Chapter 4 Economic Decision-Makers: Households, Firms, Governments, and the Rest of the World


Economics: The study of how people use their scarce resources to satisfy their unlimited wants.


Macroeconomics: Study how decisions of individuals coordinated by markets in the entire economy join together to determine economy-wide aggregates like employment and growth. They study the performance of the economy as a whole.


Market: Means by which individuals interact to buy or to sell; mechanism that coordinates the independent intentions of buyers and sellers.


Before we can go on, it is important to understand what economic actors are interacting in these markets and their relationships to one another.


Four (broadly defined) economic actors are:


1. Households

2. Firms

3. Governments

4. "The Rest of the World"


I. Households


All those people living under one roof are considered a household.


Households do two fundamental things vital to the economy.

1.      Demand goods and services from product markets

2.      Supply labor, capital, land, and entrepreneurial ability to resource markets.


Economists think of each household acting as a single decision-maker.


Householder: The key decision-maker in the household.


A.     Evolution of a Households


Households have changed considerably in economic history.


Earliest households were totally self-sufficient. They made what they consumed and consumed what they produced to a large extend. Specialization took place within the household.



Are households self-sufficient today? How are they different?


-         Very few people produce their own food. With the increase in agricultural productivity, fewer people are needed to produce the food to feed a nation.

-         People work away from the home.


How have households changed since the 1950s?


-         Women working: 1950 15% of married women with children under 18 were in the labor force. Today more than 1/2 married women with young children are in the labor force.

-         Higher education among women, growing demand for labor, increased the opportunity cost of staying at home. Opportunity cost-define.

-         Two-earner households- less production occurs at home, more goods and services demanded from the market.


B.     Households are rational utility maximizers.


Economists assume that individuals, and thus households, attempt to maximize their utility.


UTILITY: The satisfaction received from consumption; the sense of well being. Utility is subjective (not objective). One household may have different goals than another.


Rational: They act in their own best interest (in the interest of their own goals- maximizing their utility), would not make choices that would make them worse off.


C.     Households as Demanders


Personal income is allocated among three uses:

1.      savings

2.      consumption

3.      taxes


In US: 80% consumption, 5% savings, and 15% taxes




1. Durable goods: designed to last three years or more. 13%

2. Nondurable goods: food, clothing, and gasoline 30%

3. Services: childcare, medical care 57%


D.     Resource suppliers


Households use their limited resources (labor, capital, land, and entrepreneurial ability) to maximize their own utility.


They can use these resources at home, or they can sell these resources in the resource market to earn money to spend in the product market.


You can see that a majority of personal income in the US is from labor earnings, rather than from ownership of other resources such as capital or land. (Exhibit 1, page 72)


Proprietors: People who work for themselves rather than for employers (plumbers, farmers, and doctors)


Transfer payments: Cash (welfare benefits, unemployment, disability) or in-kind benefits (food stamps - for specific goods/services) given to individuals as outright grants from the government.


***Some households have few resources valued in the market. In those cases, the government provides temporary public assistance.



II. Firms


Firms: Economic units, formed by profit-seeking entrepreneurs who employ resources to produce goods and services for sale.


A.     Firms have evolved as providers of goods and service.


-         Prior to the 18th century, Britain had a cottage industry system. Firms supplied raw materials (lumber, wool) to households that turned raw materials into finished goods.

-         This system still exists in some parts of the world.

-         With the expansion of the economy-more demand for final goods and services-entrepreneurs organized various stages of production under one roof.

-          Work was organized in factories which 1. Promoted more efficient division of labor 2. Allowed for direct supervision of laborers 3. Reduced transportation costs 4. Facilitated use of machines.

-         Around 1750 (start of industrial revolution) the development of large-scale factory production spread to Europe, North America, and Australia.


B.     Kinds of Firms


1. Sole Proprietorships: A firm with a single owner who has the right to all profits and who bears unlimited liability for the firm's debts. (plumber, doctor)

-         Must raise all the money to start business, is solely responsible for all debts.

-         Account for 73% of all US businesses (6% of all US business sales)


2. Partnerships: A firm with multiple owners who share the firm's profits and each of who bears unlimited liability for the firm's debts.


-         Two or more people agree to contribute resources in return for a share of the profit or loss. (law, accounting, medical partnerships)

-         Account for 7% of all firms (5% of all US business sales)


3. Corporations: A legal entity owned by stockholders whose liability is limited to the value of their stock.


-         Owners issued stocks that entitle them to profits in proportion to their stock ownership.

-         Many individuals pool money (1000s even millions)

-         Easy to amass large funds, limited liability

-         stockholder has little influence over corporate policy

-         corporate income taxed twice



C.     Household production still exists.


Name some forms of household production that still exist.

- Cooking, cleaning

- Fixing own cars

- Paint own home




If a householder's opportunity cost of performing a task is below the market price of the task, then the householder usually performs that task.


Opportunity cost: the value of the next best alternative.




1.      Consider my decision to mow the lawn or pay someone else to do it.


What is my next best alternative to mowing the lawn? I would probably watch read, watch TV or play game; value to me $10. Preparing an extra hour isn't my next best alternative, because I'm well enough prepared, and I won't get any extra salary from over-preparing. Opportunity cost = ~$10


Suppose the market price of getting someone to mow my lawn $25. What would I do?



2.      What about a Dr. making the same decision. His next best alternative is working an extra hour. He makes about $100 after taxes. Working is hard -$20.  Opportunity cost = ~$80.


Suppose the market price of getting someone to mow his lawn $25. What would the doctor do?


Some Reasons for household production:


1.      No skills or specialized resources are required

2.      Household production avoids taxes

3.      Household production reduces transaction costs: Transaction costs-the costs of time and information required to carry out market exchange.

4.      Household production allows for more control over the final product.

5.      Technological Advances Increase Household Productivity



III. The Government



A.     MARKET FAILURE: A condition that arises when unrestrained operation of markets yields socially undesirable results.


In the case of market failure, intervention could improve society's overall welfare.


B.     The Role of the Government



1. Establishing and Enforcing the Rules of the Game.


2. Promoting Competition


3. Regulating Natural Monopolies


4. Producing public goods.


Public good: A good that, once produced, is available for everyone to consume, regardless of who pays and who doesn't.


5. Externality: A cost or benefit that falls on third parties and is therefore ignored by the two parties to the market transaction.


6. Income Distribution


7. Full employment, Price stability, Economic Growth



C.     Government is a unique Problem for Economists



1. What is the goal of government?


-         Households maximize utility

-         Firms maximize profits

-         It might be said that government officials maximize the number of votes they will get in the next election.


2. Voluntary exchange vs. Coercion


Market is based on voluntary exchange.

Unless there is 100% agreement--government decisions involve some degree of coercion


3. No Market Prices


Selling price of public output is often zero or well below the cost of production.

In government budget/expenditure does not directly link cost/benefit of a public program.


D.     Size of Government


- If we measure government spending as % of GDP (total value of all goods/services produced in US.)


Prior to 1926 never exceeded 3%

1929 (year Great Depression began) 10%

Depression, WWII-- Change in Macroeconomic thought.


By 1998 32% of GDP


Compared to:


Japan 36%

U.K 39%

Canada 42%

Germany 47%

Italy 50%

France 54%


E.      Government Revenue


Taxes: provide bulk of revenue. (Exhibit 3, page 81)


Tax Principles: principles on which tax often justified.


1. Ability to pay: Those with a greater ability to pay should pay more. (income tax)


2. Benefits-received: Those who receive more benefits from government program funded by tax should pay more. (tax on gasoline funds highway construction)


Tax Incidence: The distribution of tax burden among taxpayers. (Indicates who bears the tax burden.)


Marginal tax rate: percentage of each additional dollar that goes to taxes.



Kinds of Taxes:


1. Proportional tax (flat-rate tax): The tax as a % of income remains constant as income increases.



2. Progressive tax: the tax as a % of income increases as income increases.


3. Regressive tax - the tax as a % of income decreases as income increases.



IV. The rest of the World: Households, firms, and governments in over 200 countries around the world.



Circular Flow Model