3C H A P T E R
Economic Decision
Makers
Learning OutcomesLO1 Explain the role of the household in an
economic system
LO2 Identify the different types of firms and describe their roles in the economy
LO3 Outline the ways governments affect their economies
LO4 Outline the international influences on an economy
CHAPTER 3 Economic Decision Makers 3 5
If we live in the age of specialization, then why haven’t specialists taken over all pro-duction? For example, why do most of us still do our own laundry and performdozens of other tasks for ourselves? In what sense has production moved from thehousehold to the firm and thenback to the household? If the“invisible hand” of competitivemarkets is so efficient, why doesgovernment get into the act?Answers to these and other ques-tions are addressed in this chapter,which discusses the four economicdecision makers: households,firms, governments, and the rest ofthe world.
To develop a better feel for how the economy works, you must get moreacquainted with the key players. You already know more about them than you mayrealize. You grew up in a household. You have dealt with firms all your life, from Sonyto Subway. You know much about governments, from taxes to public schools. Andyou have a growing awareness of the rest of the world, from online sites, to imports,to foreign travel.This chapter draws on your abundant personal experience with eco-nomic decision makers to consider their makeup and objectives.
TheHouseholdHouseholds play the star-ring role in a marketeconomy. Their demandfor goods and services deter-mines what gets produced.And their supplies of labor,capital, natural resources,
and entrepreneurial ability produce that output. As demanders of goods and servicesand suppliers of resources, households make all kinds of choices, such as what tobuy, how much to save, where to live, and where to work. Although a household usu-ally consists of several individuals, we will view each household as acting like a sin-gle decision maker.
Governments are effective managers of national economies.Strongly Disagree Strongly Agree1 2 3 4 5 6 7
What do youthink?
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“What happens to personal incomeonce it comes into the household?”
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Topics discussed inthis chapter include:
Evolution of the Market failures and governmenthousehold remedies
Evolution of the firm Taxing and public spending
Types of firms International trade and finance
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LO 1
Households produce less for themselves anddemand more from the market. For example, child-care services and fast-food restaurants have dis-placed some household production (Americansconsume about one-third of their calories away fromhome). The rise in two-earner families has reducedspecialization within the household—a central fea-ture of the farm family. Nonetheless, some produc-tion still occurs in the home, as we’ll explore later.
Households Maximize UtilityThere are more than 115 million U.S. households. Allthose who live together under one roof are consid-ered part of the same household. What exactly dohouseholds attempt to accomplish in making deci-sions? Economists assume that people try to maxi-mize their level of satisfaction, sense of well-being,happiness, and overall welfare. In short, householdsattempt to maximize utility. Households, like othereconomic decision makers, are viewed as rational,meaning that they try to act in their best interestsand do not deliberately make themselves lesshappy. Utility maximization depends on eachhousehold’s subjective goals, not on some objectivestandard. For example, some households maintainneat homes with well-groomed lawns; others paylittle attention to their homes and use their lawnsas junkyards.
The Evolution of the HouseholdIn earlier times, when the economy was primarilyagricultural, a farm household was largely self-suffi-cient. Each family member specialized in a specificfarm task—cooking meals, making clothes, tendinglivestock, planting crops, and so on. These earlyhouseholds produced what they consumed and con-sumed what they produced. With the introduction ofnew seed varieties, better fertilizers, and laborsavingmachinery, farm productivity increased sharply.Fewer farmers were needed to grow enough food tofeed a nation. At the same time, the growth of urbanfactories increased the demand for factory labor. As aresult, workers moved from farms to cities, wherethey became more specialized but less self-sufficient.
Households evolved in other ways. For example,in 1950, only about 15 percent of married womenwith young children were in the labor force. Sincethen, higher levels of education among women anda growing demand for their labor increased women’searnings, thus raising their opportunity cost ofworking in the home. This higher opportunity costcontributed to their growing labor force participa-
tion. Today 70 percent ofwomen with children under18 are in the labor force.
The rise of two-earnerhouseholds has affected thefamily as an economic unit.
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
Children under 6 Children 6 to 17
% of Married Women (with Children) Who Work
1960 1970 1980 1985 1990 1995 2000 2003 2004
39.0
18.6
49.2
30.3
62.0
45.1
68.0
53.4
73.6
58.9
76.2
63.5
77.2
62.8
77.0
59.8
75.6
59.3
70% of women withchildren under 18 are
in the labor force.
utilitythe satisfaction receivedfrom consumption;sense of well-being
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3 6 PART 1 Introduction to Economics
luck, some households have few resources that arevalued in the market. Society has made the politicaldecision that individuals in such circumstancesshould receive short-term public assistance.Consequently, the government gives some householdstransfer payments, which are outright grants. Cashtransfers are monetary payments, such as welfare ben-efits, Social Security, unemployment compensation,and disability benefits. In-kind transfers provide for spe-cific goods and services, such as food stamps, healthcare, and housing.
Households as Demanders of Goods and ServicesWhat happens to personal income once it comes intothe household? Most goes to personal consumption,which sorts into three broad spending categories: (1)durable goods—that is, goods expected to last three ormore years—such as an automobile or a refrigerator;(2) nondurable goods, such as food, clothing, and gaso-line; and (3) services, such as haircuts, air travel, andmedical care. As you can see from panel (b) of Exhibit1, spending on durable goodsin 2006 claimed 10 percent ofU.S. personal income; non-durables, 25 percent; andservices, 50 percent. Taxesclaimed 10 percent, and all
Households as Resource SuppliersHouseholds use their limited resources—labor, capi-tal, natural resources, and entrepreneurial ability—in an attempt to satisfy their unlimited wants. Theycan use these resources to produce goods and ser-vices in their homes. For example, they can preparemeals, mow the lawn, and fix a leaky faucet. Theycan also sell these resources in the resource marketand use the income to buy goods and services in theproduct market. The most valuable resource sold bymost households is labor.
Panel (a) of Exhibit 1 shows the sources of per-sonal income received by U.S. households in 2006,when personal income totaled $10.9 trillion. As youcan see, 61 percent of personal income came fromwages and salaries. A distant second was transferpayments (to be discussed next), at 14 percent of per-sonal income, followed by personal interest at 9 per-cent, and proprietors’ income also at 9 percent.Proprietors are people who work for themselves ratherthan for employers; farmers, plumbers, and doctorsare often self-employed. Proprietors’ income shouldalso be considered a form of labor income. Over two-thirds of personal income in the United States comes fromlabor earnings rather than from the ownership of otherresources such as capital or natural resources.
Because of a poor education, disability, discrimina-tion, time demands of caring for small children, or bad
Rental income(1%)
Dividends(6%)
Transfer payments
(14%)
Personal interest
(9%)
Wages and salaries(61%) Proprietors’
income (9%)
(a) Over two-thirds of personal income in 2006 was from wages, salaries, and proprietors’ income
Nondurablegoods(25%)
Durable goods(10%)
Other(5%)
Taxes(10%)
(b) Half of U.S. personal income in 2006 was spent on services
Services(50%)
Exhibit 1Where U.S. Personal Income Comes From and Where It Goes
SOURCE: Based on figures from Survey of Current Business, Bureau of Economic Analysis, February 2007, Tables 1.5.5 and 2.1. For the latest figures, go tohttp://www.bea.gov/scb/index.htm.
transfer paymentscash or in-kind benefitsgiven to individuals asoutright grants from thegovernment
CHAPTER 3 Economic Decision Makers 3 7
3 8 PART 1 Introduction to Economics
served as tiny factories, especially dur-ing winter months, when farmingchores were light (so the opportunitycost was low). This approach, which
came to be known as the cottageindustry system, still exists in
some parts of the world. Youmight think of this system aspart way between householdself-sufficiency and the
modern firm.As the British economy expanded in
the 18th century, entrepreneurs began organiz-ing the stages of production under one roof.
Technological developments, such as waterpowerand later steam power, increased the productivityof each worker and contributed to the shift ofemployment from rural areas to urban factories.Work, therefore, became organized in large, centrallypowered factories that (1) promoted a more efficient divi-sion of labor, (2) allowed for the direct supervision of pro-duction, (3) reduced transportation costs, and (4)facilitated the use of machines far bigger than anythingused in the home. The development of large-scale fac-tory production, known as the Industrial Revolution,began in Great Britain around 1750 and spread to therest of Europe, North America, and Australia.
Production, then, evolved from self-sufficientrural households to the cottage industry system,where specialized production occurred in the house-hold, to production in a firm. Today, entrepreneurs
combine resources in firms such as factories,mills, offices, stores, and restaurants. Firmsare economic units formed by profit-seeking
entrepreneurs who combine labor, capital, andnatural resources to produce goods and services. Justas we assume that households try to maximize util-ity, we assume that firms try to maximize profit. Profit,the entrepreneur’s reward, equals sales revenueminus the cost of production.
Types of FirmsThere are about 30 million for-profit businesses in theUnited States. Two-thirds are small retail businesses,small service operations, part-time home-based busi-nesses, and small farms. Each year more than a mil-lion new businesses start up and many fail. Firms areorganized in one of three ways: as a sole proprie-tor-ship, as a partnership, or as a corporation.
Sole Proprietorships
The simplest form of business organization is thesole proprietorship, a single-owner firm. Examplesare self-employed plumbers, farmers, and dentists.
other categories, including savings, claimed just 5 per-cent. So half of all personal income went forservices—the fastest growing sector, because manyservices, such as child care, are shifting from do-it-yourself home production to market production.
The FirmHouseholds members once built theirown homes, made their own clothesand furniture, grew their own food,and amused themselves with books,games, and hobbies. Over time, however, theefficiency arising from comparative advantageresulted in a greater specialization amongresource suppliers. This section takes a look atfirms, beginning with their evolution.
The Evolution of the FirmSpecialization and comparative advantage explainwhy households are no longer self-sufficient. But whyis a firm the natural result? For example, rather thanmake a woolen sweater from scratch, couldn’t a con-sumer take advantage of specialization by negotiatingwith someone who produced the wool, another whospun the wool into yarn, and a third whoknitted the yarn into a sweater? Here’sthe problem with that model: If theconsumer had to visit each of thesespecialists and strike an agreement,the resulting transaction costs couldeasily erase the gains from specialization.
Instead of visiting and bar-gaining with each specialist,the consumer can pay some-one to do the bargaining—anentrepreneur, who hires allthe resources necessary tomake the sweater. An entrepre-neur, by contracting for manysweaters rather than just one, isable to reduce the transactioncosts per sweater.
For about two hundredyears, profit-seeking entrepre-neurs relied on “putting out”raw material, like wool andcotton, to rural householdsthat turned it into finishedproducts, like woolen goodsmade from yarn. The systemdeveloped in the British Isles,where workers’ cottages
LO 2
IndustrialRevolutiondevelopment of large-scale factory productionthat began in GreatBritain around 1750 andspread to the rest ofEurope, North America,and Australia
firmseconomic units formedby profit-seeking entre-preneurs who employresources to producegoods and services for sale
sole proprietorshipa firm with a singleowner who has theright to all profits butwho also bears unlim-ited liability for thefirm’s losses and debts
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zation is that the corporationhas a life apart from its owners.The corporation survives evenif ownership changes hands,and it can be taxed, sued, andeven charged with a crime as ifit were a person.
The corporate form has some disadvantages aswell. A stockholder’s ability to influence corporate pol-icy is limited to voting for a board of directors, whichoversees the operation of the firm. Each share of stockusually carries with it one vote.The typical stockholderof a large corporation owns only a tiny fraction of theshares and thus has little say. Whereas the incomefrom sole proprietorships and partnerships is taxedonly once, corporate income gets whacked twice—firstas corporate profits and second as stockholder income,either as corporate dividends or as realized capitalgains. A realized capital gain is any increase in the mar-ket price of a share that occurs between the time theshare is purchased and the time it is sold.
A hybrid type of corporation has evolved to takeadvantage of the limited liability feature of the cor-porate structure while reducing the impact of doubletaxation. The S corporation provides owners with lim-ited liability, but profitsare taxed only once—as income on eachshareholder’s per-sonal income taxreturn. To qualify asan S corporation, afirm must have nomore than 100 stock-holders and no foreign stockholders.
Corporations make up only 18 percent of all U.S.businesses, but because they tend to be much largerthan the other two business forms, corporationsaccount for 84 percent of allbusiness sales. Exhibit 2shows, by business type,the percentages of U.S.firms and the percentagesof U.S. sales. The sole propri-etorship is the most importantin sheer numbers, but the cor-poration is the most importantin terms of total sales.
CooperativesA cooperative, or “co-op” forshort, is a group of peoplewho cooperate by poolingtheir resources to buy andsell more efficiently than
Most sole proprietorshipsconsist of just the self-employed proprietor—thereare no hired employees. Toorganize a sole proprietor-ship, the owner simply opensfor business by, for example,taking out a classified ad announcing availability forplumbing or whatever.The owner is in complete con-trol. But he or she faces unlimited liability and couldlose everything, including a home and other personalassets, to settle business debts or other claimsagainst the business. Also, since the sole proprietorhas no partners or other financial backers, raisingenough money to get the business going can be achallenge. One final disadvantage is that a sole pro-prietorship usually goes out of business when theproprietor dies or leaves the business. Still, a soleproprietorship is the most common type of business,accounting most recently for 72 percent of all U.S.businesses. Nonetheless, because this type of firm istypically small, proprietorships generate just a tinyportion of all U.S. business sales—only 4 percent.
Partnerships
A more complicated form of business is the partner-ship, which involves two or more individuals whoagree to combine their funds and efforts in return fora share of the profit or loss. Law, accounting, and med-ical partnerships typify this business form. Partnershave strength in numbers and often find it easier thansole proprietors to raise enough funds to get the busi-ness going. But partners may not always agree. Also,each partner usually faces unlimited liability for anydebts or claims against the partnership, so one partnercould lose everything because of another’s mistake.Finally, the death or departure of one partner can dis-rupt the firm’s continuity and require a complete reor-ganization.The partnership is the least common formof U.S. business, making up only 10 percent of all firmsand 12 percent of all business sales.
Corporations
By far the most influential form of business is thecorporation. A corporation is a legal entity estab-lished through articles of incorporation. Shares ofstock confer corporate ownership, thereby entitlingstockholders to a claim on any profit. A major advan-tage of the corporate form is that many investors—hundreds, thousands, even millions—can pool theirfunds, so incorporating represents the easiest way toamass large sums to finance the business. Also,stockholder liability for any loss is limited to thevalue of their stock, meaning stockholders enjoy lim-ited liability. A final advantage of this form of organi-
partnershipa firm with multipleowners who share theprofits and bear unlim-ited liability for thefirm’s losses and debts
corporationa legal entity owned bystockholders whose lia-bility is limited to thevalue of their stockownership
cooperativean organization consist-ing of people who pool their resources to buy and sell moreefficiently than theycould individually
Corporations makeup only 18% of allU.S. businesses.
EVERY YEAR MORE THAN AMILLION NEW BUSINESSESSTART UP AND MANY FAIL.
ment buildings, and grocery stores, among otherbusinesses. Many college bookstores are coopera-tives. For example, the UConn Co-op is owned byabout 30,000 students, faculty, and staff. Thesemembers receive discounts on their purchases.
Producer Cooperatives
In a producer cooperative, producers join forces to buysupplies and equipment and to market their output.Each producer’s objective is to reduce costs andincrease profits. Federal legislation allows farmers tocooperate without violating antitrust laws. Firms inother industries could not do this legally. Farmerspool their funds to purchase machinery and supplies,provide storage and processing facilities, and trans-port goods to market. Sunkist, for example, is a farm
they could independently. Cooperatives try to mini-mize costs and operate with limited liability ofmembers. The government grants most cooperativestax-exempt status. There are two types: consumercooperatives and producer cooperatives.
Consumer Cooperatives
A consumer cooperative is a retail business owned andoperated by some or all of its customers in order toreduce costs. Some cooperatives require members topay an annual fee and others require them to work acertain number of hours each year. Members some-times pay lower prices than other customers or mayshare in any revenues that exceed costs. In theUnited States, consumer cooperatives operate creditunions, electric-power facilities, health plans, apart-
Partnerships(10%)
Corporations(18%)
Soleproprietorships
(72%) Soleproprietorships
(4%)
(a) Most firms are sole proprietorships (b) Corporations account for most sales
Corporations(84%)
Partnerships(12%)
Exhibit 2Number and Sales of Each Type of Firm
SOURCE: U.S. Census Bureau, Statistical Abstract of the United States: 2007. U.S. Bureau of the Census, Table No. 724 and Table No. 806. For the latest figures go tohttp://www.census.gov/compendia/statab/.
4 0 PART 1 Introduction to Economics
>>Ocean Spray is one of the best known producer cooperatives in the United States. Through product development (think Craisins), Ocean Spray has been able to increase the price it pays its farmers 100 percent over a three year period.
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CHAPTER 3 Economic Decision Makers 4 1
only a broom and sometime, so it’s usuallyperformed by house-hold members. Sandinga wooden floor, how-ever, involves specialmachinery and expert-ise, so this service is
usually left to professionals. Similarly, although youwouldn’t hire someone to brush your teeth, dentalwork is not for amateurs. Households usually performdomestic chores that demand neither expertise nor specialmachinery.
Household Production Avoids Taxes
Suppose you are deciding whether to pay someone$3,000 to paint your house or to do it yourself. If theincome tax rate is one-third, you must earn $4,500before taxes to have the$3,000 after taxes to pay forthe job. And the painterwho charges you $3,000nets only $2,000 after pay-ing $1,000 in taxes. Thus,you must earn $4,500 sothat the painter can take
cooperative owned and operated by 6,500 citrus grow-ers in California and Arizona.
Not-for-Profit OrganizationsSo far, you have learned about organizations that tryto maximize profits or, in the case of cooperatives, tominimize costs. Some organizations have neither asa goal. Not-for-profit organizations engage in chari-table, educational, humanitarian, cultural, profes-sional, and other activities, often with a socialpurpose. Government agencies do not have profit asa goal either, but governments are not included inthis definition of not-for-profit organizations.
Like businesses, not-for-profit organizationsevolved to help people accomplish their goals.Examples include nonprofit hospitals, privateschools and colleges, religious organizations, theRed Cross, Greenpeace, charitable foundations, soupkitchens, orchestras, museums, labor unions, andprofessional organizations. There are about two mil-lion not-for-profit organizations in the UnitedStates. They employ about 10 million workers, withnot-for-profit hospitals being the biggest employer.But even not-for-profit organizations must somehowpay the bills. Revenues typically include some com-bination of voluntary contributions and servicecharges, such as col-lege tuition and hospi-tal charges. In theUnited States, not-for-profit organizationsare usually exemptfrom taxes.
Why Does HouseholdProduction Still Exist?If firms are so efficient at reducing transaction andproduction costs, why don’t they make everything?Why do households still perform some tasks, suchas cooking and cleaning? If a household’s opportunitycost of performing a task is below the market price, thenthe household usually performs that task. People with alower opportunity cost of time do more for them-selves. For example, janitors are more likely to mowtheir lawns than are physicians. Let’s look at somereasons for household production.
No Skills or Special Resources Are Required
Some activities require so few skills or specialresources that householders find it cheaper to do thejobs themselves. Sweeping the kitchen floor requires
not-for-profitorganizationsgroups that do not pur-sue profit as a goal;they engage in charita-ble, educational, human-itarian, cultural,professional, or otheractivities, often with asocial purpose
Do it yourself, or pay someone to do it for you?
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“Although you wouldn’t hire some-one to brush your teeth, dental work isnot for amateurs.”
4 2 PART 1 Introduction to Economics
Establishing and Enforcing the Rules of the Game
Market efficiency depends on people like you usingyour resources to maximize your utility. But what ifyou were repeatedly robbed of your paycheck on yourway home from work? Or what if, after you workedtwo weeks in a new job, your boss called you a suckerand said you wouldn’t get paid? Why bother working?The market system would break down if you couldnot safeguard your private property or if you couldnot enforce contracts. Governments safeguard privateproperty through police protection and enforce con-tracts through a judicial system. More generally, gov-ernments try to make sure that market participantsabide by the rules of the game. These rules are estab-lished through government laws and regulations andalso through the customs and conventions of themarketplace.
Promoting Competition
Although the “invisible hand” of competition usuallypromotes an efficient allocation of resources, somefirms try to avoid competition through collusion,which is an agreement among firms to divide themarket and fix the price. Or an individual firm maytry to eliminate the competition by using unfairbusiness practices. For example, to drive out localcompetitors, a large firm may temporarily sell at aprice below cost. Government antitrust laws try topromote competition by prohibiting collusion andother anticompetitive practices.
Regulating Natural Monopolies
Competition usually keeps the product price belowwhat it would be without competition—that is, belowthe price charged by a monopoly, a sole supplier tothe market. In rare instances, however, a monopolycan produce and sell the product for less than couldcompeting firms. For example, electricity is deliveredmore efficiently by a single firm that wires the com-munity than by competing firms each stringing itsown wires. When it is cheaper for one firm to servethe market than for two or more firms to do so, thatone firm is called a natural monopoly. Since a naturalmonopoly faces no competition, it maximizes profitby charging a higher price than would be optimalfrom society’s point of view. A lower price and greateroutput would improve social welfare. Therefore, thegovernment usually regulates the natural monopoly,forcing it to lower its price and increase output.
Providing Public Goods
So far this book has been talking about privategoods, which have two important features. First, pri-vate goods are rival in consumption, meaning that
home $2,000. If you paint the house yourself, notaxes are involved. The tax-free nature of do-it-your-self activity favors household production over mar-ket transactions.
Household Production Reduces Transaction Costs
Getting estimates, hiring a contractor, negotiatingterms, and monitoring job performance all taketime and require information. Doing the job your-self reduces these transaction costs. Householdproduction also allows for more personal controlover the final product than is usually availablethrough the market. For example, some people pre-fer home-cooked meals, because they can seasonhome-cooked meals to individual tastes.
Technological Advances IncreaseHousehold Productivity
Technological breakthroughs are not confined tomarket production. Vacuum cleaners, washers anddryers, dishwashers, microwave ovens, and othermodern appliances reduce the time and often theskill required to perform household tasks. Also,new technologies such as DVD players, HDTV,broadband downloads, and computer gamesenhance home entertainment. Indeed, microchip-based technologies have shifted some productionfrom the firm back to the household.
The GovernmentYou might think that production by householdsand firms could satisfy all consumer wants.Why must yet another economic decision maker getinto the act? After all, governments play some role inevery nation on Earth.
The Role ofGovernmentSometimes the unrestrainedoperation of markets yieldsundesirable results.Too manyof some goods and too few ofother goods get produced.This section discusses thesources of market failure andhow society’s overall welfaremay be improved throughgovernment intervention.
LO 3
market failurea condition that ariseswhen the unregulatedoperation of marketsyields socially undesir-able results
monopolya sole supplier of aproduct with no closesubstitutes
natural monopolyone firm that can sup-ply the entire market ata lower per-unit costthan could two or morefirms
CHAPTER 3 Economic Decision Makers 4 3
A More Equal Distribution of Income
As mentioned earlier, some people, because of pooreducation, mental or physical disabilities, or per-haps the need to care for small children, are unableto support themselves and their families. Becauseresource markets do not guarantee even a minimumlevel of income, transfer payments reflect society’sattempt to provide a basic standard of living to allhouseholds. Most citizens agree that governmentshould redistribute income to the poor (note thenormative nature of this statement). Opinions differabout who should receive benefits, how much theyshould get, what form benefits should take, and howlong benefits should last.
Full Employment, Price Stability, and Economic Growth
Perhaps the most important responsibility ofgovernment is fostering a healthy economy, whichbenefits just about everyone. The government—through its ability to tax, to spend, and to control themoney supply—attempts to promote full employ-ment, price stability, and economic growth. Pursuingthese objectives by taxing and spending is calledfiscal policy. Pursuing themby regulating the moneysupply is called monetarypolicy. Macroeconomicsexamines both policies.
Government’sStructure and ObjectivesThe United States has a fed-eral system of government,meaning that responsibili-ties are shared across levelsof government. State govern-ments grant some powers tolocal governments and sur-render some powers to thenational, or federal, govern-ment. As the system hasevolved, the federal govern-ment has primary responsi-bility for national security,economic stability, and mar-ket competition. State gov-ernments fund public highereducation, prisons, and—with aid from the federalgovernment—highways andwelfare. Local governments
the amountconsumed byone person isu n av a i l a b l efor others toconsume. For
example, when youand some friends share a pizza,
each slice they eat is one less available for you.Second, the supplier of a private good can easilyexclude those who fail to pay. Only paying cus-tomers get pizza. Thus, private goods are said to beexclusive. So private goods, such as pizza, are bothrival in consumption and exclusive. In contrast, pub-lic goods are nonrival in consumption. For example,your family’s benefit from a safer neighborhooddoes not reduce your neighbor’s benefit. What’smore, once produced, public goods are available toall. Suppliers cannot easily prevent consumption bythose who fail to pay. For example, reducing terror-ism is nonexclusive. It benefits all in the community,regardless of who pays for it and who doesn’t.Because public goods are nonrival and nonexclusive,private firms cannot sell them profitably. The gov-ernment, however, has the authority to enforce taxcollections for public goods. Thus, the governmentprovides public goods and funds them with taxes.
Dealing with Externalities
Market prices reflect the private costs and privatebenefits of producers and consumers. But some-times production or consumption imposes costs orbenefits on third parties—on those who are neithersuppliers nor demanders in a market transaction.For example, a paper mill fouls the air breathed bynearby residents, but the price of paper fails toreflect such costs. Because these pollution costs areoutside, or external to, the market, they are calledexternalities. An externality is a cost or a benefit thatfalls on a third party. A negative externality imposesan external cost, such as factory pollution or autoemissions. A positive externality confers an exter-nal benefit, such as getting a good education ordriving carefully. Because market prices do notreflect externalities, governments often use taxes,subsidies, and regulations to discourage negativeexternalities and encourage positive externalities.For example, a polluting factory often faces taxesand regulations aimed at curbing that pollution.And because more educated people can read roadsigns and have better-paying options other thancrime, governments try to encourage educationwith free public schools and subsidized higher edu-cation and by keeping people in school until their16th birthdays.
The supplier of a private good
can easily exclude those
who fail to pay.
private gooda good that is both rivalin consumption andexclusive, such as pizza
public gooda good that, once pro-duced, is available for allto consume, regardlessof who pays and whodoesn’t; such a good isnonrival and nonexclu-sive, such as a safercommunity
externalitya cost or a benefit thataffects neither the buyeror seller, but insteadaffects people notinvolved in the markettransaction
fiscal policythe use of governmentpurchases, transfer pay-ments, taxes, and bor-rowing to influenceeconomy-wide variablessuch as inflation, employ-ment, and economicgrowth
monetary policyregulation of the moneysupply to influence econ-omy-wide variables suchas inflation, employment,and economic growth
4 4 PART 1 Introduction to Economics
Voluntary Exchange Versus Coercion
Market exchange relies on the voluntary behavior ofbuyers and sellers. Don’t like tofu? No problem—don’tbuy it. But in political markets, the situation is differ-ent. Any voting rule except unanimous consent mustinvolve some government coercion. Public choices areenforced by the police power of the state. Those whofail to pay their taxes could go to jail, even thoughthey may object to some programs those taxes sup-port, such as the war in Iraq or capital punishment.
No Market Prices
Another distinguishing feature of governments isthat public output is usually offered at either a zeroprice or at a price below the cost of providing it. Ifyou now pay in-state tuition at a public college oruniversity, your tuition probably covers only abouthalf the state’s cost of providing your education.Because the revenue side of the government budgetis usually separate from the expenditure side, thereis no necessary link between the cost of a programand the benefit. In the private sector, the expectedmarginal benefit is at least as great as marginal cost;otherwise, market exchange would not occur.
The Size and Growth ofGovernment
One way to track the impact of gov-ernment over time is by measuring government
outlays relative to the U.S. gross domestic product, orGDP, which is the total value of all final goods andservices produced in the United States. In 1929, the
year the Great Depression began,all government outlays, mostly bystate and local governments,
totaled about 10 percent of GDP.At the time, the federal gov-ernment played a minorrole. In fact, during the
provide primary and secondary education with aidfrom the state, plus police and fire protection. Here aresome distinguishing features of government.
Difficulty in Defining Government Objectives
We assume that households tryto maximize utility and firmstry to maximize profit, butwhat about governments—or, more specifically, whatabout government decision mak-ers? What do they try to maximize? Oneproblem is that our federal system consists of notone but many governments—more than 87,600 sep-arate jurisdictions in all including 1 nation, 50 states,3,034 counties, 35,933 cities and towns, 13,506 schooldistricts, and 35,052 special districts. What’s more,because the federal government relies on offsetting,or countervailing, powers across the executive, leg-islative, and judicial branches, government does notact as a single, consistent decision maker. Evenwithin the federal executive branch, there are somany agencies and bureaus that at times they seemto work at cross-purposes. For example, at the sametime as the U.S. Surgeon General required healthwarnings on cigarette packages, the U.S. Departmentof Agriculture pursued policies to benefit tobaccogrowers. Given this thicket of jurisdictions,branches, and bureaus, one useful theory of govern-ment behavior is that elected officials try to maxi-mize the number of votes they will get in the nextelection. So let’s assume that elected officials arevote maximizers. In this theory, vote maximizationguides the decisions of elected officials who, in turn,oversee government employees.
There is no necessary linkbetween the cost of a program
and the benefit.
Roles of Government
Here’s a quick review of beneficial government interventions in markets:
Establishing and enforcing the rules of the game
Promoting competition
Regulating natural monopolies
Providing public goods
Dealing with externalities
Distributing income more equally
Pursuing full employment, price stability, and economic growth
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Let’s look briefly at thecomposition of federal out-lays. Since 1960, defensespending has declined fromover half of federal outlaysto about one-fifth by 2008,as shown in Exhibit 3.Redis t r ibut ion—Socia lSecurity, Medicare, and wel-fare programs—has beenthe mirror image of defensespending, jumping fromonly about one-fifth of fed-eral outlays in 1960 tonearly half by 2008.
Sources of GovernmentRevenue
Taxes provide the bulk of revenue at all levels of gov-ernment. The federal government relies primarily onthe individual income tax, state governments rely onincome and sales taxes, and local governments relyon the property tax. Other revenue sources includeuser charges, such as highway tolls, and borrowing.For additional revenue, some states also monopolizecertain markets, such as for lottery tickets andliquor.
Exhibit 4 focuses on the composition of federalrevenue since 1960. The share made up by the indi-vidual income tax has remained relatively constant,ranging from a low of 42 percent in the mid-1960s to47 percent in 2008. The share from payroll taxesmore than doubled from 15 percent in 1960 to 35percent in 2008. Payroll taxes are deducted from pay-checks to support Social Security and Medicare,
which funds medical carefor the elderly. Corporatetaxes and revenue fromother sources, such asexcise (sales) taxes anduser charges, havedeclined as a share of thetotal since 1960.
Tax Principlesand TaxIncidenceThe structure of a tax isoften justified on thebasis of one of two general
nation’s first 150 years, federal outlays, exceptduring war years, never exceeded 3 percent relativeto GDP.
The Great Depression, World War II, and a changein macroeconomic thinking boosted the share of gov-ernment outlays to 37 percent of GDP in 2007, withabout two-thirds of that by the federal government.1
In comparison, government outlays relative to GDPwere 36 percent in Japan; 40 percent in Canada; 45percent in the United Kingdom, Germany, and Italy;and 53 percent in France. Government outlays by the28 largest industrial economies averaged 40 percentof GDP in 2007.1 Thus, government outlays in theUnited States relative to GDP are below those of mostother advanced economies.
Exhibit 3Redistribution Has Grown and Defense Has Declined as Share of Federal Outlays Since 1960
Exhibit 4Payroll Taxes Have Grown as a Share of Federal Revenue Since 1960
SOURCE: Computed based on figures from the Economic Report of the President, February 2007. Table B-80. For the latest figures, go to http://gpoaccess.gov/eop/.
Individual income taxes
Payroll taxes
Corporate taxes
All other revenue
0%
20%
40%
60%
80%
100%
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
Sh
are
of
fed
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rev
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es
Defense
Redistribution
Net interest
All other outlays
0%
20%
40%
60%
80%
100%
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
Sh
are
of
fed
eral
ou
tlay
s
2008SOURCE: Computed based on figures from the Economic Report of the President, February 2007. Table B-80. For the latest figures,go to http://gpoaccess.gov/eop/.
1. The Organization of Economic Cooperation and Development, OECD Economic Outlook (May 2007), Annex Table 25.
4 6 PART 1 Introduction to Economics
income, the dollar amount of taxes increases asincome increases.
Under progressive taxation, the percentage ofincome paid in taxes increases as income increases.The marginal tax rate indicates the percentage of eachadditional dollar of income that goes to taxes. Becausehigh marginal rates reduce the after-tax return fromworking or investing, high marginal rates can reducepeople’s incentives to work and invest. The six mar-ginal rates applied to the U.S. personal income taxranged from 10 to 35 percent in 2007, down from arange of 15 to 39.6 percent in 2000.
principles. First, a tax could relate to the individual’sability to pay, so those witha greater ability pay moretaxes. Income or propertytaxes often rely on thisability-to-pay tax principle.Alternatively, the benefits-received tax principlerelates taxes to the benefitstaxpayers receive from thegovernment activity fundedby the tax. For example, thetax on gasoline funds high-way construction and main-tenance, thereby linking taxpayment to road use, sincethose who drive more paymore gas taxes.
Tax incidence indicateswho actually bears the burden of the tax. One way toevaluate tax incidence is by measuring the tax as apercentage of income. Under proportional taxation,
taxpayers at all income levelspay the same percentage oftheir income in taxes. A pro-portional income tax is alsocalled a flat tax, since the taxas a percentage of incomeremains constant, or flat, asincome increases. Note thatunder proportional taxation,although taxes remain con-stant as a percentage of
ability-to-pay taxprinciplethose with a greaterability to pay, such asthose earning higherincomes or those own-ing more property,should pay more taxes
benefits-receivedtax principlethose who get morebenefits from the gov-ernment programshould pay more taxes
tax incidencethe distribution of taxburden among taxpay-ers; who ultimatelypays the tax
proportionaltaxationthe tax as a percentageof income remains con-stant as incomeincreases; also called aflat tax
progressivetaxationthe tax as a percentageof income increases asincome increases
marginal tax ratethe percentage of eachadditional dollar ofincome that goes to the tax
0
20
40
60
80
100
1913 1923 1933 1943 1953 1963 1973 1983 1993 2003Mar
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nt o
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Exhibit 5Top Marginal Rate on Federal Personal Income Tax Since 1913
SOURCE: U.S. Internal Revenue Service. For the latest figures on the personal income tax go to http://www.irs.gov/individuals/index.html.
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FICA (aka Social Security) stands for Federal Insurance Contributions Act: 6.2% paid by you, 6.2% paid by your employer
FUTA (aka unemployment) stands for Federal Unemployment Tax Act: 6.2% of taxable wages, paid by youremployer
Decoding the taxes on your pay stub }{
CHAPTER 3 Economic Decision Makers 4 7
to zero. For example, Social Security taxes werelevied on the first $97,500 of workers’ pay in 2007.Half the 12.4 percent tax is paid by employers andhalf by employees (the self-employed pay the entire12.4 percent).
Taxes often do more than fund public programs.Some taxes discourage certain activity. For example,a pollution tax can help clean the air. A tax on gaso-line can encourage people to work at home, carpool,or use public transportaion. Some taxes have unin-tended consequences. For example, in Egypt a prop-erty tax is not imposed until a building is complete.To avoid such taxes, builders never finish the job;multistory dwellings are usually missing the topfloor. As another example of how taxes can distortthe allocation of resources, property taxes inAmsterdam and Vietnam were originally based onthe width of the building. As a result, buildings thereare extremely narrow.
This discussion of rev-enue sources brings to aclose, for now, our examina-tion of the role of govern-ment in the U.S. economy.
The top marginal tax bracket each year during thehistory of the personal income tax is shown byExhibit 5. Although the top marginal rate is nowlower than it was during most other years, highincome households still pay most of the federalincome tax collected. For example, according to theU.S. Internal Revenue Service, the top 1 percent of taxfilers, based on income, paid 36.9 percent of allincome taxes collected in 2004.Their average tax ratewas 23.5 percent. And the top 10 percent of tax filerspaid 68.2 percent of all income taxes collected. Theiraverage tax rate was 18.6 percent. In contrast, thebottom 50 percent of tax filers paid only 3.3 percentof all income taxes collected. Their tax rate averagedonly 3.0 percent. Whether we look at marginal taxrates or average tax rates, the U.S. income tax is pro-gressive. High-income filers pay the overwhelmingshare of income taxes.
Finally, under regressive taxation, the percentageof income paid in taxes decreases as incomeincreases, so the marginal tax rate declines asincome increases. Most U.S. payroll taxes are regres-sive, because they impose a flat rate up to a certainlevel of income, above which the marginal rate drops
In France, a house’s property taxes used to be assessed on the basis of the number stories of livable space in thebuilding. Attic space was not counted as livable space, so houses designed with Mansard roofs became increasinglypopular. (More usable space, less taxes.)
Mansard roof
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regressive taxationthe tax as a percentageof income decreases asincome increases
Trade between the United States and the rest ofthe world has increased in recent decades. In 1970,U.S. exports of goods and services amounted to only6 percent of the gross domestic product. That hasincreased to 10 percent. The top ten destinations forU.S. exports in order of importance are Canada,Mexico, Japan, China, United Kingdom, Germany,South Korea, Netherlands, France, and Taiwan.
The merchandise trade balance equals the valueof exported goods minus the value of importedgoods. Goods in this case are distinguished from ser-vices, which show up in another trade account. Forthe last quarter century, the United States hasimported more goods than it has exported, resultingin a merchandise trade deficit. Just as a householdmust pay for its spending, so too must a nation. Themerchandise trade deficit must be offset by a surplusin one or more of the other balance-of-paymentsaccounts. A nation’s balance of payments is therecord of all economic transactions between its resi-dents and residents of the rest of the world.
Exchange RatesThe lack of a common currency complicates tradebetween countries. How many U.S. dollars buy aPorsche? An American buyer cares only about thedollar cost; the German carmaker cares only aboutthe euros received (the common currency of 13European countries). To facilitate trade funded bydifferent currencies, a market for foreign exchangehas developed. Foreign exchange is foreign cur-rency needed to carry out international transac-tions. The supply and demand for foreign exchangecomes together in foreign exchange markets to deter-mine the exchange rate. The exchange rate measuresthe price of one currency in terms of another. Forexample, the exchange rate between the euro and
the dollar might indicate
Government has a pervasive influence on the econ-omy, and its role is discussed throughout the book.
The Rest of the WorldSo far, the focus has been on institutionswithin the United States—that is, on domestichouseholds, firms, and governments. This focusis appropriate because our primary objective is tounderstand the workings of the U.S. economy, by farthe largest in the world. But the rest of the worldaffects what U.S. households consume and what U.S.firms produce. For example, Japan and China supplyus with all kinds of manufactured goods, therebyaffecting U.S. prices, wages, and profits. Likewise,political events in the Persian Gulf can affect whatAmericans pay for oil. Foreign decision makers,therefore, influence the U.S. economy—what weproduce and what we consume. The rest of the worldconsists of the households, firms, and governmentsin the two hundred or so sovereign nations through-out the world.
International TradeIn the previous chapter, you learned about compara-tive advantage and the gains from specialization.These gains explain why householders stoppeddoing everything for themselves and began to spe-cialize. International trade arises for the same rea-sons. International trade occurs because the opportunitycost of producing specific goods differs across countries.Americans import raw materials like crude oil, dia-monds, and coffee beans and finished goods likecameras, DVD players, and automobiles. U.S. produc-ers export sophisticated products like computersoftware, aircraft, and movies, as well as agricultural
products like wheat and corn.
merchandise tradebalancethe value during a givenperiod of a country’sexported goods minusthe value of itsimported goods
balance ofpaymentsa record of all economictransactions during agiven period betweenresidents of one coun-try and residents of therest of the world
foreign exchangeforeign money neededto carry out interna-tional transactions
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On the Porsche web site, thebase price of a 2008 TurboCayenne is $93,700. As the eurostrengthens against the dollar,that figure only rises.
4 8 PART 1 Introduction to Economics
CHAPTER 3 Economic Decision Makers 4 9
but consumers are usually unaware of this harm.Trade restrictions interfere with the free flow ofproducts across borders and tend to hurt the overalleconomy.
Final WordThis chapter examined the four economic decisionmakers: households, firms, governments, and therest of the world. Domestic households are by far themost important, for they supply resources anddemand goods and services.
If you were to stop reading right now, you wouldalready know more economics than most people.But to understand marketeconomies, you must learnhow markets work. Thenext chapter introducesdemand and supply.
that one euro exchanges for $1.20. At that exchangerate, a Porsche selling for 100,000 euros costs$120,000. The exchange rate affects the prices ofimports and exports and thus helps shape the flowof foreign trade.
Trade RestrictionsDespite clear gains from international specializa-tion and exchange, nearly all nations restrict tradeto some extent. These restrictions can take the formof (1) tariffs, which are taxes on imports; (2) quotas,which are limits on the quantity of a particular goodthat can be imported from a country; and (3) othertrade restrictions. If specialization according tocomparative advantage is so beneficial, why domost countries restrict trade? Restrictions benefitcertain domestic producers that lobby their govern-ments for these benefits. For example, U.S. growersof sugar cane have benefited from legislationrestricting imports, thereby raising U.S. sugar prices.These higher prices hurt domestic consumers,
Start ofIndustrial
Revolution inBritain > 1750
< Trillion of personal income in the United States$10.9
Base price of PorscheCayenne Turbo > $93,700
< Of all U.S. businessesare sole proprietorships 72%
Student owners of UConn
bookstore co-op> 30,000
tariffa tax on imports
quotaa legal limit on thequantity of a particularproduct that can beimported
