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Economic Decision Makers. CHAPTER 4. © 2003 South-Western/Thomson Learning. 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

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Economic decision makers l.jpg
Economic Decision Makers



© 2003 South-Western/Thomson Learning

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  • 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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  • When U.S. was an agricultural economy, a farm household was largely self-sufficient  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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  • 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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  • 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




Transfer Payments


Proprietors Income


Wages and Salaries


Dividends 5%

Rental Income 2%

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


such as haircuts and medical care account for the largest share and is the fastest growing category.







Nondurable goods

are items such as food and clothing.





Durable goods

are designed to last three years or more: automobiles,

appliances, etc.

Other 3%

Nearly one-half of personal income in 2000 was spent on services.

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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 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 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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  • 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


by Type

Percentages of Sales by Type





Sole Proprietorships


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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  • 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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  • 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 per- unit 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 domesticproduct, 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

All Other Outlays

Net Interest



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Sources of Government Revenue Outlays Since 1960

  • 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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Exhibit 4: Federal Government Receipts Outlays Since 1960

All Other Revenue

Corporate Income


Payroll Taxes

Percent of Federal Revenue

Individual Income Taxes

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Tax Principles Outlays Since 1960

  • 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 Outlays Since 1960

  • Tax incidenceindicates 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

  • 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 Outlays Since 1960

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