The Household. the Decisions of Households Are Major Factors in Determining What Is Produced

CHAPTER 3

Economic Decision Makers

INTRODUCTION

This chapter introduces the economic agents whose behavior we will analyze in the coming chapters. Of these, households are the most important because the demand for goods and services originates with households, and the resources used to produce goods and services are owned by households. Firms, governments, and the rest of the world are in some sense fictional characters— for example, there is no individual known as “Government” who makes decisions. Rather, people make decisions.

OUTLINE

The Household. The decisions of households are major factors in determining what is produced.

1.1 The Evolution of the Household

a. In earlier times, most households were farm families who were relatively self- reliant.

b. Industrialization and urbanization altered the role of families in production.

c. Since World War II married women, have entered the labor force in significant numbers.

d. Many two-income households demand more goods and services in product markets because they produce fewer goods and services at home.

1.2 Households Maximize Utility

a. Households are viewed as rational decision makers.

b. Utility maximization is based on each household’s subjective goals.

1.3 Households as Resource Suppliers

a. All resources are owned by households.

b. Households can use resources to produce goods and services within the home.

c. Households can supply their resources to firms or to governments.

d. Labor is the most valuable resource owned by most households.

e. Government gives some households transfer payments.

f. Transfer payments include cash transfers and in-kind transfers.

1.4 Households as Demanders of Goods and Services

a. Households can allocate money in three ways: (1) personal consumption expenditures, (2) savings, and (3) taxes.

b. Personal consumption is broken down into three categories: (1) durable goods, (2) nondurable goods, and (3) services.

2.1 Evolution of the Firm

a. Most production takes place outside the home because of the benefits of specialization and comparative advantage and because transaction costs make it too costly to use markets for every transaction.

b. During the cottage industry era, entrepreneurs arranged for production of goods and services and sold them to consumers. Production took place in the home.

c. During the Industrial Revolution, technological developments led to the organization of work in factories.

d. Firms are economic units formed by entrepreneurs to produce goods and services.

e. Firms seek to maximize profits.

2.2 Types of Firms

a. A sole proprietorship is a single-owner firm.

(1) Advantages

(a) Owner in complete control

(b) Easy to organize

(2) Disadvantages

(a) Unlimited liability

(b) Difficult to raise money for construction and expansion

b. A partnership is two or more individuals working together in return for a share of the profit or loss.

(1) Advantages

(a) Relatively easy to form

(b) Easier to raise startup funds

(2) Disadvantages

(a) Decision making is more difficult.

(b) Each partner is liable for the debts of the partnership.

c. A corporation is a legal entity recognized by the state and treated as if it were an individual.

(1) Advantages

(a) Easy to amass large sums of financing

(b) Liability for the firm’s losses limited to the value of an owner’s stock

(2) Disadvantages

(a) Individual stockholder has little control over the firm’s decisions.

(b) Corporate profits passed on to stockholders are taxed twice.

(3) The S corporation is a hybrid type of corporation.

(a) The S corporation provides limited liability.

(b) Corporate profits are taxed only once.

2.3 Nonprofit Institutions

2.4 Why Does Household Production Still Exist?

a. Households produce at home when the opportunity cost of home production is less than the opportunity cost of using the market.

b. Some household production requires few specialized resources.

c. People can avoid taxes by relying on household production instead of on market purchases.

d. Household production reduces transaction costs in some cases.

e. Technological advances have made household production more efficient in some cases.

2.5 CASE STUDY: The Electronic Cottage

3. The Government

3.1 The Role of Government

a. Government establishes and enforces the rules of the game: government protects private property and enforces contracts.

b. Antitrust laws attempt to promote competition by preventing collusion.

c. Government regulates natural monopolies.

d. Government produces public goods.

e. Government deals with problems associated with externalities.

f. Government attempts to promote a more equal distribution of income.

g. Government attempts to promote full employment, price stability, and economic growth.

3.2 Government’s Structure and Objectives

a. The United States has a federal system of government.

b. It is difficult to define the objectives of the government. One useful theory is that elected officials are vote maximizers.

c. Market exchange is based on voluntary exchange; public political choices may be enforced by the policing power of the government.

d. Prices in the political system are not necessarily linked to costs.

3.3 Size and Growth of U.S. Government

a. Government spending as a percentage of gross national product has increased from 10 percent in 1929 to 35 percent in 1992, but fell back to 29 percent of GDP in 2000.

b. The major source of growth has been federal outlays, particularly for Social Security and other transfer programs.

3.4 Sources of Government Revenue. Most of the government’s revenue comes from income, sales, and property taxes.

3.5 Tax Principles and Tax Incidence

a. Some think taxes should be based on the principle of ability to pay.

b. Others think taxes should be based on the principle of benefits received.

c. Tax incidence indicates who actually bears the burden of the tax.

d. Important tax terms

(1) Marginal tax rate: how much of each additional dollar of income must be paid in taxes

(2) Proportional taxes: taxes for which the percentage of income paid is constant as income increases

(3) Progressive taxes: taxes for which the percentage of income paid increases as income increases

(4) Regressive taxes: taxes for which the percentage of income paid decreases as income increases

4. The Rest of the World. The rest of the world consists of the households, firms, and governments of other countries. Some countries have formed economic alliances.

4.1 International Trade

a. International trade occurs because the opportunity cost of producing specific goods differs across countries.

b. The volume of U.S. trade with the rest of the world has increased dramatically since 1970.

c. The merchandise trade balance equals the value of commodities exported minus the value of commodities imported.

d. A nation’s balance of payments is the record of transactions between its residents and the residents of the rest of the world.

4.2 Exchange Rates

a. Foreign exchange is the currency of another country that is used to carry out international transactions.

b. The exchange rate measures the price of one currency in terms of another.

4.3 Trade Restrictions

a. Trade restrictions include

(1) Tariffs, or taxes on imports and exports

(2) Quotas--legal limits on the quantity of a good that can be imported or exported

(3) Other restrictions

b. Restrictions tend to benefit domestic producers and to harm consumers.

4.4 CASE STUDY: Wheels of Fortune

III. DISCUSSION

The Household

Households are the most important economic agents because they are the ultimate demanders of goods and services and ultimate suppliers of all resources. Households make decisions about what goods and services to buy and what resources to sell so as to maximize utility. Utility is a subjective concept; activities that provide utility to one household may not be desirable to another.

Households receive income when they sell their resources to either firms or governments. The most important resource owned by most households is the labor services of family members. Labor earnings account for the majority of personal income in the United States. Most of the income received is spent on personal consumption of both durable and nondurable goods and services. The rest of the income is either saved or spent on taxes.

The Firm

A hundred years ago most households produced most of what they consumed. Today, households purchase most of the goods and services they consume from firms. Increased specialization, fueled by technological change and increased industrialization, explains much of the change in household production and consumption. Firms developed to capture many of the gains from increased specialization.

Firms tend to specialize in certain tasks rather than produce everything. Entrepreneurs also specialize; an entrepreneur who is good at producing automobiles may not be good at finding oil. Firm size also tends to be limited because of the costs associated with coordinating the activities of more and more people. (Make sure you are familiar with the types of firms and their relative strengths and weaknesses.)

Production still takes place within the home if the task requires very few specialized resources and is easy for households to perform. Generally, households will perform tasks whenever the opportunity cost of home production is less than the opportunity cost of purchasing the good or service in the marketplace.

The Government

Households and firms do not produce all goods. Voluntary exchange does not always produce all goods that society desires and does not always produce goods in an optimal manner. An economic function of government is to handle situations that the market economy cannot handle adequately. For example, government can provide an environment in which voluntary exchange can take place. The government defines and enforces property rights so that theft and failure to fulfill contracts are limited.

The government also tries to limit the effects of monopoly in the economy. Some goods are produced in ways that make it most efficient for a single firm to supply the entire market. The government regulates such natural monopolies so that firms do not charge higher prices than necessary. Firms sometimes get together to try to raise prices above the competitive level; the government enacts antitrust laws designed to limit this behavior.

Another important role for the government is to provide public goods. A pub/ic good is a good that is available to everyone once it is produced. Private firms usually will not produce public goods in the quantities that society wishes or needs because people who have not paid for use of public goods can still consume them. The government, however, can produce public goods and force people to pay for them through taxes. One example of a public good is national defense.

The government intervenes in the economy to correct the problems associated with externali_ties1 which are unpriced by-products of consumption or production. Reckless behavior (caused by consuming too much beer) and pollution (caused by industrial production) are examples of negative externalities; increased voting rates (a by-product of consumption of education) is an example of a positive externality.

Finally, government also tries to promote equal distribution of income, full employment, price stability, and economic growth. A progressive tax system combined with transfer payments to the poor is used to promote the first goal; fiscal and monetary p0/icy are used to promote the latterthree goals.

The Rest of the World

People in the United States often trade with people in other countries. The rest of the world consists of all the other countries in the world. International trade occurs because the opportunity costs of producing specific goods differ across countries. A country exports goods for which its opportunity costs are relatively low. Even though international trade creates economic gains, most countries impose some sort of trade restrictions. These restrictions tend to benefit domestic producers at the expense of domestic consumers.

Trade with other countries involves using other currencies If an American buys a sweater from an English firm, the sweater manufacturer expects to be paid in British pounds. Foreign exchange the currency of other countries needed to carry out international transactions can be bought and sold in foreign exchange markets. The exchange rate measures the price of one currency in terms of another. The balance of payments is the record of transactions between residents of one country and residents of the rest of the world.

IV. LAGNIAPPE