1

Economic Decision Makers

CHAPTER

4

© 2003 South-Western/Thomson Learning

2

Households

Play the major role in U.S. economyFirst, they demand goods and services from the product market thereby help determine what gets producedSecond, they supply the resources to resource markets thereby make what gets produced

Householder: The key decision maker in the household

3

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

Improved farm productivity and the growth of urban factories increased the demand for factory labor and the movement from rural to urban America began

4

HouseholdsAnother dramatic change has been the increase of women in the labor force

The increased opportunity cost of working in the home because of higher wages has led to the current situation where more than half of married women with children are in the labor force less production takes place in the home and the female labor participation rate has increased

5

HouseholdsThe rise of two-earner households has affected the family as an economic unit

Less production occurs in the home, and more goods and services are demanded from the market

It has also reduce the advantages of specialization within the household

6

Households Maximize Utility We assume that people attempt to maximize their level of satisfaction, sense of well being, or overall welfare utility

Households, like other decision makers, are viewed as rational they try to act in the best interest of the household and would not deliberately make choices that are likely to make them worse off

7

Households as Resource Suppliers

Households use their limited resources to satisfy their unlimited wants

These resources can be used to produce goods and services in the home or sold in the resource market and the income used to buy goods and services in the product market

Exhibit 1 shows the sources of personal income in 2000, when personal income totaled about $8 trillion

8

Exhibit 1a: Sources of U.S. Personal Income in 2000

Wages and Salaries64%

Personal Interest

13%

Transfe

r Pay

men

ts

8%

Proprietors Income

8%Dividends 5%

Rental Income 2%

Nearly two thirds of personal income in 2000 was labor income.

9

Households as Resource Suppliers

Those in political power have made the decision that individuals who cannot provide for themselves should receive assistance from the government in the form of transfer payments

Transfer payments are cash or in-kind benefits given to individuals as outright grants from the governmentCash 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

10

Households as Demanders of Goods and Services

On average, about 81 percent of U.S. personal income goes to personal consumption, about 3 percent is saved, and 16 percent goes for taxes

Personal consumption commonly divided into three categories as can be seen in other panel of Exhibit 1

11

Exhibit 1b: Spending of Personal Income

Durable goods are designed to last three years or more: automobiles, appliances, etc.

Services 47%

Nondurable goods 24%

Durable goods 10%

Taxes 16%

Other 3%

Services such as haircuts and medical care account for the largest share and is the fastest growing category.

Nondurable goodsare items such as food and clothing.

Nearly one-half of personal income in 2000 was spent on services.

12

The Evolution of the FirmWhile it is true that the individual consumer could undertake the process of negotiating with all the necessary parties to produce a particular product

It is also true that the resulting transaction costs could easily erase the gains from specialization

Thus, in behooves the individual consumer to pay someone to undertake all these tasks – the entrepreneur who organizes the production process and reduces transaction costs

13

The Evolution of the FirmFor about 200 years, profit-seeking entrepreneurs relied on “putting out” raw material in what came to be known as the cottage industry system because the production process took place in the workers’ cottages

As the British economy expanded in the 18th century, entrepreneurs began organizing the various stages of production under one roof

14

The Evolution of the FirmThe combination of technological advances which increased worker productivity and contributed to the shift of employment from rural to urban areasWork became organized in large, centrally powered factories that

Promoted a more efficient division of laborAllowed for the direct supervision of productionReduced transportation costsFacilitated the use of machines far bigger than anything that had been used in the home

15

The Evolution of the FirmThis transformation process is generally referred to as the Industrial RevolutionProduction evolved from self-sufficient rural households to the cottage industry, to the current system of handling production under one roofFirms are economic units formed by profit-seeking entrepreneurs who combine the resources to produce goods and services

We assume firms attempt to maximize profits entrepreneur’s reward = revenue minus cost of production

16

Why Does Some Household Production Still Exist?

Why hasn’t all production shifted to firms?

Some activities require few skills or specialized resourcesHousehold production avoids taxes • that is, the tax free nature of do it yourself

activity favors household production over market transactions

17

Why Does Some Household Production Still Exist?

Why hasn’t all production shifted to firms?Household production has lower transaction costs• For example, if we want our house painted we could get

bids from contractors, hire a contractor, negotiate terms, and monitor job performance. All of these tasks take time and require information

• Doing the job yourself reduces these transaction costs and allows for more personal control over the final product

Finally, various technological advances – dishwashers, microwave ovens, PC’s, and so on – have all made household work more attractive

18

Types of Firms: Sole Proprietorship

Are approximately 25 million for-profit businesses in the United States which are organized in one of three waysSimplest form of business is the sole proprietorship which is a firm with a single owner who has the right to all profits complete controlDisadvantages

Unlimited liability for any business debts and can in fact lose personal assetsGoes out of business upon the death of the proprietor

19

Partnership

Partnership is a firm with multiple owners who share the firms profits

Commonplace in law, accounting, and medical practice

Often easier to raise sufficient funds to get the business going than with a sole proprietorshipDisadvantages

Each partner usually faces unlimited liability for all the the debts and claims against the partnershipThe death or departure of one partner may force costly reorganization

20

Corporation

Corporation is a legal entity owned by stockholders

AdvantagesFirst, and most important is that this is the easiest way to raise capital fundsSecond, stockholders have limited liability their liability for any losses is limited to the value of their stockThird, corporation has a life apart from its owners

21

CorporationDisadvantages

Stockholder’s ability to influence corporate policy is limited to voting for a board of directors. Each share of stock normally carries only one voteSecond, corporate income is taxed twice: first as corporate profits and second as stockholder income, either as corporate dividends or as realized capital gains

• Realized 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

22

Subchapter S Corporation

Subchapter S corporation is a hybrid that takes advantage of the limited liability feature of the corporate structure but has the additional advantage that is income is only taxed once as profits

Limited to no more than 35 stockholders

23

Exhibit 2: Number and Sales of Each Type of Firm

Corporations20%

SoleProprietorships

73%

Partnerships7%

Sole Proprietorships5%

Partnerships7%

Corporations88%

Corporations make up only 20% of all U.S. businesses but account for 88% of all sales. Sole proprietorships make up 73% of all U.S. businesses but account for only 5% of all sales.

Percentages of Sales by Type

Percentages by Type

24

Nonprofit Firms

Private organizations that do not have profit as an explicit objective

However, even nonprofit institutions have to generate enough revenue to pay for the resources they use

More apt title would be non taxpaying institutions

25

Government

Unrestrained operation of markets sometimes yield undesirable results

Too many of some goods and too few of other goods may be produced

Sources of market failure and how society’s overall welfare could at times be improved through government intervention

26

Government

Role of GovernmentEstablishing and enforcing the rules of the gamePromoting competitionRegulating natural monopoliesProviding public goodsDealing with externalitiesMore equal distribution of incomeFull employment, price stability, and economic growth

27

The Rules Of The GameMarkets efficiency depends on individuals having some confidence that they can use the resources they own to maximize their utilityGovernments play a role in safeguarding private property and in enforcing contracts through a judicial systemMore generally, governments try to make sure that market participants play fair and abide by the “rules of the game” as set forth by the participants through laws, customs and conventions

28

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

29

Regulating Natural Monopolies

Competition normally keeps the product price lower than it is when the product is sold by a monopolyMonopoly is a sole producer of a product for which there are no close substitutesIn some instances, however, a monopoly can produce and sell the product for less than could several competing firmsWhen it is cheaper for one firm to serve the market than for two or more firms to do so, that firm is called a natural monopoly

30

Regulating Natural MonopoliesNatural monopoly: one firm that can serve the entire market at a lower per- unit cost than can two or more firms

Since a natural monopoly faces no competition, it maximizes profit by charging a price higher than is optimal from society’s point of view government usually regulates these firms

31

Providing Public GoodsPrivate goods have two important features

First, private goods are rival in consumption the amount consumed by one person is unavailable for others to consumerSecond, the supplier of a private good can easily exclude those who fail to pay private goods are exclusive

By way of contrast, public goods are goods that once produced, are available for all to consume, regardless of who pays and who does not

32

Providing Public GoodsThus, one person’s consumption does not diminish the amount available to others they are non-rival in consumptionFurthermore, once produced, public goods are available to all they are non-exclusive suppliers cannot easily prevent consumption by those who fail to payBecause public goods are non-rival and non-exclusive, private sector firms cannot sell them profitably

33

Providing Public Goods

Conversely, government when providing these goods has the authority to collect taxes to finance public goods

National defense, system of justice, monetary system are all good examples of public goods

34

Dealing With ExternalitiesMarket prices reflect the private costs and benefits of producers and consumers

In some instances production or consumption imposes costs or confers benefits on third parties who are not a part of the market transaction

Because these costs or benefits are outside or external to market activity, they are called externalities

35

Dealing With ExternalitiesExternality 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

36

Dealing With ExternalitiesBecause market prices do not reflect externalities, governments often employ taxes, subsidies, and regulations to discourage negative externalities and encourage positive externalities

However, one should be aware that there is no guarantee that government will actually improve these situations

37

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

Many agree that society should redistribute income to the poor

Note the normative nature of this statement

38

A More Equal Distribution Of Income

There are vast differences of opinion in deciding a number of issues

How much should be redistributed?

What form should it take?

Who should receive the benefits?

How long should those benefits continue?

39

Full Employment, Price Stability, And Economic Growth

Through its ability to tax and spend and its control of the money supply, government attempts to promote full employment, price stability, and an adequate rate of economic growthFiscal policy refers to the use of government purchases, transfer payments, taxes, and borrowing to influence aggregate economic activityMonetary policy refers to regulation of the money supply in order to influence aggregate economic activity

40

Government’s Structure and Objectives

In U.S., we have a federal system of government responsibilities are shared across levels of government

As the system has evolvedFederal government has assumed primary responsibility for national security and the stability of the economyState government for public higher education, prisons, and with aid from the federal government, highways and welfareLocal government responsibilities include primary and secondary education, police and fire protection

41

Defining Government Objectives

What do government decision makers attempt to maximize?

One of the problems is that our federal system consists over over 80,000 separate jurisdictions

Second, complicating factor is that the separation of powers between the executive, legislative, and judicial branches, likely means that there is no single, consistent decision maker

42

Defining Government Objectives

Third, even within the executive branch of government, there are many agencies and bureaus that at times seem to work at cross purposesGiven these problems, about the only hypothesis that can be suggested is that elected officials try to maximize the number of votes they will get in the next electionWhich then hopefully guides the decisions of elected officials who in turn control government employees

43

Voluntary Exchange Versus Coercion

Unquestionably, the biggest difference between government and the market is that the market relies on the VOLUNTARY behavior of buyers and sellersConversely, by its very nature, any voting rule and any governmental body involves or employs some element of coercionWhich, in turn, implies that there are some who are likely to disagree with the solutions adopted by governmental bodies

44

No Market PricesAnother distinguishing feature of governments is that the selling price of public output is usually either zero or some amount below its costSince the revenue side of the government budget is separate from the expenditure sideThere is no necessary link between the cost and benefit of a public program or goodBy way of contrast, in the private sector, marginal benefits are at least equal to marginal costs

45

Size and Growth of Government

One of most useful ways to track the role of government over time is to compare government spending to gross domestic product, or GDP

GDP is the total value of all final goods and services produced in the United StatesIn 1929, the year the Great Depression began, government spending, mostly by state and local governments, totaled about 10% of GDPBy 1992, government spending was 35 percent of GDPBy 2000 government outlays were 29% of GDP

46

Size and Growth of Government

Government outlays relative to GDP in other countries

38% in Japan, the United Kingdom, and Canada43% in Germany47% in Italy51% in FranceIn the 36 largest industrial economies, the average was 36% of GDP in 2000

Composition of Federal outlays in Exhibit 3

47

Exhibit 3: Redistribution and Defense as Shares of Federal Outlays Since 1960

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1960 1965 1970 1975 1980 1985 1990 1995 2000

Per

cent

of

Fed

eral

Out

lays

Defense

Net Interest

Redistribution

All Other Outlays

48

Sources of Government Revenue

Taxes are by far the largest source of revenue at all levels of government

Federal government relies primarily on the individual income tax, state governments on income and sales taxes and local government on the property tax

Exhibit 4 provides some detail on the composition of Federal revenues

49

0

10

20

30

40

50

60

70

80

90

100

1960 1965 1970 1975 1980 1985 1990 1995 2000

Exhibit 4: Federal Government Receipts

Individual Income Taxes

All Other Revenue

Corporate Income Taxes

Payroll Taxes

Per

cen

t of

Fed

eral

Rev

enu

e

50

Tax Principles

The structure of a tax system is often justified on the basis of one or two general principles

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

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

51

Tax Incidence

Tax incidence indicates who actually bears the burden of a tax

The most common way of evaluating tax incidence is by measuring the tax as a percentage of income

Proportional taxationProgressive taxationRegressive taxation

52

Tax Incidence

Proportional taxTaxpayers at all income levels pay the same percentage of their income in taxesAlso called a flat tax since the tax as a percentage of income remains constant as income changes

ProgressiveThe percentage of income paid in taxes increases as income increases

RegressiveThe percentage of income paid in taxes decreases as income increases

53

Marginal Tax RateMarginal 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

54

Rest of the WorldConsists of the households, firms, and governments in more than 200 sovereign countries throughout 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

55

Rest of the World

In 1970, U.S. exports of goods and services accounted for only 6 percent of gross domestic product and has more than doubled to 14 percent since

Chief trading partners in order of importance are Canada, Japan, Mexico, Great Britain, Germany, France, Korea, and Taiwan

Merchandise trade balance equals the value of a country’s exported goods minus the value of its imported goods during a given time period

56

Rest of the WorldImportant to note that the merchandise trade balance distinguishes between goods and servicesFor the last two decades, the United States has experienced a merchandise trade deficit the value of goods imported into the U.S. has exceeded the value of U.S. goods exportedWhich, in turn, implies that this deficit must be offset by a surplus in one or more of the other balance-of-payments accounts

57

Rest of the World

Balance of payments refers to a record of all economic transactions between residents of one country and residents of the rest of the world during a given time period

58

Exchange Rates

The lack of a common currency complicates trade between countries

Thus, to facilitate trade when two currencies are involved, a market for foreign exchange has developed

Foreign exchange is a foreign currency needed to carry out international transactions

59

Exchange Rates

The supply and demand for foreign exchange come together in foreign exchange markets to determine the equilibrium exchange rate between two countries

The exchange rate measures the price of one currency in terms of another

60

Exchange RatesFor example, the exchange rate between the euro and the dollar might indicate that one euro exchanges for $0.90At this exchange rate, a Porsche selling for 100,000 euros would cost an American consumer $90,000 The 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

61

Trade RestrictionsWhile there are clear gains to be achieved from international specialization and exchange, nearly all countries impose restrictions of this flow of goods and services

These restrictions can take one of three forms

Tariffs which is a tax on imports or exportsQuotas are legal limits on the quantity of a particular good that can be imported

62

Trade RestrictionsOther restrictions such as voluntary

restrictions, for example the voluntary agreement by Japanese automobile manufacturers to limit their exports to the United States

Might be worthwhile asking, why, if international trade is mutually beneficial, do most countries restrict this free flow of goods?

Restrictions benefit domestic producers of these goods these groups of producers will lobby governments for these benefits while domestic consumers are generally unaware of this fact