Households are suppliers of economic resources + major spenders in the economy

Functional distribution of income - Illustrates how the nation’s income is distributed among wages, rents, interest, and profits

• Largest source of income for households is wages/salaries

Personal distribution of income - How the nation’s total income is divided among individual households

• Taxes, noncash transfers, and movement of households among categories lessens income inequality

How households dispose of income

• Personal taxes

• Personal saving - Flows into bank accounts, insurance policies, bonds and stocks, mutual funds, etc.

  • More income → Usually save more

• Personal consumption

  • Durable goods - Products with expected lives of 3 years or more

  • Non-durable goods - Products with expected lives of less than 3 years

  • Services - Work done for consumers by lawyers, barbers, doctors, etc.

Businesses

• Plant - Physical establishment that helps with manufacturing and distributing goods and services

• Firm - Organization that uses resources to produce goods and services for profit

• Industry - Group of firms that produces same, or similar, products

Legal forms of business

• Sole proprietorship - Business owned + operated by 1 person

  • Easy to set up + organize

• Partnership - Business owned + operated by 2+ people; share risks, profits, and losses

• Corporation - Distinct/separate from individual stockholders that own it; run by hired managers

  • Pools financial resources of large #s of people

  • Stock - Share in the ownership of a corporation

  • Bond - Lends money to corporation; no corporate ownership for purchaser

  • Organized stock exchanges + bond markets → Simplifies transfer of securities b/w sellers + buyers

  • Limited liability - Stockholders risk only what they paid for their stock; personal assets not at stake

  • Corporations benefit from expanding + becoming more efficient

  • Ownership can easily be transferred

• Principal-agent problem - Interests of people managing the corporation (agents) and of the owners (principals) don’t always coincide

The government’s role in the economy

• Legal framework + services needed for a market economy to operate effectively

• Legal rules that control relationships b/w businesses + consumers

• Improves resource allocation (MB = MC)

• Maintains competition

  • Monopoly - Single seller controls an industry

  • Natural monopoly - Only 1 seller can achieve lowest possible costs

  • High competition → Efficient production

• Redistributes income

  • Transfer payments - Welfare checks, food stamps, unemployment compensation, etc.

  • Market intervention - Modifying prices set by market forces

  • Taxation - Takes larger proportion of income from rich

• Reallocates resources

  • Externality - Some of the costs or benefits of a good “spill over” to 3rd parties that aren’t the buyer or seller

  • Negative externalities - Production or consumption costs that affect 3rd parties without compensation

    • Overallocation of resources

    • Corrected w/ legislation or taxes

  • Positive externalities - Production or consumption benefits that are enjoyed by 3rd parties

    • Underallocation of resources

    • Corrected w/ subsidies or government management of an industry

  • Private goods - Produced through competitive market system; rivalry + excludability

  • Public goods - Everyone can simultaneously obtain benefits; one person’s benefit does not reduce benefits available to others

  • Free-rider problem - People can receive benefits from a public good w/o paying for it

    • Unprofitable for private firms

  • Quasi-public goods - Government provides public goods and services that could include exclusion (could be provided by private firms)

  • Reallocation - Resources shifted from production of private goods to production of public + quasi-public goods

• Uses monetary + fiscal policy to fix problems with widespread unemployment or inflation

The government in the circular flow model

• Makes purchases in both product + resource markets

• Provides public goods + services to both households + businesses

• Households + businesses forced to pay taxes

Government finance

• Government purchases - Products purchased directly absorb resources + are part of domestic output

• Transfer payments - Don’t directly absorb resources or create output; recipients don’t contribute to domestic output in return for them

Federal finance

• Federal spending

  • Pensions + income security

  • National defense

  • Health

  • Interest on the public debt

Federal tax revenues

• Personal income tax - Levied on taxable income

  • Progressive tax - People w/ higher incomes pay a larger percent of their incomes

• Marginal tax rate - Rate at which the tax is paid on each additional unit of taxable income

• Average tax rate - Total tax paid divided by total taxable income

  • A progressive tax’s average rate rises as income increases

• Payroll taxes - Taxes based on wages + salaries used to finance compulsory federal programs

• Corporate income tax - Levied on a corporation’s profit

• Sales and excise taxes - Taxes on commodities or purchases

State and local finance

• State finances

  • Primary source of tax revenue for state gov’ts is sales + excise taxes

  • State personal income taxes

  • Corporate income taxes + license fees

• Local finances

  • Property taxes - Make up 72% of local governments’ tax revenue

  • Revenue from intergovernmental grants from federal + state gov’ts