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