Transcript Chapter 3
Chapter 3
Economic Decision Makers
© 2006 Thomson/South-Western
1
Households
Demand goods and services from the product
market thereby help determine what gets
produced
Supply the resources to resource markets
thereby make what gets produced
When U.S. was an agricultural economy, a
farm household was largely self-sufficient
they produced what they consumed and
consumed what they produced
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Households
Shifts from agricultural economy to industrial
economy
Improved farm productivity
Growth of urban factories
Increase in number of women in work force
Rise of two earner families
Increased opportunity cost of working at home
Advantages of specialization in household of
declined
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Households Maximize Utility
People are assumed to try and maximize their
level of satisfaction, sense of well being, or
overall welfare utility
Rational: act in the best interest of the household
Use their limited resources to satisfy their
unlimited wants
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Households as Resource Suppliers
Over two-thirds of personal income comes from
labor earnings
Certain individuals receive assistance from the
government in the form of transfer payments:
cash or in-kind benefits given to individuals as
outright grants from the government
Cash transfers are monetary payments: welfare
benefits, unemployment compensation, etc.
In-kind transfers provide specific goods and services:
food stamps, Medicare, and Medicaid are all examples
of in-kind transfers
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Exhibit 3-1(a) Nearly two-thirds of personal
income in 2003 was labor income
63%
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Households as Demanders of Goods and Services
Personal income
81 percent for personal consumption
3 percent is saved
16 percent goes for taxes
Categories of spending
Durable goods: last three or more years
Nondurable goods: food, clothing
Services: haircuts, medical care
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Exhibit 3-1(b) Half of Personal Income in 2003
was spent on services
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The Evolution of the Firm
Individual consumer could undertake the
process of negotiating with all the necessary
parties to produce a particular product
Transaction costs could easily erase the gains from
specialization
Behooves the individual consumer to pay someone to
undertake all these tasks
Entrepreneur who organizes the production process
and reduces transaction costs
Cottage industry putting out raw materials
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The Evolution of the Firm
Combination of technological advances,
increased worker productivity led to shift of
employment from rural to urban areas
Work became organized in large, centrally
powered factories that
Promoted a more efficient division of labor
Allowed for the direct supervision of production
Reduced transportation costs
Facilitated the use of machines far bigger than
anything that had been used in the home
Industrial Revolution
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The Evolution of the Firm
Firms are economic units formed by
profit-seeking entrepreneurs who
combine the resources to produce goods
and services
We assume firms attempt to maximize
profits entrepreneur’s reward = revenue
minus cost of production
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Exhibit 3-2(a) Percentage of Firms by Type
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Exhibit 3-2(b) Percentage of Sales by Type
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Sole Proprietorship
Advantages
Simplest
Single owner who has the right to all profits –
complete 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
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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
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Corporation
Legal entity owned by stockholders
Advantages
First, and most important is that this is the easiest
way to raise capital funds
Second, stockholders have limited liability their
liability for any losses is limited to the value of their
stock
Third, corporation has a life apart from its owners
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Corporation
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
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Subchapter S Corporations and
Nonprofit Organizations
Subchapter S corporation
Hybrid that takes advantage of the limited liability
feature of the corporate structure but has the
Income is only taxed once as profits
Limited to no more than 35 stockholders
Nonprofit Organizations
Do not have profit as explicit objective
Have to generate enough revenue to pay bills
Non-taxpaying entities
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Why Does Some Household Production Still
Exist?
No skills or specialized resources 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
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Role of Government
Role of Government
Establishing and enforcing the rules of the game
Promoting competition
Regulating natural monopolies
Providing public goods
Dealing with externalities
More equal distribution of income
Full employment, price stability, and economic
growth
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Exhibit 3: Redistribution has Grown and
Defense has Declined
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The Rules Of The Game
Efficiency depends on individual confidence
that they can use the resources they own to
maximize their utility
Governments
Safeguarding private property
Enforce contracts through the judicial system
Market participants play by the “rules of the
game” as set forth by the participants through
laws, customs and conventions
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Promoting Competition
Although the “invisible hand” of competition
usually promotes an efficient allocation of
resources, it is reasonable to believe that some
firms try to avoid competition through collusion
Government antitrust laws try to promote
competition by prohibiting collusion and other
anticompetitive practices
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Regulating Natural Monopolies
Monopoly is a sole producer of a product for
which there are no close substitutes
In some instances a monopoly can produce and
sell the product for less than could several
competing firms
Natural monopoly
One firm that can serve the entire market at a lower
per- unit cost than can two or more firms
Maximizes profit by charging a price higher than is
optimal from society’s point of view government
usually regulates these firms
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Providing Public Goods
Private goods
Rival in consumption: the amount consumed by one
person is unavailable for others to consumer
Suppliers can easily exclude those who fail to pay –
private goods are 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
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Dealing With Externalities
Market prices reflect the private costs and
benefits of producers and consumers
Externality is a cost or benefit that falls on
third parties and is therefore ignored by the
two parties to the market transaction
Negative externality imposes a cost on third parties
– pollution, jet noise, and auto emissions are all good
examples of negative externalities
Positive externality confers benefits on third parties
– inoculations and education are goods that are felt
to convey positive externalities
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A More Equal Distribution Of Income
Resource markets do not guarantee each
household even a minimum level of income
Transfer payments reflect in an society’s
attempt to provide a basic standard of living to
all individuals
Key Issues
How much should be redistributed?
What form should it take?
Who should receive the benefits?
How long should the benefits continue?
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Full Employment, Price Stability, And
Economic Growth
Fiscal policy refers to the use of government
purchases, transfer payments, taxes, and
borrowing to influence aggregate economic
activity
Monetary policy refers to regulation of the
money supply in order to influence aggregate
economic activity
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Government’s Structure and Objectives
Federal system of government: shared
responsibilities
Federal government has assumed primary
responsibility for national security and the
stability of the economy
State government for public higher education,
prisons, and with aid from the federal
government, highways and welfare
Local government responsibilities include
primary and secondary education, police and
fire protection
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Defining Government Objectives
What do government decision makers attempt to
maximize?
Problems
87,000 separate jurisdictions
Separation of powers between the executive, legislative,
and judicial branches: no single, consistent decision
maker
Agencies and bureaus may work at cross purposes
Elected officials try to maximize the probability of
getting elected
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Voluntary Exchange Versus Coercion
Biggest difference between government and the
market is that the market relies on the
VOLUNTARY behavior of buyers and sellers
Conversely, by its very nature, any voting rule
and any governmental body involves or
employs some element of coercion
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No Market Prices
Selling price of public output is usually
either zero or some amount below its cost
Because the revenue side of the
government budget is separate from the
expenditure side, no necessary link
between the cost and benefit of a public
program or good
In the private sector, marginal benefits
are at least equal to marginal costs
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Size and Growth of Government
Comparison of government spending to gross
domestic product, or GDP
GDP is the total value of all final goods and services
produced in the United States
In 1929, the year the Great Depression began,
government spending, mostly by state and local
governments, totaled about 10% of GDP
By 2004 government outlays were 36% of GDP
38% in Japan, the United Kingdom, and Canada,
43% in Germany, 47% in Italy, 51% in France
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Sources of Government Revenue
Taxes are largest source of revenue at all levels
of government
Largest source for Federal government is individual
income tax
State governments rely on income and sales taxes
Local government rely on the property tax
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Exhibit 4: Payroll Taxes Have Grown as a
Share of Federal Revenue
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Tax Principles
Structure of a tax system is based on one of two
general principles
Ability-to-pay principle based on premise that
those with a greater ability to pay should pay
more tax
Benefits-received tax principle based on
premise that those who receive more benefits
from the government program funded by a tax
should pay more tax
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Tax Incidence
Tax incidence indicates who actually bears the
burden of a tax
Most common way of evaluating tax incidence
is by measuring the tax as a percentage of
income
Proportional taxation
Progressive taxation
Regressive taxation
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Tax Incidence
Proportional tax
Taxpayers at all income levels pay the same
percentage of their income in taxes
Also called a flat tax since the tax as a percentage of
income remains constant as income 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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Exhibit 5: Top Marginal Tax Rate on
Personal Income Since 1913
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Rest of the World
International trade arises for the same reason
as individual trade the opportunity cost of
producing specific goods differ among
countries
International trade is becoming an increasingly
large force in the U.S. economy
Exports have doubled since 1970
Largest customers are Canada, Japan, Mexico,
Great Britain, Germany, France, South Korea &
Taiwan
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Rest of the World
Merchandise trade balance = the value of a
country’s exported goods minus the value of its
imported goods during a given time period
Distinguishes between goods and services
U.S. has experienced a merchandise trade deficit:
the value of goods imported has exceeded the value
of goods exported
Deficit must be offset by a surplus in one or more of
the other balance-of-payments accounts
Balance of payments
Record of all economic transactions between
residents of one country and residents of the rest of
the world during a given time period
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Exchange Rates
Lack of a common currency complicates trade
between countries a market for foreign
exchange has developed
Foreign exchange is a foreign currency needed
to carry out international transactions
Supply and demand for foreign exchange determine
the equilibrium exchange rate between two
countries
Exchange rate measures the price of one currency in
terms of another
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Exchange Rates
For example, the exchange rate between the
euro and the dollar might indicate that one
euro exchanges for $1.10
At this exchange rate, a Porsche selling for 100,000
euros would cost an American consumer $110,000
Exchange rate affects the prices of imports and
exports and helps shape the flow of foreign
trade
The greater the demand for a particular foreign
currency or the smaller its supply, the higher its
exchange rate
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Trade Restrictions
Nearly all countries impose restrictions
of this flow of goods and services
These restrictions can take one of three
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
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