Transcript 15 person cottages

Economic Decision
Makers
CHAPTER
4
© 2003 South-Western/Thomson Learning
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Households
Play the major role in U.S. economy
First, they demand goods and services from
the product market thereby help determine
what gets produced
Second, they supply the resources to
resource markets thereby make what gets
produced
Householder: The key decision maker in
the household
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Households
When U.S. was an agricultural economy,
a farm household was largely selfsufficient  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
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Households
Another 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
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Households
The 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
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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
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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
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Exhibit 1a: Sources of U.S. Personal
Income in 2000
Personal
Interest
13%
Wages and Salaries
64%
Nearly two thirds of personal income in 2000 was
labor income.
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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 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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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
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Exhibit 1b: Spending of Personal Income
Services
such as haircuts and
medical care account
for the largest share
and is the fastest
growing category.
Nondurable
goods
24%
Nondurable goods
Taxes
16%
are items such as food
and clothing.
Durable goods
are designed to last
three years or more:
automobiles,
appliances, etc.
Durable
goods
10%
Services
47%
Nearly one-half of personal income in 2000 was
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spent on services.
The Evolution of the Firm
While 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
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The Evolution of the Firm
For 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
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The Evolution of the Firm
The combination of technological
advances which increased worker
productivity and contributed to the 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
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The Evolution of the Firm
This transformation process is generally
referred to as the Industrial Revolution
Production evolved from self-sufficient
rural households to the cottage
industry, to the current system of
handling production under one roof
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
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Why Does Some Household
Production Still Exist?
Why hasn’t all production shifted to
firms?
Some activities require few skills or specialized
resources
Household production avoids taxes
• that is, the tax free nature of do it yourself activity
favors household production over market
transactions
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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
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Types of Firms: Sole Proprietorship
Are approximately 25 million for-profit
businesses in the United States which
are organized in one of three ways
Simplest form of business is the sole
proprietorship which is a firm with a
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
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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
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
Corporation is a 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
Disadvantages
Stockholder’s ability to influence corporate
policy is limited to voting for a board of
directors. Each share of stock normally
carries only one vote
Second, 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
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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
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Exhibit 2: Number and Sales of
Each Type of Firm
Corporations
20%
Percentages
by Type
Partnerships
7%
Sole
Proprietorships
73%
Percentages of
Sales by Type
Corporations
88%
Partnerships
7%
Sole Proprietorships
5%
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.
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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
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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
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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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The Rules Of The Game
Markets efficiency depends on
individuals having some confidence
that they can use the resources they
own to maximize their utility
Governments play a role in
safeguarding private property and in
enforcing contracts through a judicial
system
More 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
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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
Competition normally keeps the product
price lower than it is when the product is
sold by a monopoly
Monopoly is a sole producer of a product
for which there are no close substitutes
In some instances, however, a monopoly
can produce and sell the product for less
than could several competing firms
When 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
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Regulating Natural Monopolies
Natural monopoly: one firm that can
serve the entire market at a lower perunit 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
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Providing Public Goods
Private goods have two important
features
First, private goods are rival in consumption
 the amount consumed by one person is
unavailable for others to consumer
Second, 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
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Providing Public Goods
Thus, one person’s consumption does
not diminish the amount available to
others  they are non-rival in
consumption
Furthermore, once produced, public
goods are available to all  they are
non-exclusive  suppliers cannot easily
prevent consumption by those who fail
to pay
Because public goods are non-rival and
non-exclusive, private sector firms
cannot sell them profitably
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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
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Dealing With Externalities
Market 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
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Dealing With Externalities
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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Dealing With Externalities
Because 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
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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
Many agree that society should
redistribute income to the poor
Note the normative nature of this
statement
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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?
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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 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
In U.S., we have a federal system of
government  responsibilities are
shared across levels of government
As the system has evolved
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?
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
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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 purposes
Given 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 election
Which then hopefully guides the
decisions of elected officials who in turn
control government employees
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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
sellers
Conversely, by its very nature, any
voting rule and any governmental body
involves or employs some element of
coercion
Which, in turn, implies that there are
some who are likely to disagree with
the solutions adopted by governmental
bodies
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No Market Prices
Another distinguishing feature of
governments is that the selling price of
public output is usually either zero or
some amount below its cost
Since the revenue side of the
government budget is separate from the
expenditure side
There is no necessary link between the
cost and benefit of a public program or
good
By way of contrast, in the private
sector, marginal benefits are at least
equal to marginal costs
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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 States
In 1929, the year the Great Depression
began, government spending, mostly by
state and local governments, totaled about
10% of GDP
By 1992, government spending was 35
percent of GDP
By 2000 government outlays were 29% of
GDP
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Size and Growth of Government
Government outlays relative to GDP in
other countries
38% in Japan, the United Kingdom, and
Canada
43% in Germany
47% in Italy
51% in France
In the 36 largest industrial economies, the
average was 36% of GDP in 2000
Composition of Federal outlays in
Exhibit 3
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Exhibit 3: Redistribution and Defense as
Shares of Federal Outlays Since 1960
Percent of Federal Outlays
100%
90%
All Other Outlays
80%
Net Interest
70%
60%
50%
Redistribution
40%
30%
20%
Defense
10%
0%
1960
1965
1970
1975
1980
1985
1990
1995
2000
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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
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Percent of Federal Revenue
Exhibit 4: Federal Government Receipts
100
90
80
70
60
50
40
30
20
10
0
All Other Revenue
Corporate Income
Taxes
Payroll Taxes
Individual Income Taxes
1960
1965
1970
1975
1980
1985
1990
1995
2000
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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
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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 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 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
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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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Rest of the World
Consists 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
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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
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Rest of the World
Important to note that the merchandise
trade balance distinguishes between
goods and services
For 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 exported
Which, in turn, implies that this deficit
must be offset by a surplus in one or
more of the other balance-of-payments
accounts
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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
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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
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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
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Exchange Rates
For example, the exchange rate
between the euro and the dollar might
indicate that one euro exchanges for
$0.90
At 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
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Trade Restrictions
While 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 exports
Quotas are legal limits on the quantity of a
particular good that can be imported
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Trade Restrictions
Other 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
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