Unless the market output goes to buyers who have the highest valuation of the product then there is an allocation inefficiency. An equivalent requirement is that each buyers valuation of one more unit of the product (marginal value) is the same and higher than the valuation of any agent who has not bought the product.

If there is an allocation inefficiency then conceivably a buyer with a low valuation for the last unit he purchased could sell that unit to a user who has a high valuation of the last unit she purchased and they could both be better off. If there is some way of re-allocating among buyers the total market output, such that the consumer surplus is increased, then there is an allocation inefficiency

If a buyer and seller enter into a transaction with different information about the value of that which is being exchanged, then an information asymmetry exists. Classic examples of asymmetric information situations include the owner of car knowing more about the true value of the car than a buyer, the seller of a life insurance contract knowing less than the buyer about the true likelihood of a claim, or a stock market dealer knowing less than a firm's management about the value of the firm's stock. The asymmetry simply refers to the information on the two sides of the deal not being symmetric.

A simple strategic situation where each of the firms in an industry makes its decision about price and output assuming that the other firms do not change their prices from their current level. In contrast, Cournot competition arises where the firm decides price and output assuming the other firms' output levels are fixed.

Economics seeks to understand how households, firms, financial institutions, the government, etc., make choices about resources. Those choices are the outcomes of optimization problems. Households choose optimally what products to purchase, how much to work, how much to save, etc., with the objective of maximizing their own well being (welfare). Likewise, firms make optimal decisions over product type, price, quantity, technology, inputs, financing, etc., with the objective of maximizing firm value.

So we all making optimal decisions all the time on the basis of: our objective; the set of feasible decisions; the information we have; any constraints on our decision; our starting point; etc. That is, we act rationally. However, there are bounds on how rational we can be. We don't have perfect information about prices, quality, opportunities, the behavior of others etc. Moreover, without 'a brain the size of planet', such as Professor Wylie has, we cannot calculate the optimal decisions all the time. Our rationality is bounded by imperfect information and limited computation ability.

Bounded rationality leads to the use of 'rules of thumb' that reduce computation and information acquisition costs. It also leads to decision makers not making decisions continuously, but instead making new decisions only when existing decisions have become sufficiently sub-optimal

Markets that have the following characteristics are said to be perfectly competitive.

1. Many buyers and sellers -- no one buyer or seller has a significant share of the market.

2. No barriers to entry - producers can enter and exit the market freely and costlessly.

3. Homogenous products - there is no essential difference between the products offered by different producers.

4. Symmetric information -- all producers and consumers have the same information about the value of the product, production opportunities, etc.

Competitive markets are economically efficient which is why economists like them. In competitive markets none of the participants has any market power; that is, power to change the price as a function of how much they buy or sell. At the other extreme of market power is a monopoly (or monopsony) market where the seller simply sets the market price for all output. In most industries firms have some market power, so those industries fall between the book ends of competitive and monopoly markets.

If a consumer purchases x units of some good, then the consumer surplus is the total value in dollars that the individual places on those units less the amount that the individual paid. A consumer might value three airline flights to London at $1000 for the first, $800 for the second and $600 for the third but if the consumer only paid a total of $1500 for the three, then consumer's surplus is $900. That is, the excess of what that person would have been prepared to pay over what they did pay. In the same way that an industry demand curve is the summation of the demand curves of individual consumers, the industry consumer surplus is the sum of the consumer surplus of all the individuals who have purchased some of the good.

These are the costs of writing and maintaining a contract between parties. They include the costs of each party verifying that the other is meeting the terms of the contract and the cost of arbitration and enforcement if there is a dispute over whether terms are being met.

In a competitive industry we expect the industry level of production to rise or fall until marginal value (MV) equals marginal cost (MC). That is, until the value to society of one more unit is neither more nor less than the cost of the inputs required to produce that unit. If MV does not equal MC then there is a deadweight loss. Factors of the production - labor, equipment, financial capital, infrastructure, etc. - are then not being used for the most productive purpose. This situation can arise because of a production quota, price stickiness, restricted output by monopolists, taxes, tariffs, etc.

The total consumer plus producer surplus lost to society as a result of output being at a level where MV is greater than MC is deadweight loss. It is called a deadweight loss because it does not represent a transfer of value to someone else, as a result of a quota or other restriction, it is value that is simply lost - the total inefficiency of the restriction of MV away from MC.

A demand curve is also called a demand schedule. It is the amount demanded at each price. It slopes downward when price is drawn on the y axis and quantity demanded is on the x axis. When a demand curve is drawn we are implicitly holding several other quantities constant: such as, the total income of consumers of the good; the price of substitutes and complements; and consumer preferences. For instance, if we draw the demand curve for oil and the price of natural gas rises (a substitute), then the quantity of oil demanded at each price will rise. That is the same as saying that the demand schedule of oil will shift to the right.

A market exhibits economic efficiency if three things are true.

1. Marginal value of all buyers is equal.

2. Marginal cost of all producers is equal.

3. Marginal value equals marginal cost.

Conditions 1 and 2 are about the market allocating the output to the buyers who value it most highly (same marginal values) and allocating production to the lowest cost producers (same marginal cost). Condition 3 is about output level efficiency. If MV > MC then increasing output creates extra surplus because there are buyers who value an additional unit of output at more than it costs to produce it. Likewise, if MV

Has the same meaning as economic value added (EVA). The economic profit of any project or activity is the market value of the output of that project less the cost of all inputs to production of that output. Where cost, as always, is defined as the value of each input in its most valuable alternative use. The principle way in which economic profit differs from accounting profit is that the later does not take account of the cost of the financial capital employed in the project. For small businesses accounting profit does not take account of income that the owner could generate doing something else.

In most mature markets firms on average make zero economic profits. Meaning that the accounting profits are simply commensurate with the amount of financial capital employed and the riskiness of the firm's cashflows. Firms can only make positive economic profits in the long run if there are barriers to new firms entering the industry or if they can maintain a lower cost structure in the long run (which is rare).

Financial Management Service of the US Treasury defines Electronic data interchange, or EDI, as 'The electronic exchange of business documents (purchase orders, invoices, application forms, etc.) from one organization's computer to another organization's computer in standard data formats.' EDI is based on a set of standard formats that define transaction sets (or messages) that can be used to send basic business data from one computer to another. These transaction sets replace paper documents such as purchase orders, invoices, and bills of lading.

An externality is the effect of one household or firm's actions upon another, which is not brought about by market adjustments. Cigarette smoking imposes a 'negative externality' on non-smoking. Investing in your children's education creates a positive externality for other members of society.

Note that effects that travel through markets are not externalities. If a firm uses more steel in its production process and that drives up the price of steel which in turn affects the profitability of another firm - that is NOT an example of one firm imposing an externality on another. It is simply firms competing for resources through the market mechanism.

Externalities should be thought of as missing property rights. Sulphur dioxide emission is an example. Until the 1990s heavy industry could emit sulphur dioxide into the atmosphere without cost to itself. But the action of emitting SO2, by air quality, imposed a large negative externality on households and other firms. To eliminate the externality, the US Federal government auctioned rights to emit SO2. Those rights could then be traded in a new market for SO2 rights. The Government sets the total level of rights to be auctioned at the point where the value to society of production that one more ton of emission permits is just equal to the cost of reduced air quality from that last ton of SO2.

An important example of positive externalities are network externalities. In many networks the value of being connected depends upon how many other households or firms are connected. For instance being connected to a telephone network is more valuable the more people there are that you can ring. Each new connection imposes a positive 'network externality' on the existing users.

These are costs that are not related to the level of output. They are one-off costs of setting up production. For instance, a firm might purchase a software license for the next year. The cost of that software is fixed regardless of how many units of output are produced with it. See also variable cost.

Elasticity and inelasticity of demand refer to how much demand stretches when something else changes. Own price elasticity refers to the percentage change in quantity demanded divided by percentage change in price (actually the negative of that ratio since demand falls when price rises). If quantity demanded falls by 10 percent when price rises by 5 percent then the good has an elasticity of 2.

Elasticity changes along the demand curve. The elastic region of demand is where elasticity is greater than one (where prices are high) and the inelastic region is where elasticity is less than one. In the elastic region a reduction in price increases total revenue and vice versa for the inelastic region.

There are other elasticities. Income elasticity is the percentage change in quantity demanded divided by percentage change in income. Likewise, cross price elasticity is the percentage change in the quantity demanded divided by the percentage change in the price of another good (a substitute or complement).

A buyer who faces a significant cost of switching from product A to product B is said to be 'locked-in' to product A. Say that the cost to a buyer of switching from one long distance carrier to another is $100. Imagine also that the firm has mechanisms of charging different fees to different groups of customers. Then the carrier firm could raise prices to that customer above the prices of other firms until the present value of all future price premiums is $99. The firm can extract value from the customer approxiamately equal to the cost of switching.

It is common in these situations for firms to offer a discount for a a product until the customer is locked-in and then begin extracting the value of that lock-in. Think for instance of the plethora of 'introductory offers' that we see for providers of information services from magazines, through software companies, through internet service providers. It is also common for makers of durable products like aircraft engines or inkjet printers to offer the hardware at cost or below cost. Premiums can then be charged for spare parts and inkjet cartridges because once the hardware is purchased the cost of switching is high.

In economics 'marginal' always refers to the last or 'incremental' unit. Marginal value is the value to a consumer of the last unit of consumption. In an industry demand curve it is the value of the good to the consumer who bought the good but receives the lowest value from consumption. That is, the value to the consumer of the first unit that would no longer be purchased if the price rose.

Any system is in equilibrium when the forces that drive the system are balanced. If one of those forces changes then the system goes into a transitory state before reaching equilibrium of balanced forces (unless the system is unstable). In a market setting competitive forces are in balance in equilibrium. The buyers compete for supply and sellers compete for sales. If an unconstrained market, prices and quantities adjust to bring competitive forces into balance. The buyers all have the same marginal value of consumption and the sellers all have the same marginal cost of production. A market equilibrium is described by the price of the product and the volume sold (P,Q).

The total value of the equity of a publicly traded corporation implied by its stock price. Market capitalization is the number of shares issued by a firm times the price of each share. For instance, stock ABC has a market capitalization of $2 billion if it has 40 million issued shares which are currently trading at $50 each.

A firm with market power can change the volume of its sales by changing the price. Every firm faces a demand curve for its product. The firm's demand curve is different to the industry demand curve which is the total amount demanded from all firms at a particular price. A firm in a competitive industry faces a flat demand curve for its product (even though the industry demand curve is downward sloping). Competitive industry firms are price takers because they cannot raise the price of their output above the market price without the demand for their output falling to zero. Commodity producers, like wheat growers, are the purest example of price takers and have no market power.

A firm with market power faces a downward sloping demand curve for its output. A price cut will increase demand for its output and likewise a price increase will decrease it. A firm with market power is a price seeker. The firm sets (seeks for) the price that maximizes profits (or more precisely maximizes the value of the firm).

In a market in which there is only one buyer and no threat of entry of new buyers the single buyer has a monopsony over purchases. It is the buy-side analog of a monopoly. Monopoly and monopsony often go hand in hand. A single produce of a product will have monopsony power over inputs that are specific to that product. Monopsonies occur in labor markets, such as sports markets and towns where there is a single large employer.

Average total cost of a firm's production is the total cost divided by the number of units produced. If we graph average total cost (ATC) on the y axis and the level of output on the x axis then for most firms we get a U shaped graph. Gains from scale reduce average total cost over some range, but eventually problems with increasing scale lead to ATC that increases with higher levels of output. In a competitive industry prices are driven down by entry of new firms until the marginal firm (highest cost firm) is operating at the minimum of the ATC curve. If all firms have roughly the same cost curves then the number of firms in the industry is the total number of units demanded in the industry divided by the quantity at which the minimum of the ATC curve is reached. If total demand for fish is 1 million pounds and boats have lowest ATC at 8,000 pounds then in the long run there are 125 boats in the industry.

But what happens if there is no minimum to the ATC curve? That is, the average cost just keeps falling no matter how much is produced. In that case a natural monopoly exists. This is true of many utility providers such as water companies and electricity distributors. Fixed costs are everything. The more consumers that are connected to the distribution network, the lower are the costs per household. Firms with continuously decreasing average total costs are called natural monopolies because the monopoly does not arise from barriers to entry but instead arises from the cost structure.

Net present value (NPV) is the value of a stream of cashflows are discounting the value of the cashflows for time and risk. Imagine the typical project scenario in which outlays are made over a period of time to get the project going and then at some point if the project is successful cashflow turns from negative outlays to positive inflows. Also observe that a cashflows are worth less further away they are in time and more risky they are. If we adjust (discount) all the cashflows for time and risk and then sum them up the total is net present value. The 'net' part recognizes that some cashflows are positive and some are negative.

Managers and entrepeneurs create value by identifying projects that have positive net present value. The net present value of a project is essentially the excess of value of output over the cost of inputs where ALL costs of inputs are recognized, including the time and risk cost of capital. The net present value of a project is the value created by the project.

In an economically efficient market the total quantity produced is the amount at which the highest price that any buyer would pay for one more unit is equal to the lowest price that any seller would produce that last unit for. If the production level is higher or lower than this efficient level of output then we have an output level inefficiency. If the output level is higher or lower than the efficient level due to some market imperfection like fixed prices, fixed output, market power of sellers or buyers, taxes, tariffs etc. then value is destroyed. The destroyed value is then known as deadweight loss.

Price discrimination can occur in two ways. Firstly, a firm can charge a consumer different prices for different units of consumption. For instance, $10 for the first 5 music CDs and $4.99 for each additional CD (plus shipping and handling of course). Firms with market power use multi-part pricing schemes to try to capture consumer surplus and therefore increase their producer surplus.

Secondly, a firm may segment its market into two or more groups of consumers on the basis of their elasticity of demand for the firm's product. Then to maximize profit the firm sets the prices offered to the groups such that the marginal revenue from each group is the same. For instance, airlines offer higher fares to the group of travellers who have inelastic demand (business air travelers) and lower fares to those with elastic demand (vacation travelers). The marginal costs are the same for each group, so to maximize profit, the marginal revenues from each group should be equated. But this means that they are charged different prices (because their marginal revenue curves have different slopes). To conduct this type of price discrimination effectively, the firm must be able to prevent the groups from exchanging the product.

There is a great variety in the way that prices are formed. The equilibration of supply and demand drive prices to an equilibrium in every market. However, the means by which demand is aggregated over demanders and over suppliers varies a great deal. Suppliers may modulate price and / or quantity. Or there may be an auction process by which demand information is aggregated. Or there may be dealers holding inventory and adjusting bid and ask prices. Or prices may be set by government fiat. Each of these is a price formation process. Price formation is studied in the field of market microstructure, the study of markets at the level of individual transactions.

Also known as price setters. Firms that have market power face a downward sloping demand curve for their product (as opposed to the industry demand curve which relates price to the output of all firms). Ideally firms will set the price of their output to maximize profits (more precisely, to maximize the value of the equity of the firm). However, to set the value maximizing price of output the firm needs to know the demand schedule that it faces and that is difficult to determine. Instead the firm may undertake price adjustments (price seeking) to get to the optimal price.

Firms in competitive industries have no control over the price of their product. If they raise the price above the market price then demand for their output will fall to zero. If they reduce price below the industry level then they can essentially sell any amount of the product. Commodity markets provide the purest examples of price takers. Think, for example, of how much control a gold miner has over the price at which it can sell its output. See also price seekers.

The of a particular firm is total revenue less the total variable costs. The sum of the surplus of each producer is the market producer surplus.

In evaluating any project there are three choices: reject the project, proceed immediately, or delay the decision until some uncertainty over the value of the project is resolved. The option to delay the project is termed a 'real option' because the it is an option over real rather than financial assets. However, in general useage 'real option' has come to mean the option to delay a decision until uncertainty is resolved.

A supply curve is also called a supply schedule. It is the amount supplied at each price. It slopes upward when price is drawn on the y axis and quantity demanded is on the x axis. A supply curve is only meaningful in an industry in which firms are price takers; that is, a competitive industry. All firms set output such that marginal revenue equals marginal cost (MR=MC). For a firm in a competitive industry the additional revenue from selling one more unit of output is simply the market price, so that P=MC. Therefore, for prices above which the firm will shut down, the competitive firm's supply curve is its MC curve. Summing up the supply curves of the industries's firms gives the total amount that all firms will supply at each price, which is the industry supply curve.

When a supply curve is drawn we are implicitly holding several other quantities constant: such as, the price of inputs, and the price of substitutes. For instance, if we draw the supply curve for concrete and the price of lime goes up then the quantity of concrete supplied at each price will fall. That is the same as saying that the supply curve for concrete will shift to the left.

Every product has different degrees of substitutes. Corn syrup is a close substitute for cane sugar. Aspartemine and saccharine are also substitutes but not as close as corn syrup. To account for these degrees of substitutibility, substitutes are defined in terms of cross elasticity of demand. If we divide the percentage change in cane sugar demanded by the percentage change in the price of corn syrup then we get a positive number (negative if they were complements) which measures the closeness of substitution. The equivalent calculation for an increase in the price of aspartemine would yield a lower figure.

The cost of exchanging the ownership of a consumer good, capital good, financial claim etc. Transactions costs are not confined to physical costs, such as the cost of transport, legal costs or of clearing a share purchase. They also include costs arising from moral hazard, adverse selection and other information asymmetries. In many markets, particularly financial markets, the costs arising from information asymmetry dominate other costs and determine the nature of transactions and intermediation between buyers and sellers.

The process of separating one product into separate constituent products. Many products that are consumed as complements are bundled as a form of price discrimination, such as cheap airline tickets and vacation hotel accommodation. Business travelers are excluded from the cheap airfares by the bundling. Services may also be bundled to command producer rents. For instance, by an optician who bundles a contact lens eye exam with purchase of the first pair of lenses. The optician could previously bundle the service and product to command a rent from being in the contact lens distribution channel. But not any more because contact lenses can be purchased on websites - leading to unbundling of the eye exam and contact lens purchase.

Costs that are a function of the level of production. For instance, labor, parts, electricity, bank loans etc. See also fixed costs.