allocation: In an economic interaction, an allocation is a particular distribution of goods or other things of value to all participants.
altruism: Altruism is a social preference: a person who is willing to bear a cost to benefit somebody else is said to be altruistic.
appreciation, nominal appreciation: If the number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency decreases, the home currency is said to have appreciated relative to the foreign currency. This is sometimes described as a nominal appreciation; it corresponds to an decrease in the conventional measure of the nominal exchange rate. See also: exchange rate, real appreciation.
artificially scarce: A good is artificially scarce if it is non-rival (can be supplied to more users at no additional cost) but some users are excluded from using it, either directly or because the price is greater than their willingness to pay. See also: excludable public good.
asset: Something that is owned, and has value.
asset price bubble: An asset price bubble is an episode in which the market price of an asset rises substantially and continuously over time, fuelled by expectations of future price increases (that is, people want to hold the asset because they believe that its price will be higher in future). Eventually the bubble bursts and the price drops suddenly.
asset prices: Asset prices is a general term used to refer to the prices of both financial assets (like shares or bonds) and real assets (such as housing, land, gold, or works of art). See also: asset.
asymmetric information, asymmetry of information: Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.
austerity: A term used to describe policies through which a government tries to improve its budgetary position in a recession by increasing its saving.
automatic stabilizers: Automatic stabilizers are tax and transfer policies that have the effect of offsetting an expansion or contraction of the economy. For example, spending on unemployment benefits rises during a recession.
autonomous consumption: In a model of consumption demand, autonomous consumption is planned consumption expenditure that does not depend on other variables in the model (such as income, or the interest rate).
autonomous demand: In a model of demand for goods and services, autonomous demand is planned expenditure that does not depend on other variables in the model (such as income, or the interest rate).
autonomous investment: In a model of investment demand, autonomous investment is planned investment expenditure that does not depend on other variables in the model (such as income, or the interest rate).
average cost: The total cost of producing the firm’s output divided by the total number of units of output produced.
average product: The average product of an input is the total amount of output divided by the total amount of input. For example, the average product of a worker is the total output divided by the number of workers employed to produce it.
bail-in: A bail-in resolution is a way of allocating losses to a bank’s shareholders and potentially to some of its creditors. The bail-in procedure follows a legal order of priorities in terms of liability. The first step is to ‘write down’ the bank’s equity capital to reflect the losses incurred: that is, to reduce the value of the shareholders’ equity. If these funds are insufficient, other liabilities, such as bonds, are written down or converted into equity.
balance sheet: A record of all the current assets and liabilities, and the net worth, of an economic actor such as a household, bank, firm, or government. See also: net worth, liability.
bank money: Money in the form of deposits in commercial banks. The bank allows bank deposits, created for example when the bank makes a loan, to be used as a means of exchange, debiting the buyer’s deposit and crediting the seller with a new deposit.
bank run: A situation in which depositors withdraw funds from a bank because they fear that it may go bankrupt and not honour its liabilities (that is, not repay the funds owed to depositors).
bargaining gap: The difference between the real wage that firms wish to offer in order to recruit/retain workers and provide them with incentives to work, and the real wage that allows firms the markup that maximizes profits given the degree of competition.
bargaining power: The extent of a person or firm’s advantage in securing a larger share of the economic rents made possible by an interaction.
barriers to entry, entry barriers: The term barriers to entry refers to anything making it difficult for new firms to enter a market, such as intellectual property rights or economies of scale in production.
base money, monetary base, high-powered money: Base money (also called the monetary base and sometimes high-powered money) consists of the cash held by households, firms, and banks, together with the balances held by commercial banks in their reserve accounts at the central bank.
best-fit line, line of best fit, best-fit curve: In a scatterplot of two variables x (on the horizontal axis) and y (vertical axis), we can summarize the relationship between y and x by estimating a line of best fit to the set of points. The best-fit line uses the data to predict the average value of y for each value of x. The line slopes upward if x and y are positively correlated, and downward if they are negatively correlated. A best-fit straight line is called a linear regression line; it is also possible to estimate a best-fit curve.
best response: In game theory, a player’s best response is the strategy that will bring about the player’s most-preferred outcome, given the strategies adopted by the other players.
bond: A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
bond market: A financial market in which people buy and sell bonds that have been issued by governments or companies. See also: bond.
budget constraint: An equation that represents all combinations of goods and services one could acquire that would exactly exhaust one’s budgetary resources.
business cycle: Alternating periods of faster and slower (or even negative) growth rates. The economy goes from boom to recession and back to boom. See also: short-run equilibrium.
capacity constrained: A situation in which a firm has more orders for its output than it can fill. See also: low capacity utilization.
capacity utilization: A firm, industry, or entire economy is at full capacity utilization if it is producing as much as the stock of its capital goods and current knowledge will allow. If is is producing less, it is ‘below full capacity utilization’ or ‘at a low capacity utilization rate’.
capital adequacy requirements: At both the national and international level, regulators require banks to hold a minimum amount of equity or capital relative to their assets. The objective of this regulation is to reduce risk-taking by banks. If unregulated, banks, believing they are too large or too interconnected to be allowed to fail, may take excessive risks and impose costs on society were they either to fail or to be rescued. Regulators assess the riskiness of a bank’s assets (its loans) and specify the capital that must be held relative to their risk-weighted assets.
capital controls, exchange controls: Capital controls (sometimes called exchange controls) are government regulations that limit the extent to which investors based in the home country are permitted to buy foreign assets.
capital gain: If the market value of an asset increases, the owner of an asset receives a capital gain equal to the difference between the current and previous market prices.
capital goods, capital: Capital goods (sometimes shortened to ‘capital’) are the durable and costly non-labour inputs used in production (e.g. machinery, equipment, buildings). They do not include some essential inputs (e.g. air, water, knowledge) that are used in production at zero cost to the user.
capitalism: An economic system in which the main form of economic organization is the firm, where the private owners of capital goods hire labour to produce goods and services to be sold in markets with the intent of making a profit. The main economic institutions in a capitalist economic system are private property, markets, and firms.
cartel: A group of firms that collude (work together) to set output and/or prices in order to raise their joint profits.
causal, causality, causation: We can say that a relationship between two variables is causal if we can establish that a change in one variable produces a change in the other. While a correlation is simply an assessment that two things have moved together, causation implies a mechanism accounting for the association, and is therefore a more restrictive concept. See also: natural experiment, correlation.
central bank independence: A central bank is described as independent if it controls the operation of monetary policy (subject to the objectives of monetary policy set by the government).
central planning: In a centrally-planned economy, decisions about what to produce and how are taken by the government, rather than by firms responding to market prices.
ceteris paribus: Economists often simplify analysis by setting aside things that are thought to be of less importance to the question of interest. The literal meaning of the expression is ‘other things equal’. In an economic model, it means an analysis ‘holds other things constant’.
co-insurance: A co-insurance scheme enables households to pool savings so that individual households can maintain consumption when they experience a temporary fall in income or the need for greater expenditure.
collateral: An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.
commodity markets: Markets in which natural resources (such as oil, or silver) and agricultural products (such as wheat, coffee, or cotton) are bought and sold, typically in large quantities by institutional investors and producers.
commodity money: In an economy without a well-developed banking system, people may use a particular commodity such as gold, as money. The commodity is typically a basic good that is widely valued, but can also act as a means of exchange, a store of value, and a unit of account. See also: money.
common currency area, currency union, monetary union: A common currency area (sometimes called a currency union or monetary union) is group of countries that use the same currency. This means there is just one monetary policy for the group.
common-pool resource: A resource that is rival or partially rival (more people using it reduces the benefits to others) but non-excludable within a community of users. All members of the community are able (and in some cases have a legal right) to use it, but outsiders can be excluded.
comparative advantage: A person or a country has a comparative advantage in the production of a particular good if the cost to them of producing it, relative to the cost of another good, is lower than for another person or a country. See also: absolute advantage.
competition policy, antitrust policy: Government policies and laws to limit market power and prevent cartels, or to otherwise regulate the process of competition, are collectively known as competition policy or antiitrust policy.
competitive equilibrium: A market is in competitive equilibrium if the quantity supplied is equal to the quantity demanded at the prevailing price, and all buyers and sellers are price-takers, so that no-one can benefit from attempting to trade at a different price.
complete contract: A contract is complete if it a) covers all of the aspects of the exchange in which any party to the exchange has an interest, and b) is enforceable (by the courts) at close to zero cost to the parties.
concave, concave function: A function, $f(x)$, is said to be concave if its second derivative is negative for all values of x.
conflict of interest: The situation that arises in an interaction if, in order for one party to gain more, another party must do less well.
congestible public goods: If a public good becomes partially rival as more people use it, it may be described as a congestible public good.
conspicuous consumption: The purchase of goods and services to publicly display one’s social and economic status.
constant prices: To compare the value of goods and services bought or sold at different times we need to allow for changes in the value of the currency in which they are measured (inflation or deflation). To do this, we choose a base year, and then calculate the value of goods and services in other years using the prices in the base year: that is, at constant prices.
constant returns to scale: When production exhibits constant returns to scale, increasing all of the inputs to a production process by the same proportion increases output by the same proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, decreasing returns to scale.
constrained choice problem: A problem in which a decision-maker chooses the values of one or more variables to achieve an objective (such as maximizing profit, or utility) subject to a constraint that determines the feasible set (such as the demand curve, or budget constraint).
consumer good: Any good that can be bought by consumers, including both short-lived goods and long-lived goods, which are called consumer durables.
consumer price index (CPI): A measure of the general level of prices that consumers have to pay for goods and services, including consumption taxes.
consumer surplus: Each consumer who buys a good receives a surplus equal to their willingness to pay minus the price. The term ‘consumer surplus’ normally refers to the sum of these surpluses across all consumers.
consumption: Expenditure on consumer goods. Consumer goods include both short-lived goods and services and long-lived goods, which are called consumer durables.
consumption function (aggregate): A relationship that shows how consumption spending in the economy as a whole depends on other variables. For example, in the multiplier model, aggregate consumption depends on current disposable income and autonomous consumption. See also: disposable income, autonomous consumption.
consumption smoothing: Actions taken by an individual, family, or other group in order to sustain their customary level of consumption. Actions include borrowing or reducing savings to offset negative shocks, such as unemployment or illness; and increasing saving or reducing debt in response to positive shocks, such as promotion or inheritance.
contract: A legal document or understanding that specifies a set of actions that parties to the contract must undertake.
convex, convex function: A function, $f(x)$, is said to be convex if its second derivative is positive for all values of x.
convex preferences: A person whose indifference curves have a convex shape—they get flatter as you move along the curve to the right of the diagram—is said to have convex preferences. This typical shape arises because when someone has more of one good (relative to another) they are willing to give up more of it in exchange for a unit of the other good: their marginal rate of substitution falls along the curve.
cooperation: Participating in a common project that is intended to produce mutual benefits.
cooperative firm, worker-owned cooperative: A cooperative is a business organization whose members together own the assets of the organization; they share the income resulting from their activities and jointly determine how the organization will be run. A worker-owned cooperative is a firm that is mostly or entirely owned by its workers, who hire and fire the managers.
coordination game: A game in which there are two Nash equilibria, one of which may be Pareto superior to the other. Also known as: assurance game.
copyright: Ownership rights over the use and distribution of an original work.
correlation: A statistical association observed between two variables in a sample of data. If high values of one variable (for example, people’s earnings) commonly occur along with high values of another variable (for example, years of education) the variables are positively correlated. When high values of one variable (for example, air pollution) are associated with low values of the other variable (for example, life expectancy) there is a negative correlation. If variables are correlated, it doesn’t mean that there is a causal relationship between them: air pollution may not have caused the lower life expectancy we observed. See also: causality.
cost function: The relationship between a firm’s total costs and its quantity of output. The cost function C(Q) tells you the total cost of producing Q units of output (including the opportunity cost of capital).
costs of entry: Startup costs that are incurred when a seller enters a market or an industry. These would usually include the cost of acquiring and equipping new premises, research and development, the necessary patents, and initial costs of finding staff.
creative destruction: Joseph Schumpeter’s name for the process by which old technologies and the firms that do not adapt are swept away by the new, because they cannot compete in the market. In his view, the failure of unprofitable firms is creative because it releases labour and capital goods for use in new combinations.
credit constraints: Credit constraints are restrictions on the amounts or terms on which individuals can borrow.
credit market constrained: A description of individuals who are limited in how much they can borrow or can borrow only on unfavourable terms. See also: credit market excluded.
credit market excluded: A description of individuals who are unable to borrow on any terms. See also: credit market constrained.
crowding out, crowded out: There are two quite distinct uses of the term. One is a negative effect that is observed when economic incentives displace people’s ethical or social motivations. In studies of individual behaviour, incentives may have a crowding out effect on social preferences. The second use of the term is to refer to the effect of an increase in government spending in reducing private spending, as would be expected for example in an economy working at full capacity utilization, or when a fiscal expansion is associated with a rise in the interest rate.
cyclical unemployment: The additional unemployment above the equilbrium level that is caused by a fall in aggregate demand associated with the business cycle. Also known as: demand-deficient unemployment. See also: equilibrium unemployment.
deadweight loss: A measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market.
decile: A subset of observations, formed by ordering the full set of observations according to the values of a particular variable, and then splitting the set into ten equally-sized groups. For example, the 1st decile refers to the smallest 10% of values in a set of observations.
decreasing returns to scale, diseconomies of scale, decreasing returns: When production exhibits decreasing returns to scale, increasing all of the inputs to a production process by the same proportion increases output by a lower proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, constant returns to scale.
default: A borrower who fails to repay a loan, or repays less than is required under the contract, is said to default on the loan. More generally, any failure to meet the terms of a contract can be described as a default.
default premium: If there is a risk that borrower will default on a loan, the lender may still be prepared to lend if the interest rate is higher than it would be without this risk. The difference between the two rates is the default premium.
deflation: A decrease in the general price level. See also: inflation.
demand curve: A demand curve shows the number of units of a good that buyers would wish to buy at any given price. Also known as: demand function.
demand shock: An unexpected or exogenous change in demand. In macroconomics a demand shock means a change in aggregate demand, such as a rise or fall in autonomous consumption, investment, or exports. In microeconomics it refers to an exogenous shift in the demand curve for a particular good. See also: supply shock, exogenous shock.
demand side, demand-side: The demand side of the economy refers to the expenditure on the goods and services it produces, which consists of consumption, investment, government purchases, and purchases by foreigners. In a microeconomic model of the market for a particular good, it refers to the decisions of the buyers of the good. See also: supply side.
democracy: A political system that ideally gives equal political power to all citizens, and which is defined by individual rights such as freedom of speech, assembly, and the press; and fair elections in which virtually all adults are eligible to vote, and the government leaves office if it loses.
depreciation: The loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).
depreciation (of a currency), nominal depreciation: If the number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency increases, the home currency is said to have depreciated relative to the foreign currency. This is sometimes described as a nominal depreciation; it corresponds to an increase in the conventional measure of the nominal exchange rate. See also: exchange rate, real depreciation.
developmental state: A government that takes a leading role in promoting the process of economic development through its public investments, subsidies of particular industries, education, and other public policies.
differentiated product: A product produced by a single firm that has some unique characteristics compared to similar products of other firms.
diminishing average product of labour: A property of a production process in which, as the input of labour is increased, the amount of output per unit of labour (the average product) falls.
diminishing marginal utility: If the value to the individual of an additional unit of some good declines the more that is consumed, holding constant the amount of other goods, we say that the good has diminishing marginal utility.
discount rate: A measure of someone’s impatience: how much the person values an additional unit of consumption now relative to an additional unit of consumption later. It is equal to the slope of the indifference curve for consumption now and consumption later, minus one. Also known as: subjective discount rate.
disequilibrium rent: The economic rent that arises when a market is not in equilibrium, for example when there is excess demand or excess supply in a market for some good or service. In contrast, rents that arise in equilibrium are called equilibrium rents.
disinflation: A decrease in the rate of inflation. See also: inflation, deflation.
disposable income: A household’s disposable income is the maximum the household can spend (‘dispose of’) without borrowing or using savings, after paying tax and receiving transfers (such as unemployment insurance and pensions) from the government.
diversify, diversification: An individual, bank, or company that holds risky assets can reduce the overall risk to their wealth by diversifying: that is, holding a diverse range of risky assets. Although some of their assets will generate low (or negative) profits, the profits on others will be high, with the result that they make a reasonable profit on average.
division of labour: The specialization of producers to carry out different tasks in the production process.
dominant strategy: A strategy is dominant if it yields the highest pay-off for the player, no matter what strategies the other players choose.
dominant strategy equilibrium: A dominant strategy equilibrium is a Nash equilibrium in which the strategies of all players are dominant stategies.
earnings: Wages, salaries, and other income from labour.
economically inactive: People in the population of working age who are neither employed nor actively looking for paid work are classified as economically inactive. Those working in the home raising children, for example, are not considered as being in the labour force, so they are classified this way.
economic cost: The direct costs of an action (including monetary costs and costs of effort, for example), plus the opportunity cost.
economic dynamics: Economic dynamics refers to the process of change in an economy, especially changes occurring when the economy is not in equilibrium.
economic rent: Economic rent is the difference between the net benefit (monetary or otherwise) that an individual receives from a chosen action, and the net benefit from the next best alternative (or reservation option). See also: reservation option.
economics: Economics is the study of how people interact with each other and with their natural environment in producing and acquiring their livelihoods, and how this changes over time and differs across societies.
economic system: A way of organizing the economy that is distinctive in its basic institutions. Economic systems of the past and present include: central economic planning (e.g. the Soviet Union in the twentieth century), feudalism (e.g. much of Europe in the early Middle Ages), slave economy (e.g. the US South and the Caribbean plantation economies prior to the abolition of slavery in the nineteenth century), and capitalism (most of the world’s economies today).
economies of scope: Cost savings that occur when two or more products are produced jointly by a single firm, rather being produced in separate firms.
employment contract: A system in which producers are paid for the time they work for their employers.
employment rate: The employment rate is the fraction of the population of working age that is employed. See also: population of working age, unemployment rate.
employment rent: The economic rent a worker receives when the net value of their job exceeds the net value of their next best alternative (that is, being unemployed). Also known as: cost of job loss.
endogenous: Endogenous means ‘generated by the model’. In an economic model, a variable is endogenous if its value is determined by the workings of the model (rather than being set by the modeller). See also: exogenous.
endowment: A person’s endowments are the things they have that enable them to receive income. They include physical wealth (for example: land, housing, machinery); financial wealth (for example: savings, stocks/shares, bonds); intellectual property (for example: patents, copyrights); knowledge, skills, abilities, and experience that affect labour income; citizenship and rights to work. They can include characteristics such as nationality, gender, race, and social class, if these affect their income.
enforceable contract: A contract is enforceable if it is legally binding. For a contract to be enforceable, a court must be able to establish whether the both parties complied with its terms.
entrepreneur: A person who creates or is an early adopter of new technologies, organizational forms, and other opportunities.
equilibrium: An equilibrium is a situation or model outcome that is self-perpetuating: if the outcome is reached it does not change, unless an external force disturbs it. By an ‘external force’, we mean something that is determined outside the model.
equilibrium price: This term normally refers to the price at which supply and demand for a good are equalized, so that the market is in equilibrium (also known as the market-clearing price). But it could refer to the level of the price in the equilibrium of other economic models. See also: market-clearing price.
equity: Shares (stocks) in a business are known collectively as equity. The total value of the equity held by the shareholders is equal to the net worth of the business, and an individual shareholder’s equity in the business is the total value of the shares they own. The term equity is also used more generally for a share of ownership of any asset, and for the net worth of any household, business, or project. There is a second entirely different use of the term, meaning fairness, as in ‘an equitable division of the pie’. See also: net worth.
evolutionary economics: An approach that studies the process of economic change, which includes technological innovation, the diffusion of new social norms, and the development of novel institutions.
excess demand: A situation in which the quantity of a good demanded is greater than the quantity supplied at the current price. See also: excess supply.
excess supply: A situation in which the quantity of a good supplied is greater than the quantity demanded at the current price. See also: excess demand.
exchange rate: The number of units of home currency that can be exchanged for one unit of foreign currency. For example, Australia’s exchange rate between the Australian dollar (AUD) and the US dollar (USD) is defined as the number of AUD per USD. An increase in this number is a depreciation of the AUD, and a decrease is an appreciation of the AUD.
excludable, excludability: A good is excludable if (at zero or low cost) a potential user may be denied access to the good. See also: non-rival.
excludable public good, club good: A good that is non-rival (can be supplied to more users at no additional cost) but excludable (it is possible to prevent people from using it) may be called an excludable public good, or a club good.
exogenous: Exogenous means ‘generated outside the model’. In an economic model, a variable is exogenous if its value is set by the modeller, rather than being determined by the workings of the model itself. See also: endogenous.
exogenous shock: An exogenous shock (for example a demand shock or a supply shock) is a change in one or more of the exogenous variables in a model—that is, variables that are othewise held constant by the modeller.
expected inflation: The belief formed by wage-setters and price-setters about the level of inflation in the next period. See also: inflation.
exports: Goods and services produced in a particular country and sold to households, firms, and governments in other countries.
external benefit, positive externality, external economy: A positive external effect: that is, a positive effect of an economic decision on other people, that is not taken into account by the decision-maker. It may be described as an external benefit, a positive externality, or an external economy. See also: external effect.
external cost, negative externality, external diseconomy: A negative external effect: that is, a negative effect of an economic decision on other people, that is not taken into account by the decision-maker. It may be described as an external cost, or a negative externality, or an external diseconomy. See also: external effect.
external effect, externality: An external effect occurs when a person’s action confers a benefit or imposes a cost on others and this cost or benefit is not taken into account by the individual taking the action. External effects are also called externalities.
factor of production: Any input into a production process is called a factor of production. Factors of production may include labour, machinery and equipment (usually referred to as capital), land, energy, and raw materials.
fairness: A way to evaluate an allocation based on one’s conception of justice.
fallacy of composition: Mistaken assumption that what is true of the parts (such as households) must be true of the whole (such as the economy as a whole). For an example see: paradox of thrift.
feasible frontier: The curve or line made of points that defines the maximum feasible quantity of one good for a given quantity of the other. See also: feasible set.
feasible set: All of the combinations of goods or outcomes that a decision-maker could choose, given the economic, physical, or other constraints that they face. See also: feasible frontier.
financial accelerator: When an asset (such as housing) is used as collateral for loans, an increase in price raises the value of the collateral enabling more borrowing, raising demand, and causing further price rises. This amplification process is called a financial accelerator.
financial intermediary: An economic agent, such as a bank or pension fund, that borrows from savers and simultaneously lends to borrowers. Intermediation provides an alternative to bilateral loan contracts as a way of channelling savings from people who want to lend to those who want to borrow.
fire sale: The sale of something at a very low price because of the seller’s urgent need for money.
firm: An economic organization in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.
firm-specific asset: An asset is something that is owned, and has value. It is firm-specific if it is only of value within a particular firm. Firm-specific assets include any knowledge or skills that are only valuable while a person remains employed in a particular firm. See also: relationship-specific asset.
fiscal policy, discretionary fiscal policy: Fiscal policy refers to policies setting the levels of taxes, transfers, and goverment spending. Since fiscal policy affects the level of aggregate demand, it may be used by the government to stabilize the economy by changing aggregate demand; in this case, it may be described as discretionary fiscal policy. See also: aggregate demand.
Fisher equation: The relation that gives the real interest rate as the difference between the nominal interest rate and expected inflation: real interest rate = nominal interest rate – expected inflation.
fixed costs: Costs of production that do not vary with the number of units produced.
fixed exchange rate: A country’s exchange rate is fixed if it is managed by the central bank or the government, and either held constant over time or kept within a narrow range of values. A country in a common currency zone effectively has a permanently fixed exchange rate relative to all other countries in the zone. See also: exchange rate, flexible exchange rate.
fixed exchange rate regime, target exchange rate regime: In a fixed exchange rate regime (or more accurately, a target exchange rate regime), the objective of monetary policy is to hold the exchange rate constant at a particular value, or within a narrow range of values, against one or more other currencies.
fixed investment, gross fixed capital formation: In the national accounts, fixed investment, also known as gross fixed capital formation, refers to investment by firms and government in new capital goods (equipment and buildings), plus spending on new residential buildings. See also: investment.
fixed-proportions technology: A technology that requires inputs in fixed proportions to each other. To increase the amount of output, all inputs must be increased by the same percentage so that they remain in the same fixed proportions to each other.
flexible exchange rate: A country’s exchange rate is flexible if it can change in response to trading in the foreign exchange markets, rather than being held constant by the government or central bank. See also: exchange rate, fixed exchange rate.
flow: A quantity measured per unit of time, such as weekly income, or annual carbon emissions. See also: stock.
free rider, free riding, free ride: Someone who benefits from the contributions of others to some cooperative project without contributing themselves is said to be free riding, or to be a free rider.
gains from trade, gains from exchange: The benefits that each party gains from a transaction compared to how they would have fared without the transaction.
game: A model of strategic interaction that describes the players, the feasible strategies, the order of play, the information that the players have, and their pay-offs. See also: game theory.
game theory: A branch of mathematics that studies strategic interactions, meaning situations in which each actor knows that the benefits they receive depend on the actions taken by all. See also: game.
GDP deflator: A measure of the change in the level of prices for domestically produced output, based on price changes of consumption, investment, government expenditure, and exports.
gender division of labour: The ways men and women differ in how they spend their (paid and unpaid) work time.
general equilibrium: General equilibrium analysis studies what happens in two or more markets, taking into account that what happens in one market affects, and is affected by, what happens in the other(s). See also: partial equilibrium.
Gini coefficient: A measure of inequality of a quantity such as income or wealth, varying from a value of zero (if there is no inequality) to one (if a single individual receives all of it). It is the average difference in, say, income between every pair of individuals in the population relative to the mean income, multiplied by one-half. Other than for small populations, a close approximation to the Gini coefficient can be calculated from a Lorenz curve diagram. See also: Lorenz curve.
goods: Economists sometimes use this word in a very general way, to mean anything an individual cares about and would like to have more of. As well as goods that are sold in a market, it can include (for example) ‘free time’ or ‘clean air’.
goods market equilibrium: A goods market is in equilibrium when the supply of goods is equal to the demand. In the multiplier model, aggregate demand for goods and services, AD, depends on income, Y, and income is equal to the output that firms supply. Goods market equilibrium is at the value of Y where aggregate demand is equal to output: AD = Y.
government bond: A financial asset where the government borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
government budget deficit: If government spending exceeds its tax revenue in the same year, the government budget is in deficit and the size of the deficit is the difference between spending and tax revenue.
government spending: Expenditure by the government to purchase goods and services. When used as a component of aggregate demand, this does not include spending on transfers such as pensions and unemployment benefits. See also: government transfers.
government transfers: Spending by the government in the form of payments to households or individuals. Unemployment benefits and pensions are examples. Transfers are not included in government spending (G) in the national accounts. See also: government spending.
gross domestic product (GDP): A measure of the total output of goods and services in the economy in a given period.
hawk–dove game: A coordination game in which the players want to coordinate on the opposite action from their opponent, and in each of the Nash equilibria, (Hawk, Dove) and (Dove, Hawk), the Hawk obtains the higher pay-off; but both players choosing Hawk is the worst outcome for both.
homo economicus: Latin for ‘economic man’, used to describe an economic actor who is assumed to make decisions entirely in pursuit of their own of self-interest.
human capital: The stock of knowledge, skills, behavioural attributes, and personal characteristics that determine the labour productivity or labour earnings of an individual. Investment in human capital, through education, training, and socialization can increase the stock. Human capital is part of an individual’s endowment. See also: endowment.
hyperinflation: Economists usually define hyperinflation as a monthly inflation rate of more than 50%. In such situations, a unit of currency loses more than 99% of its real spending power within a year.
impatience: A preference for consuming something sooner rather than later. Impatience may by situational (because the person has little now and will have more later); or intrinsic, in which case they would prefer to consume more now rather than the same amounts now and later.
imports: Goods and services produced in other countries and purchased by domestic households, firms, and the government.
imputed rent: The rent that the owner of a house could receive from renting it to a tenant, rather than living in it.
incentive: An economic reward or punishment, which influences the benefits and costs of alternative courses of action.
income: In general, income refers to any flow of resources (goods, or money) that an individual (or other economic actor) receives over time. It is the amount received per period. It could include labour earnings, profits, rent from property, or interest on assets. Your income is the maximum amount that you could consume per period and leave your wealth unchanged.
income effect: The effect that an increase in income has on an individual’s demand for a good (the amount that the person chooses to buy) because it expands the feasible set of purchases. When the price of a good changes, this has an income effect because it expands or shrinks the feasible set, and it also has a substitution effect. See also: substitution effect.
incomplete contract: A contract that does not specify, in a way that can be enforced by a court, every aspect of the exchange that affects the interests of parties to the exchange (or of others).
increasing returns to scale, economies of scale, increasing returns: When production exhibits increasing returns to scale, increasing all of the inputs to a production process by the same proportion increases the output by a higher proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: decreasing returns to scale, constant returns to scale.
indifference curve: A curve that joins together all the combinations of goods that provide a given level of utility to the individual.
Industrial Revolution: A wave of technological advances and organizational changes that began in Britain in the eighteenth century; it transformed an agricultural and craft-based economy into a commercial and industrial economy.
inequality aversion: A preference for more equal outcomes and a dislike of outcomes in which some individuals (even if they include oneself) receive more than others.
inflation: An increase in the general price level in the economy, usually measured as the percentage increase in prices over the last year. See also: deflation, disinflation.
inflation-stabilizing unemployment rate: The unemployment rate (at supply-side equilibrium) at which inflation is constant. Originally known as the ‘natural rate’ of unemployment. Also known as: structural unemployment rate, non-accelerating rate of unemployment (NAIRU). See also: equilibrium unemployment, structural unemployment.
inflation target, inflation targeting: Inflation targeting is a form of monetary policy, where the central bank changes interest rates in order to influence aggregate demand and keep the economy close to an inflation target rate, which is normally specified by the government.
innovation rent: Profits in excess of the opportunity cost of capital that an innovator gets by introducing a new technology, organizational form, or marketing strategy.
institution: An institution is a set of laws and informal rules that regulate social interactions among people, and between people and the biosphere; sometimes also termed ‘the rules of the game’.
interest rate, rate of interest: The price of bringing buying power forward in time, by borrowing; it is the additional amount that the borrower promises to repay; the rate of interest is the amount of interest to be repaid per period, as a proportion of the loan. See also: nominal interest rate, real interest rate.
intertemporal choice model: A model representing decision making concerning borrowing, lending, and investing as ways of moving purchasing power forward (to the present) or backward (to the future) in time.
inventories: Inventories are goods held by a firm prior to sale or use, including raw materials, and partially-finished or finished goods intended for sale.
inventory investment: Increases in the inventories held by firms are a form of investment, since they are assets that will bring a return to the firm at a later date. Decreases in inventories correspond to negative inventory investment (a reduction in assets). See also: investment, inventories.
investment: Investment is expenditure undertaken in order to generate a return in future: for example, buying financial assets that will generate income in future, or a house that will provide accommodation, or capital goods to be used by a firm to produce output. In the national accounts, investment expenditure refers more specifically to fixed investment (gross fixed capital formation) together with inventory investment. See also: fixed investment, inventory investment.
investment function (aggregate): A relationship that shows how investment spending in the economy as a whole depends on other variables, such as the interest rate and profit expectations. See also: interest rate, rate of interest, profit.
invisible hand game: A game in which there is a single Nash equilibrium that is Pareto efficient may be called an invisible hand game. See also: Nash equilibrium, Pareto efficient.
involuntary unemployment: A person is involuntarily unemployed if they are seeking work, and willing to accept a job at the going wage for people of their level of skill and experience, but unable to secure employment.
isocost line: A line that represents all combinations of inputs that cost a given total amount.
isoprofit curve: A curve that joins together the combinations of prices and quantities of a good that provide equal profits to a firm.
joint surplus: The sum of the economic rents of all involved in an economic interaction.
labour discipline problem, labour discipline model: Employers face a labour discipline problem when they need to give employees an incentive to ensure that they work hard and well. In the labour discipline model, they do this by setting wages that include an economic rent (employment rent), which will be lost if the job is terminated. See also: employment rent.
labour force: The number of people in the population of working age who are, or wish to be, in work outside the household. They are either employed (including self-employed) or unemployed.
labour market: The market in which employers offer wages to individuals who may agree to work under their direction. Economists say that employers are on the demand side of this market, while employees are on the supply side.
labour market power: A firm has labour market power (sometimes called monopsony power) if it can reduce the wage it needs to pay its workers by lowering the number of workers that it employs.
labour productivity, productivity of labour: The total output of a production process divided by the labour input (the number of hours of work, or some other measure of the amount of labour).
Law of One Price: The Law of One Price states that in equilibrium, identical goods or services will be traded at the same price by all buyers and sellers.
legal tender: Coins or banknotes that, according to the law, must be accepted in payment for goods and services.
leverage, gearing, leverage ratio: Leverage (or gearing) refers to the process of increasing investments or asset purchases by borrowing. There are several different, but closely related, measures of leverage of a household, a firm, or a bank. CORE uses the proportion of the investment financed by borrowing; in other words, the leverage ratio is the ratio of debt to assets.
liability: A debt; an amount that is owed, with a contractual obligation to repay it in future.
life cycle model of consumption: A model of consumption spending in which individuals’ current consumption depends not only on their current income, but also on their expected future income, and their assets, allowing for savings and debts.
liquidity, liquid, illiquid: An asset is described as liquid if it can easily be sold (exchanged for money). Savings at a commercial bank are highly liquid if you can instantly withdraw them in cash, but less so if you have to give notice to the bank several weeks or months before a withdrawal. Housing is a relatively illiquid asset (that is, not liquid): it can take months or even years to complete the sale of a house.
long run: The term does not refer to a specific length of time, but instead to what is held constant and what can vary within a model. The short run refers to what happens while some variables (such as prices, wages, or capital stock) are held constant (taken to be exogenous). The long run refers to what happens when these variables are allowed to vary and be determined by the model (they become endogenous). A long-run cost curve, for example, refers to costs when the firm can fully adjust all of the inputs including its capital goods.
Lorenz curve: A graphical representation of the inequality of some quantity such as income or wealth. Taking income as an example, individuals in the population are arranged in ascending order of income. First we calculate the total income of the population. Then for each level of income, we plot the percentage of total income held by people at this income level or lower, against the percentage of people at this income level or lower. The area between the Lorenz curve and the 45-degree line, expressed as a fraction of the total area below the 45-degree line, is a measure of inequality. Other than for small populations, it is a close approximation to the Gini coefficient. See also: Gini coefficient.
macroeconomics: Macroeconomics is the study of the economy as a whole, and how the outcomes in one part of the economy affect, and are affected by, what happens in others. So that macroeconomic models are manageable, we typically simplify them by focusing on totals and averages—for example, total employment, or average prices—and ignoring some of the variability among people, firms, and goods.
marginal change: When two variables, x and y, are related to each other, the effect of a marginal change is the change in y that occurs in response to a small increase in x. If y is a continuous function of x, the marginal change in y is the rate of change of y with respect to x: that is, the derivative of the function.
marginal cost: The increase in total cost when one additional unit of output is produced. It corresponds to the slope of the total cost function at each point.
marginal external benefit, MEB: The marginal external benefit (MEB) is the beneft of an additional unit of a good for someone other than the decision-maker (or the sum of these benefits if several others are affected). The marginal social benefit is the sum of the MEB and the marginal private benefit to the decision-maker: MSB = MEB + MPB.
marginal external cost, MEC: The marginal external cost (MEC) is the cost of an additional unit of output that is incurred by someone other than the producer (or the sum of these costs if several others are affected). The marginal social cost is the sum of the MEC and the marginal private cost to the producer: MSC = MEC + MPC.
marginal private benefit, MPB: The benefit for a producer or consumer of producing or consuming an additional unit of a good. It is called the marginal private benefit, or MPB, to emphasise that it doesn’t include any external benefits conferred on others. See also: marginal external benefit, marginal social benefit.
marginal private cost, MPC: The cost for the producer of producing an additional unit of output. It is called the marginal private cost, or MPC (rather than simply the marginal cost) when we want to emphasise that it doesn’t include any external costs that production imposes on others. See also: marginal external cost, marginal social cost.
marginal product: The marginal product of an input to production (for example, the marginal product of labour) is the additional amount of output produced in response to a 1-unit increase in the input.
marginal propensity to consume (MPC): The change in consumption when disposable income changes by one unit.
marginal propensity to import: The change in total imports when aggregate income changes by one unit.
marginal rate of substitution (MRS): The trade-off that a person is willing to make between two goods. At any point, the MRS is the absolute value of the slope of the indifference curve. See also: marginal rate of transformation.
marginal rate of transformation (MRT): The quantity of a good that must be sacrificed to acquire one additional unit of another good. At any point, it is the absolute value of the slope of the feasible frontier. See also: marginal rate of substitution.
marginal revenue: The change in revenue obtained by increasing the quantity sold by one unit.
marginal social benefit, MSB: The marginal social benefit (MSB) is the benefit of the production or consumption of an additional unit of a good, including both the benefit for the producer or consumer (marginal private benefit) and the benefits conferred on others. MSB = MPB + MEB.
marginal social cost, MSC: The marginal social cost (MSC) is the cost of producing an additional unit of output, including both the cost for the producer (marginal private cost) and the costs imposed on others (the MEC). MSC = MPC + MEC.
marginal utility: The additional utility resulting from a one-unit increase in the amount of a good.
market: A market enables people to exchange goods and services by means of directly reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit (unlike theft, taxation), in a way that is often impersonal (unlike transfers among friends, family).
market clearing: A market clears when the amount of the good supplied is equal to the amount demanded.
market-clearing price: The price at which the amount of the good demanded is equal to the amount supplied. See also: equilibrium price.
market failure: If the allocation resulting from market interactions is not Pareto efficient, we describe the situation as a market failure. The term may be used loosely to refer to any interaction resulting in a Pareto-inefficient allocation, whether or not a specific market is concerned.
market income: Market income is income before the payment of taxes or the receipt of transfers from the government; it includes earnings (wages and salaries from employment) as well as income from self-employment and from the ownership of assets (interest, rents, or dividends). See also: disposable income.
market power: A firm has market power if it can sell its product at a range of feasible prices, so that it can benefit by acting as a price-setter (rather than a price-taker).
market share: A firm’s proportion of the market in which its product is sold. It may be measured as its share of the total revenue in the market, or of the total quantity sold in the market.
matching market: A market for interactions between two distinct groups, in which the members have different characteristics from other members of their own group, and would benefit from matching with particular members of the other group. For example, firms and workers in the labour market, men and women in what is sometimes called the marriage market. Also known as a two-sided market.
maturity: The maturity of a debt—such as a bond, or mortgage—is the date at which the loan must be fully repaid.
means of exchange: One of the characteristics of money is that it serves as a means of exchange: something that buyers and sellers are willing to exchange for goods and services.
menu costs: The resources used in setting and changing prices.
merit good: A good or service that should be available to everyone on moral grounds, irresprective of their ability to pay.
microeconomics: Microeconomics is the study of the economic interactions between individual decision makers—consumers, firm owners, employers, employees, borrowers, and lenders—and the particular markets within which they buy and sell goods and services. It is concerned with understanding and explaining what we observe in specific markets, rather than the links between different parts of the economy.
minimum acceptable offer: In the ultimatum game, the smallest offer by the Proposer that will not be rejected by the Responder. More generally in bargaining situations, it is the least favourable offer that would be accepted.
minimum wage: A minimum level of pay laid down by law or regulation, for workers in general or of some specified type. The intention of a minimum wage is to guarantee living standards for the low-paid. Many countries, including the UK and the US, enforce this with legislation.
missing market: When there is no market within which a potentially beneficial exchange or trade could occur, because of asymmetric or non-verifiable information, we say that the market for the good is missing.
monetary policy: Central bank or government actions aimed at influencing economic activity through changes in interest rates or the prices of financial assets. See also: quantitative easing.
money: Money is something that acts as a store of value and is widely accepted as a means of exchange. Typically it is also used as the unit of account, for measuring the value of goods and services, and assets and liabilities. Some commodities can be used as money, but in a modern economy money in the hands of the public consists of commercial bank deposits and currency (notes and coins) issued by the central bank. See also: means of exchange, store of value.
monopoly: A firm that is the only seller of a product without close substitutes. Also refers to a market with only one seller. See also: natural monopoly.
monopsony power: A firm has labour market power if it can reduce the wage it needs to pay its workers by lowering the number of workers that it employs. It is sometimes called monopsony power because it applies, in particular, to a firm that is the only employer in a particular labour market.
moral hazard, hidden actions: If there is a conflict of interest between a principal and an agent over the agent taking some action that cannot be observed or cannot be verified by a court, then the principal faces a problem of hidden actions; also known as moral hazard.
mortgage (or mortgage loan): A loan contracted by households and businesses to purchase a property without paying the total value at one time. Over a period of many years, the borrower repays the loan, plus interest. The debt is secured by the property itself, referred to as collateral. See also: collateral.
multiplier model: A model of aggregate demand that includes the multiplier process. See also: fiscal multiplier, multiplier process.
multiplier process: A mechanism through which the direct effect of an increase (or decrease) in aggregate spending is amplified through indirect effects that further increase (or decrease) aggregate output. See also: fiscal multiplier, multiplier model.
Nash equilibrium: An outcome is termed a Nash equilibrium if none of those involved, by individually choosing a different action, could bring about an outcome that they would prefer. In game theory, a Nash equilibrium is a set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else. See also: game theory.
national accounts: The system used for measuring overall output and expenditure in a country.
natural experiment: An empirical study that exploits a difference in the conditions affecting two populations (or two economies), that has occurred for external reasons: for example, differences in laws, policies, or weather. Comparing outcomes for the two populations gives us useful information about the effect of the conditions, provided that the difference in conditions was caused by a random event. But it would not help, for example, in the case of a difference in policy that occurred as a response to something else that might affect the outcome.
natural monopoly: A production process in which the average cost curve is sufficiently downward-sloping, even in the long run, that a single firm can supply the whole market at lower average cost than two firms, making it impossible to sustain competition.
negative feedback: Feedback that counteracts (pushes back against) movement away from equilibrium.
negative feedback (process): We say that negative feedback occurs if an initial change sets in motion a process of further changes that dampen the original change.
net present value: The net present value of a project that will generate income at some time in the future is the present value of the stream of income, minus the present value of the associated costs (whether the costs are incurred in the present or the future). See also: present value.
network economies of scale: A firm experiences network economies of scale when an increase in the number of users of an output of the firm implies an increase in the value of the output to each of them, because they are connected to each other.
net worth: The net worth (or equivalently, wealth) of an individual, household, or organization is the difference between the total value of its assets and the total value of its liabilities.
nominal exchange rate: The number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency—that is, the market exchange rate—is described as a nominal exchange rate to distinguish it from the real exchange rate, which is the relative price of foreign and domestic goods and services. See also: real exchange rate.
nominal interest rate: An interest rate is nominal if it is not corrected for inflation. The rates quoted by high-street banks on loans and savings accounts are nominal interest rates. See also: interest rate, rate of interest, real interest rate.
nominal wage: The actual amount received in payment for work, per unit of time, expressed in a particular currency. Also known as: money wage. See also: real wage.
non-excludable, non-excludability: A good is non-excludable if it is impossible to prevent anyone from having access to it.
non-rival, non-rivalry: A good is non-rival if, when it is made availaible to one person, it can be made available to everyone else at no additional cost. Non-rivalry is the primary characteristic of a public good.
non-verifiable information, unverifiable information: Information is verifiable if it can be verified by a court and hence used to enforce a contract.
normal profits: Normal profits are the returns on investment that the firm must pay to the shareholders to induce them to hold shares. The normal profit rate is equal to the opportunity cost of capital and is included in the firm’s costs. Any additional profit (revenue greater than costs) is called economic profit. A firm making normal profits is making zero economic profit.
no-shirking condition: The condition that must be satisfied by the wage to ensure that the worker’s pay-off from exerting the level of effort required by the employer is greater than or equal to the pay-off from shirking. See also: no-shirking wage
no-shirking wage: The wage that is just sufficient to motivate a worker to provide effort at the level specified by their employer. See also: no-shirking condition
open-access resource: A resource that is rival or partially rival (more people using it reduces the benefits to others) but non-excludable (it is impossible to exclude anyone from using it).
opportunity cost: What you lose when you choose one action rather than the next best alternative. Example: ‘I decided to go on vacation rather than take a summer job. The job was boring and badly paid, so the opportunity cost of going on vacation was low.’
opportunity cost of capital: The opportunity cost of capital is the amount of income an investor could have received, per unit of investment spending, by investing elsewhere.
paradox of thrift: If a single individual consumes less, their savings will increase; but if everyone consumes less, the result may be lower rather than higher savings overall. This happens if the increase in the saving rate is unmatched by an increase in investment (or other source of aggregate demand such as government spending on goods and services). Then aggregate demand and income fall, so actual levels of saving do not increase.
Pareto criterion: The Pareto criterion is a way of comparing two allocations, A and B. It states that A is is an improvement on B if at least one person would be strictly better off with A than B (in other words, would strictly prefer A to B) and nobody would be worse off. We say that A Pareto dominates B.
Pareto dominate, Pareto dominant: Allocation A Pareto dominates allocation B if it is better according to the Pareto criterion. That is, at least one person would be strictly better off with A than B, and nobody would be worse off. See also: Pareto criterion.
Pareto efficiency curve: The set of all allocations that are Pareto efficient. The Pareto efficiency curve is sometimes called the ‘contract curve’, even though it is not necessary for any contract to be involved. See also: Pareto efficiency.
Pareto efficient, Pareto efficiency: An allocation is Pareto efficient if there is no feasible alternative allocation in which at least one person would be better off, and nobody worse off.
Pareto improvement: A change that benefits at least one person without making anyone else worse off. See also: Pareto dominant, Pareto criterion.
partial equilibrium: Partial equilibrium analysis is the study of what happens in a single market, or sometimes just a single economic interaction. See also: general equilibrium.
participation rate: The ratio of the number of people in the labour force to the population of working age. See also: labour force population of working age.
patent: A right of exclusive ownership of an idea or invention, which lasts for a specified length of time. During this time, it effectively allows the owner to be a monopolist or exclusive user.
pay-off: The pay-off for an individual player in a game is the benefit that the player receives as a result of the joint actions of all the players.
perfect competition: Perfect competition is the type of interaction between buyers and sellers that takes place in the equilibrium of a market when (i) there are with many buyers and sellers of identical goods, and (ii) supply equals demand and all participants act as price-takers.
perfectly competitive: A market may be described as perfectly competitive if (i) there are many buyers and many sellers of identical goods, all acting independently, who are aware of prices and always choose the best price they can get, and (ii) the market is in competitive equilibrium, with supply equal to demand and all buyers and sellers acting as price-takers.
Phillips curve: An inverse relationship between the rate of inflation and the rate of unemployment. It is named after Bill Phillips, who observed the relationship empirically, but it can also be derived from a theoretical model of wage and price setting.
piece rate: Under a piece rate contract, a worker is paid a fixed amount for each unit (‘piece’) of the product made.
Pigouvian subsidy: A government subsidy on activities that generate positive external effects, so as to correct an inefficient outcome. See also: external effect, Pigouvian tax
Pigouvian tax: A tax levied on activities that generate negative external effects so as to correct an inefficient market outcome. See also: external effect, Pigouvian subsidy.
policy (interest) rate: The nominal interest rate set by the central bank, which applies to banks that borrow base money from each other, and from the central bank. Also known as: base rate, official rate. See also: real interest rate, nominal interest rate.
political system: A political system determines how governments will be selected, and how those governments will make and implement decisions that affect all or most members of a population.
population of working age: A statistical convention, which in many countries is all people aged between 15 and 64 years.
positive feedback: Feedback that amplifies (reinforces) a movement away from equilibrium.
positive feedback (process): We say that positive feedback occurs if an initial change sets in motion a process of further changes that magnify the original change.
power: The ability to do (and get) the things one wants in opposition to the intentions of others.
precautionary saving: An increase in saving to restore wealth to its target level. See also: target wealth.
preferences: A description of the relative values a person places on each possible outcome of a choice or decision they have to make.
present bias: An individual or household with present bias puts more weight on present rather than future consumption. They may prefer to consume all of their current income now, even when they know that income will be lower in the future.
present value: The effective value today of a stream of income or other benefits that will be received in the future. The present value is less that the future value when future income is discounted using an interest rate or the person’s own discount rate. See also: net present value.
present value criterion: A criterion for deciding whether or not to undertake an investment, taking into account all the costs and benefits now and in future: specifically, invest if the net present value is positive.
price discrimination: A selling strategy in which different prices are set for different buyers or groups of buyers based on the buyers’ differing willingness to pay.
price dynamics curve: The price dynamics curve is a graph of the relationship between the price of a good in period $t$ (on the horizontal axis) and the price in period $t + 1$ (on the vertical axis). A point where the graph crosses the 45-degree line represents a market equilibrium: at this price demand = supply so the price stays constant from one period to the next. At other prices excess demand or excess supply leads to a change in price.
price elasticity of demand: The percentage change in demand that would occur in response to a 1% increase in price. We express this as a positive number. Demand is elastic if this is greater than 1, and inelastic if less than 1.
price markup: The price minus the marginal cost divided by the price. In other words, the profit margin as a proportion of the price. If the firm sets the price to maximize its profits, the markup is inversely proportional to the elasticity of demand for the good at that price.
price-setting curve, PS curve: A relationship showing, for each level of economy-wide employment, the real wage that results when firms maximize profits by setting prices as a constant markup on costs.
price-taker: A buyer or seller acts as a price-taker if they cannot benefit from attempting to trade at any other price than the prevailing market price. A price-taker has no power to influence the market price, but can buy or sell as many items as they wish at that price.
primary labour market: When the labour market is segmented into separate parts, a primary labour market is a segment where conditions for workers are relatively good, typically with trade union representation, high wages, and job security. See also: secondary labour market, segmented labour market.
principal–agent relationship, principal–agent problem: A principal–agent relationship or problem exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute, that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract.
prisoners’ dilemma: A prisoners’ dilemma is a game that has a dominant strategy equilibrium, but also has an alternative outcome that gives a higher pay-off to all players. So the Nash equilibrium is not Pareto efficient.
private good: A good that is rival (when one person consumes a unit of the good, that unit is not available to others) and excludable (people can be prevented from consuming it).
private property: Something is private property if the person possessing it has the right to exclude others from it, to benefit from the use of it, and to exchange it with others.
procedural judgement of fairness: An evaluation of an outcome based on how the allocation came about, and not on the characteristics of the outcome itself (for example, how unequal it is). See also: substantive judgement of fairness.
producer surplus: The producer of a good receives a surplus on each unit, equal to the price minus the marginal cost of producing it. The term ‘producer surplus’ normally refers to the sum of these surpluses across all units sold.
production function: A production function is a graphical or mathematical description of the relationship between the quantities of the inputs to a production process and the amount of output produced.
profit, economic profit: A firm’s profit is its revenue minus its total costs. We often refer to profit as ‘economic profit’ to emphasise that costs include the opportunity cost of capital (which is not included in ‘accounting profit’).
profit margin: The difference between the price of a product and its marginal production cost.
profit rate, rate of profit: The rate of profit on an investment is the net profit that it will generate in future (per period) as a percentatge of the initial investment cost.
property rights: Legal protection of ownership, including the right to exclude others and to benefit from or sell the thing owned. Property rights may cover broadly-defined goods such as clean water, safety, or education, if these are protected by the legal system.
protectionist policy: Measures taken by a government to limit trade; in particular, to reduce the amount of imports in the economy. These are designed to protect local industries from external competition. They can take different forms, such as taxes on imported goods or import quotas.
prudential policy: A policy that is prudent in that it places a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is fundamental uncertainty about the conditions under which a disastrous outcome would occur.
public good: A good that, if available to anyone, can be made available to everyone at no additional cost. This characteristic is called non-rivalry. Some economists define public goods more strictly as goods that are both non-rival and non-excludable (non-excludable means that it is impossible to prevent anyone from consuming them).
public good game: A public good game is a game in which individual players can take an action that would be costly to themselves, but would produce benefits for all players (including themselves).
purchasing power parity (PPP): PPPs are price indices that measure how much it costs to purchase a basket of goods and services compared to how much it costs to purchase the same basket in a reference country in a particular year, such as the United States in 2011.
quantitative easing (QE): Central bank purchases of financial assets aimed at reducing interest rates on those assets when conventional monetary policy is ineffective because the policy interest rate is at the zero lower bound. See also: zero lower bound.
quartiles, quartile groups: Quartiles split a set of observations into four equally-sized groups. The full set of observations is ordered according to a particular variable (e.g. wealth). The first quartile group is the observations in the bottom 25% (e.g. the 25% with the lowest wealth), the second is the next lowest 25%, and the fourth or top quartile group is the highest 25%. The quartiles are the cutoff values that separate the groups; the first quartile is the cutoff between the first and second quartile groups, and so on.
quasi-linear, quasi-linear function: A utility function is said to be quasi-linear if it depends linearly on the amount of one good, and non-linearly on another. The marginal rate of substitution between the two goods then depends only on the non-linear variable.
rate of return: The rate of return on a loan, or any investment, is the net amount the lender or investor gets back (that is, the total amount minus what they lent or put in) as a proportion of what they put in.
real depreciation: A real depreciation (depreciation of the real exchange rate) occurs if the price of foreign goods and services, converted into domestic currency at the market (nominal) exchange rate, increases relative to the price of domestic goods and services: that is, foreign goods and services become relatively more expensive. A real depreciation is referred to as an improvement in home’s price competitiveness. See also: real exchange rate.
real depreciation, real appreciation: A country experiences a real depreciation if its real exchange rate (measured as the relative price of foreign goods and services, also known as competitiveness) increases. Likewise a fall in competitiveness is a real appreciation. See also: real exchange rate.
real estate: A general term that covers three types of property: land, housing, and other buildings.
real exchange rate, competitiveness: The relative price of foreign and domestic goods and services; specifically, it is the price of foreign goods and services, converted into domestic currency at the market (nominal) exchange rate, divided by the price of domestic goods and services. The real exchange rate is a measure of competitiveness.
real interest rate: An interest rate corrected for expected inflation (that is, the nominal interest rate minus the expected rate of inflation). It represents how many goods in the future one gets for the goods not consumed now. See also: nominal interest rate, interest rate, rate of interest.
real wage: The wage expressed in terms of the amount of goods and services the worker can buy with it. It is calculated by dividing the nominal wage by the current price level in the same currency. See also: nominal wage.
recession: The US National Bureau of Economic Research defines a recession as a period when output is declining. It is over once the economy begins to grow again. An alternative definition is a period when the level of output is below its normal level, even if the economy is growing. It is not over until output has grown enough to get back to normal. The latter definition has the problem that the ‘normal’ level is subjective.
reciprocity: A preference to be kind to or to help others who are kind and helpful, and to withhold help and kindness from people who are not helpful or kind.
relationship-specific asset: An asset is something that is owned, and has value. It is relationship-specific if it is only of value within an economic relationship (e.g. a contract for one firm to supply another). Relationship-specific assets include any knowledge or skills that are only valuable while a person remains employed in a particular firm. See also: firm-specific asset.
relative price: The price of one good or service compared to another (usually expressed as a ratio of the two prices).
rent ceiling: The maximum legal price a landlord can charge for a rent.
research and development: Expenditures by a private or public entity to create new methods of production, products, or other economically relevant new knowledge.
reservation indifference curve: A curve that indicates combinations of goods that are as highly valued as one’s reservation option.
reservation option: When someone makes a choice amongst the available options in a particular transaction, the reservation option is their next best alternative option. Also known as: fallback option. See also: reservation price.
reservation price: The lowest price at which someone is willing to sell a good.
reservation wage: The reservation wage is the lowest wage a worker is willing to accept to take up a new job. It is the wage available in the worker’s next best job option (the reservation option). For workers whose next best option is unemployment, the reservation wage takes into account the wages they expect to receive when they find a new job as well as any income received while unemployed.
reserves: Reserves (or reserve accounts) are deposits of banks with the central bank, which are classified as part of base money. Only banks can have these accounts and only reserves can be used to settle transactions with other banks. The central bank supplies reserves by buying assets from banks or by directly lending to them.
residual claimant: The person who receives the income left over from a firm or other project after the payment of all contractual costs (for example, the cost of hiring workers and paying taxes).
resolution: The process of closing or restructuring a bank without interrupting its critical economic functions. Bank shareholders and some or all of the bank’s creditors bear the losses, instead of taxpayers. One approach to resolution is bail-in. See also: bail-in.
reverse causality: If we are looking for evidence that one variable (x) causes another (y) and find that the variables are correlated, the explanation may be the reverse: that y causes x. For example, if we find that people who attend university earn more, does that mean that university increased their earning ability? Could it be that people with high earning potential are more likely to attend university? See also: correlation.
risk: The term ‘risk’ is conventionally used in economics to describe cases in which we do not know which of two or more situations will occur in the future, but the probabilities of each occurring are known or can be reliably estimated.
risk aversion, risk-averse: A risk-averse person has a preference for certainty (for example, getting $100 for sure) over a risky outcome of the same average value (such as a 50-50 chance of getting $200 or nothing).
risk premium: Risky assets have to offer a higher rate of return than risk-free assets to compensate the buyer for risk. The risk premium is the difference between the return on the risky asset, and the risk-free rate.
rival, partially rival: A good is rival if, when one person consumes a unit of the good, no-one else can consume that unit. It is partially rival if more people using the good reduces the benefits available to other users. See also: non-rival.
saving: When consumption expenditure is less than net income, saving takes place and wealth rises. See also: wealth.
scarcity: A good is scarce if it is valued, and there is an opportunity cost of acquiring more of it.
search unemployment: Since workers differ from each other, and so do jobs, unemployed workers and firms with vacancies spend time searching for an employment match that suits them both. Unemployment caused by the search and matching process is called search unemployment.
secondary labour market: When the labour market is segmented into separate parts, a secondary labour market is a segment where conditions for workers are relatively poor, typically with low wages and short-term contracts or limited job security. This might be due to their age, or because they are discriminated against according to race or ethnic group. See also: primary labour market, segmented labour market.
segmented labour market: A labour market with two or more distinct segments that function as separate labour markets, with limited mobility of workers from one segment to the other (including for reasons of racial, language, or other forms of discrimination). See also: primary labour market, secondary labour market.
self-insurance: To maintain their consumption, households can use savings and borrowing to self-insure against a temporary fall in income or need for greater expenditure.
separation of ownership and control: The attribute of some firms by which managers are a separate group from the owners.
sequential game: A game in which players do not all choose their strategies at the same time, and players who choose later can see the strategies already chosen by the other players. An example is the ultimatum game. See also: simultaneous game.
shares, stocks: Shares (also known as stocks) are financial assets that can be bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a right to receive a corresponding share of the firm’s profit.
short run: The term does not refer to a specific length of time, but instead to what happens while some things (such as prices, wages, capital stock, technology, or institutions) are assumed to be held constant (they are assumed to be fixed, or exogenous). For example, the firm’s stock of capital goods may be fixed in the short run, but in the longer run the firm could vary it (by selling some, or buying more).
simultaneous game: A game in which the players choose their strategies simultaneously, for example, the prisoners’ dilemma. See also: sequential game.
social dilemma: A situation in which actions taken independently by individuals in pursuit of their own private objectives result in an outcome that is inferior to some other feasible outcome that could have occurred if people had acted together, rather than as individuals.
social interactions: Situations in which the actions taken by each person affect other people’s outcomes as well as their own.
social norm: An understanding that is common to most members of a society about what people should do in a given situation when their actions affect others.
social preferences: An individual is said to have social preferences if their individual utility depends on what happens to other people, as well as on their own pay-offs.
sovereign debt crisis: If a government is unable to repay its debt as required, and cannot negotiate a change in terms with the lender, it may default on some or all of the debt. A situation in which the government either defaults, or is expected to default, is described as a sovereign debt crisis.
stable equilibrium: An equilibrium is stable if a small movement away from the equilibrium is self-correcting (leading to movement back toward the equilibrium). See also: equilibrium.
stock: A quantity measured at a point in time, such as a firm’s stock of capital goods, or the amount of carbon dioxide in the atmosphere. Its units do not depend on time. See also: flow.
stock market: A financial market in which people buy and sell shares (stocks) in companies. See also: shares, stocks.
store of value: One of the characteristics of money is that it can be used as a store of value: people can store their wealth in this form until they want to use it to buy goods and services.
strategic interaction: A social interaction in which the participants are aware of the ways in which their actions affect others (and the ways in which the actions of others affect them).
strategy: An action (or action plan) that a person may choose, while being aware that the outcomes for themselves and others depend on their own strategy and the strategies chosen by others.
structural unemployment: The level of unemployment where the supply side of the economy is in equilibrium. In the WS–PS model, it is the unemployment level at which the price-setting real wage equals the wage-setting real wage. See also: WS–PS model, Nash equilibrium, supply side.
subsistence level: The level of living standards (measured by consumption or income) below which the population will decline.
substantive judgement of fairness: An evaluation of an outcome based on the characteristics of the allocation itself, not how it was determined. See also: procedural judgement of fairness.
substitutes: Two goods (or services) are described as substitutes when consumers would readily replace one with the other if the prices were similar. If the price of one of the goods increased, consumers would be more likely to choose the other (so demand for it would increase).
substitution effect: When the price of a good changes, the substitution effect is the change in the consumption of the good that occurs because of the change in the good’s relative price. The price change also has an income effect, because it expands or shrinks the feasible set. See also: income effect.
supply curve: A supply curve shows the number of units of output that would be supplied to the market at any given price. The firm’s supply curve shows the units supplied by an individual firm, and the market (or industry) supply curve shows the total number of units supplied by all sellers in the market (or firms in the industry). Also known as: supply function.
supply shock, supply-side shock: An unexpected or exogenous change in supply. In macroeconomics a supply shock means a change on the supply side of the economy, such as a rise or fall in oil prices or an improvement in technology. In microeconomics it refers to an exogenous shift in the supply curve for a particular good. See also: demand shock, exogenous shock.
supply-side equilibrium: The economy is in supply-side equilibrium when the markets involved in the production of output are in equilibrium. In the WS–PS model it is the labour market equilibrium; that is, where the price-setting real wage equals the wage-setting real wage.
supply-side policies: Economic policies that are designed to improve the functioning of the economy by increasing productivity and international competitiveness, and reducing costs for producers. They include cutting taxes on profits, tightening conditions for the receipt of unemployment benefits, changing legislation to make it easier to fire workers, and the reform of competition policy to reduce monopoly power.
supply side, supply-side: The supply side of the economy consists of the activities that produce the economy’s output, including the markets for labour and capital. In a microeconomic model of the market for a particular good it refers to the decisions of the sellers who supply the good to the market. See also: demand side.
target wealth: The level of wealth that a household aims to hold, based on its economic goals (or preferences) and expectations. We assume that households try to maintain this level of wealth in the face of changes in their economic situation, as long as it is possible to do so.
tax: A tax is a compulsory payment to the government levied, for example, on workers’ incomes (income taxes) or firms’ profits (profit taxes) or included in the price paid for goods and services (value added or sales taxes).
tax incidence: The effect of a tax on the surplus of buyers, sellers, or both.
technological progress: A change in technology that reduces the amount of resources (labour, machines, land, energy, time) required to produce a given amount of the output.
technology: The description of a process that uses a set of materials and other inputs, including the work of people and machines, to produce an output.
terms of trade: A country’s terms of trade are measured by the ratio of the export price to the import price. When the price it receives for exports falls relative to the price it pays for imports, we say that its terms of trade have deteriorated.
tipping point: A tipping point is an unstable equilibrium at the boundary between two regions. A small movement into either of the regions causes a movement further into the same region, away from the equilibrium. See also: asset price bubble.
total costs: The sum of all the costs a firm incurs to produce its total output.
total revenue, revenue: A firm’s total revenue is the number of units sold times the price per unit.
trade balance: The value of exports minus the value of imports. Also known as: net exports. See also: trade deficit, trade surplus.
trade deficit: If a country’s imports exceed its exports, the trade balance (X – M) is negative, and we say that it has a trade deficit. The size of the deficit is M – X (the negative of the trade balance).
trade surplus: If a country’s exports exceed its imports, the trade balance (X – M) is negative. We say that it has a trade surplus of X – M.
trade union, labour union: A trade union, or labour union, is a membership organization of workers. Its principal activities are the negotiation with employers of rates of pay and conditions of employment for its members.
transaction costs: Costs that impede the bargaining process or the agreement of a contract. They include costs of acquiring information about the good to be traded, and costs of enforcing a contract.
ultimatum game: A game in which the first player proposes a division of a ‘pie’ with the second player, who may either accept, in which case they each get the division proposed by the first person, or reject the offer, in which case both players receive nothing.
uncertainty: The term ‘uncertainty’ (sometimes called fundamental uncertainty) describes cases in which we do not know which of two or more situations will occur in the future, and the probabilities of each occurring are not known or cannot be reliably estimated.
uncovered interest parity, UIP: When interest rates and expected depreciation of the exchange rate are such that the expected rates of return on domestic and foreign assets are equal, we say that the uncovered interest parity (UIP) condition holds.
unemployed, unemployment: An unemployed person is someone who is able and willing to work, but is not currently employed.
unemployment benefit: A government transfer that is paid to an unemployed person while they are unemployed (or for part of the unemployment period). Also known as: unemployment insurance.
unemployment rate: The unemployment rate is the fraction of the total labour force that is seeking work, but is not currently employed. See also: labour force employment rate.
union voice effect: The union voice effect refers to the beneficial effect that a trade union, by providing a ‘voice’ to otherwise unheard workers, can have on their treatment by employers and their job satisfaction.
unit of account: A standard unit that is used to measure and compare the market value of different goods and services. One of the functions of money in the economy is to act as a unit of account.
unstable equilibrium: An equilibrium is unstable if, when a shock disturbs the equilibrium, there is a subsequent tendency to move even further away from the equilibrium. See also: equilibrium.
utility: A numerical indicator of the value that one places on an outcome. Outcomes with higher utility will be chosen in preference to lower valued ones when both are feasible.
utility function: A utility function is a mathematical representation of a person’s preferences for one or more goods. It gives a numerical value to the amount of utility the person obtains from each possible combination of goods.
value added: The value of output minus the value of all inputs (called intermediate goods).
variable costs: Costs of production that vary with the number of units produced.
Veblen effect: A negative effect on others that arises from a person’s consumption of goods such as luxury housing, clothing, or vehicles, that display or signal social status. See also: conspicuous consumption.
verifiable information: Information is verifiable if it can be verified by a court and hence used to enforce a contract.
voluntary unemployment: A person may be said to be voluntarily unemployed if they are seeking work, but not willing to accept a job at the going wage for people of their level of skill and experience. See also: involuntary unemployment.
wage inflation: An increase in the level of the nominal wage, usually measured as the percentage increase over one year. See also: nominal wage.
wage markdown: When employers have labour market power they ‘mark down’ the wage. In our model with constant output per worker, the markdown is equal to the difference between the marginal cost of output and the average wage cost of a unit of output, as a proportion of the average wage cost of a unit of output.
wage–price spiral: This occurs if an initial increase in wages in the economy is followed by an increase in the price level, which is followed by an increase in wages and so on. It can also begin with an initial increase in the price level.
wage-setting curve, WS curve: A relationship showing, for each level of economy-wide employment, the wage that employers need to set to recruit and motivate workers.
wage subsidy: A government payment either to firms or employees, to raise the wage received by workers or lower the wage costs paid by firms, with the objective of increasing hiring and workers’ incomes.
wealth: The stock of things owned, or value of that stock; it may generate income, or contribute to the owner’s well-being in some other way; it includes the market value of a home, car, any land, buildings, machinery, or other capital goods that a person may own, and any financial assets such as shares or bonds. To calculate wealth, debts are subtracted—for example, the mortgage owed to the bank. Debts owed to the person are added.
willingness to accept (WTA): An indicator of how much a person values a good, measured by the minimum amount of money they would accept in exchange for a unit of the good (that is, their reservation price). See also: willingness to pay
willingness to pay (WTP): An indicator of how much a person values a good, measured by the maximum amount they would pay to acquire a unit of the good. See also: willingness to accept.
WS–PS model: Model of the aggregate economy that combines wage-setting (WS) and price-setting (PS) decisions. Where the WS and PS curves intersect is the Nash equilibrium and determines structural unemployment and the real wage. See also: wage-setting curve, price-setting curve, structural unemployment.
zero lower bound: This refers to the fact that the nominal interest rate cannot be negative, thereby setting a floor on the nominal interest rate that can be set by the central bank at zero. See also: quantitative easing.