Dictionary - Accounting Profit

Definition

A company's total revenue minus its total explicit costs.

Example

Assume a carpenter produces 1'000 chairs, which he then sells at a price of $100 each. His total revenue will add up to $100'000. If he faces total costs of $60'000, accounting profit will amount to $40'000 ($100'000 - $60'000).

Relevance

As the name suggests accounting profit is an essential part of accounting. It is used to provide a true and fair view of the results of a company's operations. However it is important to note that accounting profit does not include implicit costs (such as opportunity costs), as a result it is usually a bit higher than economic profit.

Dictionary - Adverse Selection

Definition

A situation where asymmetric information (between buyers and sellers) causes unwanted results, because the unobserved attributes lead to an undesirable selection from the perspective of the uninformed party.

Example

A good example of adverse selection is the market for health insurance. In this market, the buyers know more about their health issues than the sellers. However both buyers and sellers know that people with health problems are more likely to get insurance than healthy people. Therefore the price of insurance will be set higher than necessary for average customers. As a result this will discourage healthy people from getting insurance and thereby intensify the adverse selection.

Relevance

Because of its self-reinforcing nature, adverse selection can have significant negative effects on markets or entire industries (such as the insurance industry). Without interventions it results in a vicious circle of increasing risks for sellers or decreasing quality of goods and services for customers.

Dictionary - Business Cycle

Definition

Often irregular and mostly unpredictable fluctuations (i.e. expansions or recessions) in economic activity experienced in an economy over a certain period of time. 

Example

As the economy expands, unemployment decreases while income and as spending increase. Once the expansion reaches its maximum, productivity starts to decline which results in higher unemployment, lower income, and lower spending. The economy falls into a recession. 

However after some time, the productivity will slowly rise again, which will lead to lower unemployment and rising income again. Hence, the next business cycle begins.

Relevance

Knowledge about the different states of an economy and their timing is a crucial aspect for governments and other policy makers. By analyzing historical patterns of economic activity, the possible effects of government interventions can be assessed more precisely and future economic developments can be predicted more reliably.

Dictionary - Positive Consumption Externality

Definition

The positive effects on unrelated third parties that originate during the consumption of a good or service.

Example

A possible example could be your neighbor’s flower garden. She most likely cultivates the plants solely for her own pleasure, yet everybody can enjoy the beauty of the flowers whenever they walk by.

Relevance

Without any regulatory influence, positive externalities will not be taken into account by the causers. This results in a market failure and an undersupply of beneficial behavior, because the suppliers produce less than in an efficient market. Hence, regulations are needed to provide incentives and internalize the externalities.

Dictionary - Negative Consumption Externality

Definition

The negative effects on unrelated third parties that originate during the consumption a good or service.

Example

An example of a negative consumption externality could be your neighbor who likes to play loud music in the middle of the night and thereby prevents you from sleeping. He will not take this into account since he is not directly affected by your sleep deprivation.

Relevance

Without any regulatory influence, negative externalities will not be taken into account by the causers. This results in a market failure and an excess supply of harmful behavior, because the suppliers produce more than they would in an efficient market. Hence, regulations are needed to internalize the externalities.

Dictionary - Deadweight Loss

Definition

The decrease in overall social welfare in an economy that results from a market distortion. A deadweight loss occurs whenever there is no efficient market equilibrium.

Example

A common cause for deadweight losses is the imposition of a tax. If consumers have to pay a specific tax on ice cream, some of them will not be willing to pay the higher price and thus not buy anything. In other words, they won't make the purchases they would have made without the tax, which results in a loss of welfare for society.

Relevance

Since deadweight losses are caused by market distortions, virtually all government interventions (such as taxes, price ceilings, minimum wages, etc.) will result in a loss of social welfare. By looking at those deadweight losses, policy makers can compare the social costs of an intervention to the costs of existing inefficiencies. This allows to take actions that are in the best interest for society.

Dictionary - Economic Growth

Definition

The increase in the amount of goods and services that are produced in an economy over a certain period of time. Economic growth can be measured in nominal or real terms using the respective GDP (Gross Domestic Product). Nominal GDP accounts for the effects of inflation, whereas they are excluded in the real GDP.

Example

When productivity in an economy increases, more goods and services can be produced and sold over the same period of time. As a result, the economy grows and overall wealth increases. Economic growth is necessary because people generally want more commodities and a higher standard of living. Furthermore it is easier to redistribute wealth and advance new technologies while an economy is growing. 

Relevance

The principle of economic growth has become quite controversial in recent years. While many economists perceived the necessity of growth almost as a dogma, critics have become increasingly numerous. Since the global economies are continuously overexploiting natural and non-renewable resources, the idea of unlimited economic growth seems to be doomed  to fail at this point. It is important to be aware that after all economic growth is a means to an end and not an end in itself.

Dictionary - Fixed Costs

Definition

Costs that are constant irrespective of the quantity of output produced. Fixed costs have to be paid even if production is zero.

Example

The monthly rent an ice cream seller needs to pay for his store is a fixed cost (at least in the short run). The rent has to be paid regardless of production volume or economic activity. 

Relevance

Fixed costs are an important aspect when it comes to making production decisions. Since per unit fixed costs sink as output increases, companies with higher fixed costs are more likely to produce more (and vice versa).
Furthermore, fixed costs should also be considered when a company is struggling. As long as the firm can pay at least part of those costs from its revenue (even if it is still operating at a loss) it may be reasonable to stay in the market, since fixed costs would still need to be paid if the firm went out of business.

Dictionary - Gross Domestic Product (GDP)

Definition

The monetary value of all final goods and services produced within a country over a certain period of time (most commonly a year).

Example

Assume a country produces 5 cars (market price per unit: 2000$) and 4 motorcycles (market price per unit: 1000$). To keep things simple, there is no further production in the economy. 
Since GDP is defined as the monetary value of all final goods, we need to multiply the amount of cars and motorcycles with the respective market prices. This will result in a GDP of 14'000$ (5*2000 + 4*1000).

Relevance

GDP is a measure for economic activity, thus it allows to compare the economic performance of a country with other countries or over time. Therefore GDP is essential for policy makers, because it helps to take appropriate and justified decisions to support the economy when necessary.

Dictionary - Human Capital

Definition

The skills, talent, and knowledge that the employees of a company possess, measured in terms of economic value to the employer.

Example

Human capital can either be acquired from external sources or developed within an organization. This is usually done by recruiting new employees or providing on-the-job training and development programs for employees.

Relevance

Skilled and well-trained employees may result in a competitive advantage for companies. Therefore, it is essential for those firms to invest in their human capital to be successful in the long run. Furthermore, employees often request education opportunities, thus investing in human capital will positively affect their motivation.

Dictionary - Inflation

Definition

The rate at which the overall price level in an economy increases. Inflation causes a decrease in the purchasing power of money.

Example

Suppose the annual inflation rate of an economy is 5%. That means, on average a product (e.g. a shirt) that costs 10 $ this year, will cost 10.50 $ next year. As a result, the amount of goods you can buy with 10 $ decreases, thus purchasing power falls.

Relevance

Changes in price levels and purchasing power have significant implications for overall wealth and wealth distribution in an economy. A moderate level of inflation is generally accepted and taken as a sign of a growing economy. However if inflation is too high, people will eventually lose faith in the currency and the economy.

Dictionary - J Curve

Definition

A graphic representation of the initial increase in a country's trade deficit after a deprecation of its currency. 

Example

A deprecation of the local currency will temporarily result in a higher import volume than export volume. However, since (relatively speaking) the local goods and services become cheaper for other countries, the export volume will gradually increase and return to the initial level over time.

Relevance

The J curve can predict the economic effects of a decline in value of a currency. It suggests that a deprecation can actually result in a trade surplus for a country. This may in turn have significant implications on the measures taken by policy makers.

Dictionary - K-Percent Rule

Definition

A monetary theory (postulated by Milton Friedman) that states that in order to control inflation in the long run, central banks should grow the money supply by a set amount ("k-percent") each year.

Example

Usually, the "k variable" is set depending on GDP-growth (between 1-4%). By setting "k" slightly above GDP growth, economic activity can be stimulated, since the money supply grows faster than the overall value of the economy. To slow economic activity down, "k" should be set below GDP growth.

Relevance

A central bank's primary objective is to stabilize the economy. This also includes monitoring growth rates to make sure it does not grow too slowly or too quickly. Therefore, the K-percent rule is a useful tool to protect an economy from hyperinflation or deflation.

Dictionary - Liquidity

Definition

The degree to which an asset can be converted into the common medium of exchange of an economy without affecting its valuation.

Example

An example of a highly liquid asset could be publicly traded shares of a company. Those can be bought or sold at a moment's notice. A house on the other hand is not very liquid, as it will usually take some time to find a buyer who is willing to pay the right price. If you need to sell the house quickly, you will have to do so at a much lower price (i.e. a lower valuation).

Relevance

Liquidity is a crucial aspect for both firms and individuals in an economy. If the majority of their assets is rather illiquid, the risk of insolvency increases. Therefore it is essential to take liquidity into account at all times, and especially before taking investment decisions.

Dictionary - Macroeconomics

Definition

The study of the economy on an aggregate level. Macroeconomics looks at economy-wide phenomena and the economy as a whole.

Example

Some of he topics that are covered in macroeconomics include: Monetary and fiscal policy and its effects, taxes, interest rates economic trends, economic growth, trade and globalization.

Relevance

Macroeconomics is one of the two major branches of economic studies. By analyzing the behavior of the economy as a whole, it provides important information on economic coherences and allows to influence the economy to benefit society.

Dictionary - Microeconomics

Definition

The study of small economic units (households, firms, specific markets, etc.), their decision-making, and their interactions in the market. 

Example

Some of he topics that are covered in microeconomics include: consumer behavior (decision making, utility maximization), profit maximization of firms, supply and demand (for individual markets), externalities, and labor markets.

Relevance

Microeconomics is one of the two major branches of economic studies. By analyzing the behavior of individuals and firms, it provides important information on economic coherences and builds the foundation for further macroeconomic studies, as it provides the data to calculate aggregate variables.

Dictionary - Monopoly

Definition

A Monopoly is a market situation where a sinlgle firm (or individual) is the sole producer and seller of a product or service for an entire market.  Monopolies can arise because of specific resources, government regulations, costs of procution, or deliberate actions. They are characterized through a lack of competition, which results in lower production outputs and higher prices.

Example

When a pharmaceutical company creates a new drug, it can apply for a patent (i.e. the right to be the sole producer and seller of this drug for a limited time). If it is granted, the company becomes a monopolist for the patent period, which means entry to the market for other suppliers is prohibited.

Relevance

Due to the lack of competition, monopolies often result in higher prices, lower outputs and sometimes inferior quality, as compared to competitive markets. In reaction to that, the government can enact competition law, impose price regulations, nationalize the monopolies or, if the inefficiency is acceptable (or even desirable) for society, not do anything at all.

Dictionary - Natural Monopoly

Definition

A market situation where a single firm (or individual) is the sole producer and seller of a good or service for an entire market, because it faces lower costs of production than two or more producers would.

Example

In many countries, the railway system is operated by a natural monopolist. Due to the high costs for infrastructure and maintenance (tracks, power lines, etc.), it would be more costly for two or more firms to provide railway services.

Relevance

Due to the lack of competition, monopolies often result in higher prices, lower outputs and sometimes inferior quality, as compared to competitive markets. However, natural monopolies are sometimes in the best interest for society, as they are more efficient than a competitive situation. Therefore, natural monopolies may require different types of interventions than other monopolies.

Dictionary - Opportunity Cost

Definition

The value of the next best alternative that has been given up in order to get something. The foregone benefits one could have received by taking an alternative decision.

Example

Suppose you have 20$ in your piggy bank. You can either spend that money on a new t-shirt or buy your favorite band's new album. If you chose to buy a new t-shirt, your opportunity cost would be the value you forgo by not being able to buy and listen to the new album.

Relevance

Opportunity costs are one of the most basic and omnipresent principles in economics. Every time we take a decision, we face trade-offs and thus opportunity costs. It is important to be aware of the fact that choosing something also always means not choosing something else.

Dictionary - Negative Production Externality

Definition

The negative effects of economic activities that originate during the production process on unrelated third parties.

Example

The most common example of a negative production externality is the pollution caused by a firm during the production of their goods. Pollution affects the entire population, however as long as companies are not held accountable for their activities, they have no incentive to reduce their economic impact (since that would be more expensive).

Relevance

Without any regulatory influence, negative externalities will not be taken into account by the causers. This results in a market failure and an excess supply of harmful behavior, because the firms produce more than in an efficient market. Hence, regulations are needed to internalize externalities.