Economic Decision Makers Chapter 3 Economic Decision Makers © 2006 Thomson/South-Western

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

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

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

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

Exhibit 3-1(a) Nearly two-thirds of personal income in 2003 was labor income 63%

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

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

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

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 home Industrial Revolution

The Evolution of the Firm Firms 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

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

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

Sole Proprietorship Advantages Disadvantages Simplest Single owner who has the right to all profits – complete control Disadvantages 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

Partnership Multiple owners who share the firms profits Commonplace in law, accounting, and medical practice Advantage: 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

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

Corporation Disadvantages Stockholder’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 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

Subchapter S Corporations and Nonprofit Organizations 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

Why Does Some Household Production Still Exist? No skills or specialized resources required Household production avoids taxes Tax free nature of do it yourself activity favors household production over market transactions Reduces transaction costs Various technological advances have increased household productivity

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

Exhibit 3: Redistribution has Grown and Defense has Declined

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

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

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

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 exclusive Public 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

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

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?

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

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

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

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

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

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

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

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

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

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

Tax Incidence Proportional tax Progressive Regressive 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 changes Progressive The percentage of income paid in taxes increases as income increases Regressive The percentage of income paid in taxes decreases as income increases

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

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

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

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

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

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

Trade Restrictions 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 exports Quotas are legal limits on the quantity of a particular good that can be imported Voluntary agreements