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Economic Decision Makers

Chapter 3

© 2006 Thomson/South-Western

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Households

Demand goods and services from the product market thereby help determine what gets produced

Supply the resources to resource markets thereby make what gets produced

When U.S. was an agricultural economy, a farm household was largely self-sufficient they produced what they consumed and consumed what they produced

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Households

Shifts from agricultural economy to industrial economy Improved farm productivity Growth of urban factories Increase in number of women in work force Rise of two earner families Increased opportunity cost of working at home Advantages of specialization in household of

declined

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Households Maximize Utility

People are assumed to try and maximize their level of satisfaction, sense of well being, or overall welfare utility Rational: act in the best interest of the household

Use their limited resources to satisfy their unlimited wants

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Households as Resource Suppliers

Over two-thirds of personal income comes from labor earnings

Certain individuals receive assistance from the government in the form of transfer payments: cash or in-kind benefits given to individuals as outright grants from the government Cash transfers are monetary payments: welfare

benefits, unemployment compensation, etc. In-kind transfers provide specific goods and services:

food stamps, Medicare, and Medicaid are all examples of in-kind transfers

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Exhibit 3-1(a) Nearly two-thirds of personal income in 2003 was labor income

63%

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Households as Demanders of Goods and Services

Personal income 81 percent for personal consumption 3 percent is saved 16 percent goes for taxes

Categories of spending Durable goods: last three or more years Nondurable goods: food, clothing Services: haircuts, medical care

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Exhibit 3-1(b) Half of Personal Income in 2003 was spent on services

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The Evolution of the Firm

Individual consumer could undertake the process of negotiating with all the necessary parties to produce a particular product Transaction costs could easily erase the gains from

specialization Behooves the individual consumer to pay someone

to undertake all these tasks Entrepreneur who organizes the production process

and reduces transaction costs Cottage industry putting out raw materials

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The Evolution of the Firm

Combination of technological advances, increased worker productivity led to shift of employment from rural to urban areas

Work became organized in large, centrally powered factories that Promoted a more efficient division of labor Allowed for the direct supervision of production Reduced transportation costs Facilitated the use of machines far bigger than

anything that had been used in the homeIndustrial Revolution

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The Evolution of the Firm

Firms are economic units formed by profit-seeking entrepreneurs who combine the resources to produce goods and servicesWe assume firms attempt to maximize

profits entrepreneur’s reward = revenue minus cost of production

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Exhibit 3-2(a) Percentage of Firms by Type

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Exhibit 3-2(b) Percentage of Sales by Type

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Sole Proprietorship

Advantages Simplest Single owner who has the right to all profits –

complete controlDisadvantages

Unlimited liability for any business debts and can in fact lose personal assets

Goes out of business upon the death of the proprietor

Limited ability to raise capital

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Partnership

Multiple owners who share the firms profitsCommonplace in law, accounting, and medical

practiceAdvantage: Often easier to raise sufficient

funds to get the business going than with a sole proprietorship

Disadvantages: Each partner usually faces unlimited liability for all

the the debts and claims against the partnership The death or departure of one partner may force

costly reorganization

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Corporation

Legal entity owned by stockholders

Advantages First, and most important is that this is the easiest

way to raise capital funds Second, stockholders have limited liability their

liability for any losses is limited to the value of their stock

Third, corporation has a life apart from its owners

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Corporation

DisadvantagesStockholder’s ability to influence corporate

policy is limited to voting for a board of directors

Corporate income is taxed twice: first as corporate profits and second as stockholder income, either as corporate dividends or as realized capital gainsRealized capital gain is any increase in the

market value of a share that occurs between the time the share is purchased and the time it is sold

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Subchapter S Corporations and Nonprofit Organizations

Subchapter S corporation Hybrid that takes advantage of the limited liability

feature of the corporate structure but has the Income is only taxed once as profits Limited to no more than 35 stockholders

Nonprofit Organizations Do not have profit as explicit objective Have to generate enough revenue to pay bills Non-taxpaying entities

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Why Does Some Household Production Still Exist?

No skills or specialized resources requiredHousehold production avoids taxes

Tax free nature of do it yourself activity favors household production over market transactions

Reduces transaction costsVarious technological advances have

increased household productivity

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Role of Government

Role of Government Establishing and enforcing the rules of the game Promoting competition Regulating natural monopolies Providing public goods Dealing with externalities More equal distribution of income Full employment, price stability, and economic

growth

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Exhibit 3: Redistribution has Grown and Defense has Declined

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The Rules Of The Game

Efficiency depends on individual confidence that they can use the resources they own to maximize their utility

Governments Safeguarding private property Enforce contracts through the judicial system

Market participants play by the “rules of the game” as set forth by the participants through laws, customs and conventions

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Promoting Competition

Although the “invisible hand” of competition usually promotes an efficient allocation of resources, it is reasonable to believe that some firms try to avoid competition through collusion

Government antitrust laws try to promote competition by prohibiting collusion and other anticompetitive practices

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Regulating Natural Monopolies

Monopoly is a sole producer of a product for which there are no close substitutes

In some instances a monopoly can produce and sell the product for less than could several competing firms

Natural monopoly One firm that can serve the entire market at a lower

per- unit cost than can two or more firms Maximizes profit by charging a price higher than is

optimal from society’s point of view government usually regulates these firms

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Providing Public Goods

Private goods Rival in consumption: the amount consumed by one

person is unavailable for others to consumer Suppliers can easily exclude those who fail to pay –

private goods are exclusivePublic goods

Nonrival in consumption: one person’s consumption does not diminish the amount available to others

Nonexclusive: sellers cannot easily exclude nonpayers Government uses taxing power to finance these goods National Defense and Judicial System are good examples

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Dealing With Externalities

Market prices reflect the private costs and benefits of producers and consumers

Externality is a cost or benefit that falls on third parties and is therefore ignored by the two parties to the market transaction Negative externality imposes a cost on third parties

– pollution, jet noise, and auto emissions are all good examples of negative externalities

Positive externality confers benefits on third parties – inoculations and education are goods that are felt to convey positive externalities

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A More Equal Distribution Of Income

Resource markets do not guarantee each household even a minimum level of income

Transfer payments reflect in an society’s attempt to provide a basic standard of living to all individuals

Key Issues How much should be redistributed? What form should it take? Who should receive the benefits? How long should the benefits continue?

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Full Employment, Price Stability, And Economic Growth

Fiscal policy refers to the use of government purchases, transfer payments, taxes, and borrowing to influence aggregate economic activity

Monetary policy refers to regulation of the money supply in order to influence aggregate economic activity

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Government’s Structure and Objectives

Federal system of government: shared responsibilities Federal government has assumed primary

responsibility for national security and the stability of the economy

State government for public higher education, prisons, and with aid from the federal government, highways and welfare

Local government responsibilities include primary and secondary education, police and fire protection

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Defining Government Objectives

What do government decision makers attempt to maximize?

Problems 87,000 separate jurisdictions Separation of powers between the executive, legislative,

and judicial branches: no single, consistent decision maker

Agencies and bureaus may work at cross purposes

Elected officials try to maximize the probability of getting elected

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Voluntary Exchange Versus Coercion

Biggest difference between government and the market is that the market relies on the VOLUNTARY behavior of buyers and sellers

Conversely, by its very nature, any voting rule and any governmental body involves or employs some element of coercion

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No Market Prices

Selling price of public output is usually either zero or some amount below its cost

Because the revenue side of the government budget is separate from the expenditure side, no necessary link between the cost and benefit of a public program or good

In the private sector, marginal benefits are at least equal to marginal costs

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Size and Growth of Government

Comparison of government spending to gross domestic product, or GDP GDP is the total value of all final goods and services

produced in the United States In 1929, the year the Great Depression began,

government spending, mostly by state and local governments, totaled about 10% of GDP

By 2004 government outlays were 36% of GDP 38% in Japan, the United Kingdom, and Canada,

43% in Germany, 47% in Italy, 51% in France

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Sources of Government Revenue

Taxes are largest source of revenue at all levels of government

Largest source for Federal government is individual income tax

State governments rely on income and sales taxes

Local government rely on the property tax

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Exhibit 4: Payroll Taxes Have Grown as a Share of Federal Revenue

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Tax Principles

Structure of a tax system is based on one of two general principles

Ability-to-pay principle based on premise that those with a greater ability to pay should pay more tax

Benefits-received tax principle based on premise that those who receive more benefits from the government program funded by a tax should pay more tax

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Tax Incidence

Tax incidence indicates who actually bears the burden of a tax

Most common way of evaluating tax incidence is by measuring the tax as a percentage of income Proportional taxation Progressive taxation Regressive taxation

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Tax Incidence

Proportional tax Taxpayers at all income levels pay the same

percentage of their income in taxes Also called a flat tax since the tax as a percentage of

income remains constant as income changesProgressive

The percentage of income paid in taxes increases as income increases

Regressive The percentage of income paid in taxes decreases as

income increases

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Marginal Tax Rate

Marginal tax rate measures the percentage of each additional dollar of income, assuming this is the appropriate base, that is paid as taxes

MTR = Δ Tax Liability / Δ Income

Key here is that high marginal tax rates reduce the after tax return from working or investing – incentives to work or invest are reduced

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Exhibit 5: Top Marginal Tax Rate on Personal Income Since 1913

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Rest of the World

International trade arises for the same reason as individual trade the opportunity cost of producing specific goods differ among countries

International trade is becoming an increasingly large force in the U.S. economy Exports have doubled since 1970 Largest customers are Canada, Japan, Mexico,

Great Britain, Germany, France, South Korea & Taiwan

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Rest of the World

Merchandise trade balance = the value of a country’s exported goods minus the value of its imported goods during a given time period Distinguishes between goods and services U.S. has experienced a merchandise trade deficit:

the value of goods imported has exceeded the value of goods exported

Deficit must be offset by a surplus in one or more of the other balance-of-payments accounts

Balance of payments Record of all economic transactions between

residents of one country and residents of the rest of the world during a given time period

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Exchange Rates

Lack of a common currency complicates trade between countries a market for foreign exchange has developed

Foreign exchange is a foreign currency needed to carry out international transactions Supply and demand for foreign exchange determine

the equilibrium exchange rate between two countries

Exchange rate measures the price of one currency in terms of another

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Exchange Rates

For example, the exchange rate between the euro and the dollar might indicate that one euro exchanges for $1.10 At this exchange rate, a Porsche selling for 100,000

euros would cost an American consumer $110,000

Exchange rate affects the prices of imports and exports and helps shape the flow of foreign trade The greater the demand for a particular foreign

currency or the smaller its supply, the higher its exchange rate

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Trade Restrictions

Nearly all countries impose restrictions of this flow of goods and services

These restrictions can take one of three formsTariffs which is a tax on imports or exportsQuotas are legal limits on the quantity of a

particular good that can be importedVoluntary agreements