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

2 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

3 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

4 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

5 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

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

7 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

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

9 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

10 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

11 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

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

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

14 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

15 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

16 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

17 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

18 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

19 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

20 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

21 Exhibit 3: Redistribution has Grown and Defense has Declined

22 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

23 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

24 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

25 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

26 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

27 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?

28 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

29 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

30 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

31 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

32 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

33 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

34 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

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

36 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

37 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

38 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

39 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

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

41 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

42 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

43 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

44 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

45 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