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CHAPTER

Economic activity arises from scarcitythe aable resources are insufficient to meet all our

wants. Microeconomics studies the choices th

individuals and businesses make, the way thes

choices respond to incentives, interact, and a

influenced by governments to determine wha

how, and for whom goods and services are

produced.

Most of your microeconomics course is about the the

ries that explain and in some cases enable economists tomake predictions about these choices and their consequen

But in this chapter, we are going to describe the main feat

of the U.S. economy.You will learn about the resources av

able and how they are used.You will learn what, how, and

whom goods and services are produced.And you will lea

about the division of economic activity between individua

and businesses and governments.

The U.S. Economy

When you have completed your study of this chapter,you will be able to

1 Describe the patterns and changes in what goods and services are

produced in the United States.

2 Describe the patterns and changes in howgoods and services areproduced in the United States.

3 Describe for whom goods and services are produced in the United

States.

4 Use the circular flow model to provide a picture of how households,

firms, and governments interact to determine what, how, and for whom

goods and services are produced.

C H A P T E R C H E C K L I S T

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2.1 WHAT GOODS AND SERVICES ARE PRODUCED?

Walk around a shopping mall and pay close attention to the range of goods anservices that are being offered for sale. Go inside some of the shops and look at thlabels to see where various items are manufactured. The next time you travel o

an interstate highway, look at the large trucks and pay attention to the names anproducts printed on their sides and the places in which the trucks are registeredOpen the Yellow Pages and flip through a few sections. Notice the huge range ogoods and services that businesses are offering.

Youve just done a sampling of what goods and services are produced anconsumed in the United States today.

What We Consume

Because people buy millions of different goods and services, we can describe whathey buy only if we classify them in large groups. Even then, we would need several pages of small print to list the types and quantities of goods and services thapeople buy.

Rather than trying to describe everything that people buy, we focus on a fewmajor items, and that is what Figure 2.1(a) does. It shows the expenditures on thfive largest items on which we spend our incomes. Medical careall the goodand services that maintain good healthis now the largest single category oexpenditure and is 17 percent of household expenditure. Housing is 15 percent ohousehold expenditure. Transportation comes next at 12 percent and food is 1percent of total expenditure, only a little more than recreation at 8 percent.

34 Part 1 INTRODUCTION

FIGURE 2.1

What We ConsumePractice Onlin

Food expenditure(percentage of income)

(a) What we consume today

25

20

195019401930 1960

Year

(b) Changes in what we consume

15

10

5

40

30

20

1020001970 1980 1990

Falling percentageof income spenton food ...

... and increasing percentageof income spent on food

away from home

Food expenditure away from home(percentage of food expenditure)

0 5 10 15 20

Medical care

Housing

Transportation

Food

Recreation

Percentage of total expenditure

Medical care, housing, transportation, food, and recreation are the

items on which Americans spend the largest share of their income.

Americans spend a falling share of their total expenditure on food

and other necessities and an increasing share on services, such as

meals away from home.

SOURCE: U.S. Census Bureau, Statistical Abstract of the United States, 1999 and Bureau of Economic Analysis.

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The data in Figure 2.1(a) show the situation in the United States at the end ofthe 1990s. How have spending patterns changed over time? The main answer isthat over time, incomes have increased, and as they have done so, expenditure onthe necessities of life has taken a smaller percentage of income and expenditure onservices has taken a larger percentage of income. Figure 2.1(b) illustrates oneaspect of this change by looking at our expenditures on food. Total expenditure on

food has fallen from 24 percent of income in 1930 to 11 percent in 2000. But theamount that we spend on food away from home has increased from 13 percent oftotal food expenditure in 1930 to almost 40 percent of food expenditure in 2000.

What We Produce

Businesses located in the United States produce most of the goods and servicesthat people in the United States buy. Businesses in the rest of the world producegoods and services that the United States imports.

By far the largest part of what we produce today is services, not goods. Figure2.2 shows the largest five items in each category. Real estate services are the largestitem and represent 11 percent of the value of total production. The main compo-

nent of this item is the services of rental and owner-occupied housing. Retail andwholesale trade are the next two largest categories. Health services and educationcomplete the largest five services. (Medical-care expenditures in Figure 2.1 arelarger than health services in Figure 2.2 because expenditures cover services and

goods such as drugs and medical equipment.)The largest categories of goodsconstruction, electronic equipment such as

computers, food, industrial equipment, and chemicalseach account for less than4 percent of the value of total production.

Chapter 2 The U.S. Economy

FIGURE 2.2

What We ProducePractice On

Percentage of total production

Services

Real estate

Retail trades

Wholesale trades

Health

Education

Goods

Construction

Electronic equipment

Food

Industrial equipment

Chemicals

0 2 4 6 8 1210

Real estate services, retail and w

sale trades, health, and educatio

the largest five service items pr

duced.

Construction, electronic equipm

food, industrial equipment, and

icals are the largest five goods p

duced.

Services production exceeds go

production and is growing faste

SOURCE: Bureau of Economic Analysis.

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1 Describe the patterns and changes in what goods and services are pro-duced in the United States.

Practice Problems 2.11. On which goods and services do Americans spend most of their incomes?2. How have the goods and services on which Americans spend most of their

incomes changed since the 1930s?

Exercises 2.11. Which goods and services do businesses in the United States produce and

which do they import from the rest of the world?2. How has the number of people employed in agriculture, manufacturing, and

services in the United States changed since 1940?

Solutions to Practice Problems 2.11. Americans spend 17 percent of their incomes on medical care, 15 percent on

housing, 12 percent on transportation, 11 percent on food, and 8 percent onrecreation.

2. In the 1930s, Americans spent 24 percent of their income on food, and todaythey spend 11 percent on food. In the 1930s, Americans spent 13 percent oftheir food expenditure on meals outside the home. Today, Americans spend40 percent of their food expenditure on meals outside the home.

C H E C K P O I N T 2.1

Study Guide pp. 2

Practice Onlin

Agriculture, mining, manufacturing, aconstruction employ a shrinking pro

tion of the U.S. labor force, and servemploy an expanding proportion.

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2.2 HOW ARE GOODS AND SERVICES PRODUCED?

Goods and services are produced by using productive resources. Economists cathe productive resources factors of production. Factors of production argrouped into four categories:

Land Labor Capital Entrepreneurship

Land

In economics, land includes all the gifts of nature that we use to produce goodand services. Land is what, in everyday language, we call natural resources. includes land (in the everyday sense); minerals, energy, water, and air; and wilplants, animals, birds, and fish.

Some of these resources are renewable, and some are nonrenewable. The U.SGeological Survey maintains a national inventory of the quantity and quality onatural resources and monitors changes to that inventory. The most recent inventory is for 1997.

Figure 2.4(a) shows how the surface area of the United States is used and howthat use is very slowly changing. The United States covers 1,944 million acres. I

LandThe gifts of nature, or naturalresources, that we use to producegoods and services.

Factors of productionThe productive resources used toproduce goods and servicesland,

labor, capital, and entrepreneurship.

FIGURE 2.4

Land Use in the United StatesPractice Onlin

(a) Urban and rural uses (b) Urban distribution

2,000

Area (millions of acres)

Agricultural land

Urban developed landUrban developed land

Water and federal land

Forest and other rural land

19871982 1992

Year

New York (7.5%)

Los Angeles (5.9%)

Chicago (3.2%)

Washington (2.7%)

San Francisco (2.5%)1,500

1,000

0

500

1997

Philadelphia(2.2%)

Boston(2.2%)Detroit(2.0%)Dallas(1.8%)Houston(1.6%)

12 cities > 2m(12.5%)

25 cities > 1m

(12.2%)

28 cities > 0.5m

(7.6%)

Rest < 0.5m

(36.1%)

Part (a) shows how the 1,944 million acres covered by the United

States are used. Agriculture, water and federal lands, and forests

cover 94 percent of the land area. Built-up urban areas use only

105 million acres, up from 70 million acres in 1982.

Part (b) shows the dense urban distribution of land use. A quarte

of the population lives in the six largest cities (or metropolitan

areas), almost a third lives in the ten largest cities, and more than

half lives in cities that exceed 1 million.

SOURCE: U.S. Geological Survey and U.S. Census Bureau.

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1997, 930 million of these acres were in agricultural use (as cropland, pastureland,or rangeland). Agricultural land has decreased from 970 million acres in 1982. Ofthe 40 million acres that have gone from agricultural use, 35 million have been con-verted to built-up urban land. Urban land use has increased from 70 million acresin 1982 to 105 million acres in 1997. Water and federal land (lakes and rivers,national parks, and other federal lands) cover a roughly constant 450 million acres.

Forests and other rural land cover another roughly constant 450 million acres.People live on a very small proportion of the nations land area, and for the

most part, in a few very large cities (or metropolitan areas). Figure 2.4(b) showswhere Americans live. You can see that one quarter of the population lives in thesix largest cities. Almost one third lives in the ten largest cities. More than one halfof the population lives in cities that exceed 1 million people.

Our land surface and water resources are renewable. Some of our mineralresources can be recycled, but many mineral resources, and all those that we useto create energy, can be used only once. They are nonrenewable resources. Figure2.5 shows the current reserves of the three major energy resources: coal, oil, andnatural gas. Because nations can buy and sell these resources, the relevant quanti-ties are the world totals, not the resources of a single nation. Figure 2.5 shows the

known quantities in both the United States and the rest of the world.The world has a huge known reserve of coal, and a large part of that coal

reserve is in the United States. At current rates of use and if the rates of use con-tinue to grow at the same pace as in the past, the U.S. known coal reserves will lastfor 77 years and the rest of the worlds known coal reserves will last about 79years. The rest of the world has large reserves of gassufficient to last for 40yearsand oilsufficient to last for 27 years. But the United States has only smallknown reserves of oil and gassufficient to last for about 7 years.

The known or proven quantities of natural resources grow over time as moresources are discovered. Also, over time more fuel-efficient technologies get devel-oped. So the time until energy resources run out will be longer, perhaps muchlonger, than the numbers in the previous paragraph.


FIGURE 2.5

U.S. and Global Nonrenewable Energy ResourcesPractice On

Percent of world total

(years to empty)

Rest of world coal

U.S. coal

Rest of world gas

Rest of world oil

U.S. oil

U.S. gas

0 2010 30 40 50

79 years

77 years

40 years

27 years

7 years

7 years

The United States and the rest

world have large known reserve

coal, and the rest of the world

large reserves of gas and oil. At

current rate of use and if the ra

use continues to grow at the sa

pace as in the past, the United

will exhaust its currently known

reserves of gas and oil in 7 year

SOURCE: U.S. Department of Energy.

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Labor

Laboris the work time and work effort that people devote to producing goodand services. It includes the physical and the mental efforts of all the people whwork on farms and construction sites and in factories, shops, and offices. ThCensus Bureau and Bureau of Labor Statistics measure the nations labor forc

every month.The quantity of labor increases as the adult population increases. The quantity of labor also increases if a larger percentage of the population takes jobDuring the past 50 years, a larger proportion of women have taken paid work, anthis trend has increased the quantity of labor available.

Figure 2.6 shows the changes in the number of men and women and theitotals in the U.S. labor force since 1982. In 1982, a labor force of 110 million consisted of 62 million men and 48 million women. In 2002, a labor force of 144 milion consisted of 77 million men and 67 million women.

The quality of labor depends on how skilled people are. Economists use a special name for human skill: human capital. Human capital is the knowledge anskill that people obtain from education, on-the-job training, and work experienc

You are building your own human capital right now as you work on your economics course and other subjects. And your human capital will continue to growwhen you get a full-time job and become better at it. Human capital improves thquality of labor. Today, more than 80 percent of the population of the United Statehave completed high school and 25 percent have a college or university degre

LaborThe work time and work effort thatpeople devote to producing goodsand services.


Human capitalThe knowledge and skill that peopleobtain from education, on-the-job

training, and work experience.

FIGURE 2.6

Labor in the United StatesPractice Onlin

100

150

Labor force(millions of people)

Total

1982 1992 19971987

Year

50

0

2002

48 millionwomen

62 millionmen

67 millionwomen

77 millionmen

In 2002, 77 million men and 67 million

women worked outside the home in

the United States.The growth of the

female labor force has been more

rapid than growth of the male labor

force as an increasing percentage of

women have sought jobs.

SOURCE: Bureau of Labor Statistics.

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CapitalThe tools, instruments, machinebuildings, and other constructiothat have been produced in the

and that businesses now use toproduce goods and services.

Figure 2.7 shows a measure of the growth of human capital in the United Statesover the past century. In 1910, some 25 percent of the population had less than fiveyears of elementary school and fewer than 3 percent had a college or universitydegree. You can see how the number of high school and college graduates hasincreased steadily over the past 90 years.

CapitalIn addition to human capital, economists distinguish between two meanings ofcapitalfinancial capital andphysical capital. In everyday language, we talk aboutmoney, stocks, and bonds as being capital. For example, we talk about firms rais-ing capital by issuing stocks or bonds. These items arefinancial capital, and theyare not productive resources. They play an important role in enabling people tolend to businesses, and they provide businesses with financial resources, but theyare not used to produce goods and services. They are not capital.

Capital consists of the tools, instruments, machines, buildings, and other con-structions that have been produced in the past and that businesses now use to pro-duce goods and services. Capital includes hammers and screwdrivers, computers,auto assembly lines, office towers and warehouses, interstate highways, dams andpower plants, airports and airplanes, shirt factories, and cookie shops. The Bureauof Economic Analysis in the U.S. Department of Commerce keeps track of the totalvalue of capital, which grows over time. In the United States today, the value ofcapital is around $20 trillion. In the world as a whole, the value of capital exceeds$130 trillion.


FIGURE 2.7

Measures of Human CapitalPractice On

75

100

Percentage of adult population

4 years or more of college

Completed high school

Less than 5 years of elementary school

Some high school

1910 1950 1960 1970 1980 19901920 1930 1940

Year

50

25

0

2000

In 2000, 25 percent of the popuhad 4 years or more of college,

from fewer than 3 percent in 19

An additional 58 percent had co

pleted high school, up from 11

cent in 1910.

SOURCE: U.S. Census Bureau, Statistical Abstract of the United States, 1999.

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How We Produce in theNew Economy

The new economy consists of the

jobs and businesses that produce

Internet services, e-commerce, data-

base and other information services,

and other computer-driven services.

The new economy also consists of the

biotechnology industries.

These new economy sectors are

indeed growing rapidly. But they are not

really the heart of tomorrows economy.

Tomorrows economy, like todays

economy, will be an increasingly ser-

vice-oriented economy.

In 1996, some 15 million people

worked in general clerical and sales

jobs. By 2006, their number will be

swelled by another 2 million workers,

an increase of 14 percent since 1996.

Clerical work and retail selling are the

core of tomorrows economy.

Health care and personal care make

up a second large and fast-growing area.

The 6 million workers in these jobs will

grow to almost 8 million by 2006.

Food preparation and serving will

grow by 1 million workers to more

than 7 million by 2006.This increase

continues the trend toward people

buying an ever-increasing proportion

of their meals away from home.

The education sector will also

expand quickly with close to a million

more teachers by 2006, an increase of

33 percent since 1996.

The computer-driven economy will

expand rapidly too. In fact, it will grow

more quickly than any of the areas

weve just reviewed. In 1996, about

1 million people worked in this sec-tor. By 2006, this number will have

more than doubled.

These projections through 2006

reinforce the strong sense that our

economy is increasingly a service

economy.

Eye on the

U.S.Economy

Eye on the

U.S.Economy


Entrepreneurship

Entrepreneurship is the human resource that organizes labor, land, and capitaEntrepreneurs come up with new ideas about what and how to produce, makbusiness decisions, and bear the risks that arise from these decisions.

The quantity of entrepreneurship is hard to describe or measure. At som

periods, there appears to be a great deal of imaginative entrepreneurship aroundPeople such as Sam Walton, who created Wal-Mart, one of the worlds largesretailers; Bill Gates, who founded the Microsoft empire; and Michael Dell, whestablished Dell Computers, are examples of extraordinary entrepreneurial talenBut these highly visible entrepreneurs are just the tip of an iceberg that consists ohundreds of thousands of people who run businesses, large and small.

EntrepreneurshipThe human resource that organizeslabor, land, and capital.

Change from 1996 to 2006 (thousands)

Clerical and sales

Health and personal care

Food preparation and serving

Computer related

Teaching

(14)

(percent change)

(35)

(16)

(108)

(33)

0 500 1,000 1,500 2,5002,000

SOURCE: U.S. Census Bureau, Statistical Abstract of the United States, 2000.

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2 Describe the patterns and changes in howgoods and services areproduced in the United States.

Practice Problems 2.21. Describe how land is used in the United States and comment on the view

that urban sprawl is destroying our environment.

2. Which energy resources will run out first? What will the United States use toproduce electricity when its oil and natural gas are all gone?

3. Classify each of the following as one of the four factors of production:a. The Mississippi Riverb. School teachersc. A parking lot attendantd. Robot owned by General Motorse. A cruise ship

Exercises 2.21. How have the size, composition, and skill of the U.S. labor force changed

during the last few decades?

2. Why is it difficult to estimate how long the worlds nonrenewable energysources will last? Does it matter that one day they might all be used up?

3. Classify each of the following as land, labor, capital, entrepreneurship, ornot a factor of production:a. Yankee Stadiumb. I-80

c. Bill Gatesd. Halle Berrye. The Atlantic Ocean

Solutions to Practice Problems 2.21. The United States covers 1,944 million acres. Forests, parks, water, and other

federal land covers 450 million acres, agriculture uses 930 million acres, andother forest and rural land covers about 450 million acres. Urban land covers105 million acres. It is true that urban sprawl is using former farmland. But overthe past 20 years, only 35 million acres, or 1.8 percent of land, has been trans-ferred from agricultural to urban use. Forests and parks have not decreased.

2. Oil and natural gas will run out first. Coal reserves are very large, and knownreserves will last for almost 80 years at the current rate of use and if the rate ofuse continues to grow as it has in the past. So most likely, the United Stateswill continue to use coal to generate electricity after the oil and gas are gone.

3. Economists classify a. the Mississippi River as land; b. school teachers aslabor; c. a parking lot attendant as labor; d. a robot owned by GeneralMotors as capital; e. a cruise ship as capital.


Study Guide pp. 2

Practice Onlin

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2.3 FOR WHOM ARE GOODS PRODUCED?

Who gets the goods and services that are produced depends on the incomes thapeople earn and the goods and services that they choose to buy. A large incomenables a person to buy large quantities of goods and services. A small incom

leaves a person with few options and small quantities of goods and services.You know of lots of people who earn very large incomes. Tiger Woods winseveral million a year in prize money and earns substantially more than thiamount in endorsements. The average major league baseball players salary i2002 was $2.4 million, and some stars, such as Barry Bonds, Sammy Sosa, MannRamirez, Kevin Brown, Carlos Delgado, and Alex Rodriguez were paid $15 to $2million a year. News anchors Tom Brokaw, Peter Jennings, and Dan Rather, morning show host Katie Couric, and interviewer Barbara Walters all earn several milion dollars a year.

You know of even more people who earn very small incomes. Servers aMcDonalds average around $6.50 an hour. Checkout clerks, gas station attendants, textile and leather workers earn less than $10 an hour.

People earn their incomes by selling the services of the factors of productiothey own. Rent is paid for the use of land,wages are paid for the services of labointerest is paid for the use of capital, and entrepreneurs receive a profit (or incua loss) from running their businesses.

Which factor of production in the United States earns more income: labor ocapital? And how is income distributed among individuals? Figure 2.8 providesome answers. Part (a) shows the functional distribution of income, which is thdistribution of income among the factors of production. Labor earns most of thincome72 percent of total income in 2002. Capital incomecorporate incomand net interest incomewas 17 percent in 2002. The proprietors of businessewhose earnings are a mixture of labor and capital income, earned 9 percent of totaincome in 2002. Rental income of persons was 2 percent in 2002. These percentageremain remarkably constant over time.

Figure 2.8(b) shows the personal distribution of income, which is the distribution of income among households. The incomes are shown for five groupeach of which represents 20 percent of the population. If incomes were equaeach 20 percent group would receive 20 percent of total income. You know thaincomes are unequal, and the figure provides a measure of just how unequathey are.

The 20 percent of households with the lowest incomes receive only 5 percenof total income. The average income of this group in 2001 was about $10,000. Thsecond lowest 20 percent receive about 10 percent of total income. The averagincome of this group in 2001 was about $25,000. The next 20 percentthe middl20 percentreceive 16 percent of total income. The average income of this grouin 2001 was about $43,000. All three of these groupsthe lowest 60 percent o

householdsreceive only 31 percent of total income.The second richest 20 percent receives 23 percent of total income. The averag

income in this group in 2001 was about $67,000, and the highest income of thigroup was $83,500. So 80 percent of households receive less than $90,000 a year.

The richest 20 percent of households receive 47 percent of total income. Thaverage income in this group in 2001 was about $146,000. So the richest 20 percent get about half the goods and services produced, and the other 80 percent gethe other half.

RentIncome paid for the use of land.

WagesIncome paid for the services of labor.

InterestIncome paid for the use of capital.

Profit (or loss)Income earned by an entrepreneurfor running a business.

Functional distribution ofincomeThe distribution of income amongthe factors of production.

Personal distribution ofincomeThe distribution of income amonghouseholds.


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3 Describe for whom goods and services are produced in the United States.

Practice Problems 2.31. Distinguish between the functional distribution of income and the personal

distribution of income.2. How can wages account for 70 percent of all incomes when the 20 percent of

the population with the highest incomes receive 47 percent of total income?

Exercise 2.31. If everyone were to consume an equal quantity of goods and services, what

percentage of total income would the poorest 20 percent of individuals haveto receive from higher-income groups? What percentage would the second

poorest 20 percent have to receive?

Solutions to Practice Problems 2.31. The functional distribution of income is the percentage of total income

received by each factor of production. The personal distribution of income isthe percentage of total income received by households.

2. Many individuals own large amounts of capital and receive the largestincomes. In addition, many of these individuals earn high salaries.


FIGURE 2.8

For Whom?Practice On

(a) Functional distribution of income (b) Personal distribution of income

0 10 20 30 40 50

Poorest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Richest 20 percent

Percentage of total incom

Proprietors' income

(9%)

Corporate income

(9%)

Net interest income(8%)

Personal rental income(2%)

Labor income

(72%)

SOURCES: Bureau of Economic Analysis and U.S. Census Bureau,Money Income in theStates: 2001, Current Population Reports P60-218

Study Guide pp. 2

Practice Online

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Circular flow modelA model of the economy that showsthe circular flow of expenditures andincomes that result from decision

makers choices and the way thosechoices interact to determine what,how,and for whom goods andservices are produced.


2.4 CIRCULAR FLOWS

We can organize the data youve just studied using the circular flow modelmodel of the economy that shows the circular flow of expenditures and incomethat result from decision makers choices and the way those choices interact t

determine what, how, and for whom goods and services are produced. Figure 2shows the circular flow model.

Households and Firms

Households are individuals or groups of people living together. The 109 milliohouseholds in the United States own the factors of productionland, labor, captal, and entrepreneurshipand choose the quantities of these resources to providto firms. Households also choose the quantities of goods and services to buy.

Firms are the institutions that organize the production of goods and serviceThe 20 million firms in the United States choose the quantities of the factors oproduction to hire and the quantities of goods and services to produce.

MarketsHouseholds choose the quantities of the factors of production to provide to firmand firms choose the quantities of factors of production to hire. Householdchoose the quantities of goods and services to buy, and firms choose the quantties of goods and services to produce. How are these choices coordinated anmade compatible? The answer is: by markets.

A market is any arrangement that brings buyers and sellers together anenables them to get information and do business with each other. An example ithe market in which oil is bought and soldthe world oil market. The world omarket is not a place. It is the network of oil producers, oil users, wholesalers, anbrokers who buy and sell oil. In the world oil market, decision makers do not mephysically. They make deals by telephone, fax, and the Internet.

Figure 2.9 identifies two types of markets: goods markets and factor marketGoods markets are markets in which goods and services are bought and soldFactor markets are markets in which factors of production are bought and sold

Real Flows and Money Flows

When households choose the quantities of land, labor, capital, and entrepreneurship to offer in factor markets, they respond to the incomes they receiverent foland, wages for labor, interest for capital, and profit for entrepreneurship. Whefirms choose the quantities of factors to hire, they respond to the rent, wageinterest, and profits they must pay to households.

Similarly, when firms choose the quantities of goods and services to produc

and offer for sale in goods markets, they respond to the dollar amounts that thereceive from the expenditures that households make. When households choosthe quantities of goods and services to buy, they respond to the dollar amountthey must pay to firms.

Figure 2.9 shows the flows that result from these choices made by householdand firms. The real flows are shown in orange. These are the flows of the factorof production that go from households through factor markets to firms and thgoods and services that go from firms through goods markets to households. Thmoney flows go in the opposite direction. These flows are the payments made i

HouseholdsIndividuals or groups of people livingtogether as decision-making units.

MarketAny arrangement that brings buyersand sellers together and enables themto get information and do businesswith each other.

Goods marketsMarkets in which goods and servicesare bought and sold.

Factor marketsMarkets in which factors ofproduction are bought and sold.

FirmsThe institutions that organize theproduction of goods and services.

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exchange for factors of production (blue flow) and expenditures on goods and ser-vices (red flow).

Lying behind these real flows and money flows are millions of individualchoices about what to consume, what to produce, and how to produce. Thesechoices result in buying plans by households and selling plans by firms in goodsmarkets. And the choices result in selling plans by households and buying plans

by firms in factor markets. When these buying plans and selling plans are carriedout, they determine the prices that people pay and the incomes they earn and sodetermine for whom goods and services are produced. Youll learn in Chapter 4how markets coordinate the buying plans and selling plans of households andfirms and make them compatible.

Firms produce most of the goods and services that we consume. But govern-ments provide some of the services that we enjoy. And governments play a bigrole in modifying for whom goods and services are produced by changing the dis-tribution of income. So were now going to look at the role of governments in theU.S. economy and add them to the circular flow model.


FIGURE 2.9

The Circular Flow ModelPractice On

Goods andservices bought

Land, labor, capital,and entrepreneurshipsupplied

Goods andservicessupplied

Land, labor, capital,

and entrepreneurshiphired

Rent, wages, interest,and profit paid

Rent, wages, interest,and profit received

Revenue from sale ofgoods and services

Expenditure ongoods and services

FACTORMARKETS

GOODSMARKETS

HOUSEHOLDS

FIRMS

The orange flows are the factor

production that go from househ

through factor markets to firms

the goods and services that go

firms through goods markets to

households.

The flows in the opposite direc

are the payments made in excha

for the factors of production (t

blue arrows) and the goods andvices (the red arrows).

The choices that generate these

flows determine what, how, and

whom goods and services are p

duced.

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Governments

More than 86,000 organizations operate as governments in the United StateSome are tiny like the Yuma, Arizona, school district and some are enormous likthe U.S. federal government. We divide governments into two levels:

Federal government

State and local government

Federal Government

The federal governments major expenditures are to provide

1. Goods and services

2. Social security and welfare benefits

3. Transfers to state and local governments

The goods and services provided by the federal government include the legal sytem, which defines property rights and enforces contracts, and national defensSocial security and welfare benefits, which include income for retired seniors an

programs such as Medicare and Medicaid, are transfers from the federal government to households. Transfers to state and local governments are designed to provide more equality across the states and regions.

The federal government finances its expenditures by collecting a variety otaxes. The main taxes paid to the federal government are

1. Personal income taxes

2. Corporate (business) income taxes

3. Social security taxes

In 2002, the federal government spent and raised in taxes more than $2 trilionabout 20 percent of the total value of all the goods and services produced ithe United States in that year.

State and Local Government

The state and local governments major expenditures are to provide

1. Goods and services

2. Welfare benefits

The goods and services provided by state and local governments include the statcourts and law enforcement, schools, roads, garbage collection and disposawater supplies, and sewage management. Welfare benefits provided by state governments include unemployment benefits and aid to low-income families.

State and local governments finance these expenditures by collecting taxe

and receiving transfers from the federal government. The main taxes paid to thstate and local governments are

1. Sales taxes

2. Property taxes

3. State income taxes

In 2002, the state and local governments spent more than $1.3 trillionabou13 percent of the total value of all the goods and services produced in the UniteStates in that year.

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Governments in the Circular Flow

Figure 2.10 adds governments to the circular flow model. As you study this fig-ure, first notice that the outer circle is the same as Figure 2.9. In addition to theseflows, governments buy goods and services from firms. The red arrows that runfrom governments through the goods markets to firms show this expenditure.

Households and firms pay taxes to governments. The green arrows runningdirectly from households and firms to governments show these flows. Also, gov-ernments make money payments to households and firms. The green arrows run-ning directly from governments to households and firms show these flows. Taxesand transfers are direct transactions with governments and do not go through thegoods markets and factor markets.

Not part of the circular flow and not visible in Figure 2.10, governments pro-vide the legal framework within which all transactions occur. For example, theyoperate the courts and legal system that enable contracts to be written andenforced.


FIGURE 2.10

Governments in the Circular FlowPractice On

Expenditureson goods andservices


Rent, wages,interest, andprofit

Rent, wages,interest, andprofit

Expenditures

on goods andservices


Taxes

TaxesTransfers

Transfers

FACTORMARKETS

GOODSMARKETS

HOUSEHOLDS

FIRMS

GOVERNMENTS

The green flows from househol

and firms to governments are ta

and the green flows from gover

ments to households and firms

money transfers.

The red flow from governments

through goods markets to firms

the expenditures on goods and

vices by governments.

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Federal Government Expenditures and Revenue

What are the main items of expenditures by the federal government on goods anservices and transfers? And what are its main sources of tax revenue? Figure 2.1answers these questions.

You can see that by far the largest part of what the federal government spend

is on social security payments and other transfers to persons. National defensalso takes a big slice of the federal governments expenditures. The interest payment on the national debt is another large item. The national debt is the totaamount that the federal government has borrowed to make expenditures thaexceed tax revenueto run a government budget deficit. The national debt is a blike a large credit card balance. And paying the interest on the national debt is likpaying the minimum required monthly payment.

Transfers to other levels of government also use up a large part of the federagovernments expenditures. Purchases of goods and services (other than nationdefense) are relatively small, and subsidies and aid to other countries take a tinslice of expenditures.

Most of the tax revenue of the federal governmentalmost a half of itcome

from personal income taxes. And two thirds of the rest comes from social securittaxes. Corporate income taxes are a small part of the federal governments revenue

National debtThe total amount that the federalgovernment has borrowed to makeexpenditures that exceed taxrevenueto run a governmentbudget deficit.

FIGURE 2.11

Federal Government Expenditures and RevenuePractice Onlin

(a) Federal government expenditures (b) Federal government revenue

Social security

benefits(22.5%)

Other transfers

to persons(20.2%)

Goods andservices

(9.4%)

Subsidies(1.9%)

Aid toothercountries

(0.5%)Nationaldefense

(17.6%)

Interest on

national debt(15.1%)

Transfers to state and

local governments(12.8%)

Othertaxes

(5%)

Corporateincome taxes

(12%)

Social security taxes(35%)

Personal income taxes(48%)

Social security benefits and other transfers to persons take the

largest slice of federal government expenditures. National defense,

interest on the national debt, and transfers to state and local gov-

ernments also take a large share.

Most of the federal governments revenue comes from personal

income taxes and social security taxes. Corporate income taxes ar

only a small part of total revenue.

SOURCE: Bureau of Economic Analysis.

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State and Local Government Expenditures and Revenue

What are the main items of expenditures by the state and local governments ongoods and services and transfers? And what are their main sources of revenue?Figure 2.12 answers these questions.

You can see that education is by far the largest part of the expenditures made

by state and local governments. This item covers the cost of public schools, col-leges, and universities. It absorbs 40 percent of total expendituresapproximately$520 billion, or $1,870 per person.

Welfare benefits are the second largest item, and it takes 20 percent of totalexpenditures. Highways are the next largest item, and it accounts for 8 percent oftotal expenditures. The remaining 32 percent is spent on other local public goodsand services such as police services, garbage collection and disposal, sewage man-agement, and water supplies.

Sales taxes and transfers from the federal government bring in similaramountsabout 25 percent of total revenue. Property taxes account for 21 percentof total revenue. Individual incomes taxes account for 15 percent, and corporateincome taxes account for 3 percent. The remaining 13 percent comes from other

taxes such as estate taxes.

FIGURE 2.12

State and Local Government Expenditures and RevenuePractice On

(a) State and local government expenditures (b) State and local government revenue

Education(40%)

All other(32%)

Highways(8%)

Sales taxes(25%)

Transfers from

federal governme(23%)

Property taxes(21%)

Individualincome taxes

(15%)

All other(13%)

Public welfarebenefits

(20%) Corporateincome taxes

(3%)

Education, highways, and public welfare benefits take the largest

slice of state and local government expenditures.

Most of the state and local government revenue comes from

taxes, property taxes, and transfers from the federal governm

SOURCE: Bureau of Economic An

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Production and People

in the World TodayIn the United States, 5 percent of the

worlds people produce 22 percent of

the value of the worlds output.The

figure shows the percentages of popu-

lation and production for other

nations and regions.

Eye on the

Global

Economy

Eye on the

Global

Economy

52

4 Use the circular flow model to provide a picture of how households,firms, and governments interact to determine what, how, and for whom


Practice Problem 2.4What are the real flows and money flows that run between households, firms, angovernments in the circular flow model?

Exercises 2.41. What are the choices made by households and firms that determine what,

how, and for whom goods and services are produced? Where, in the circulaflow model, do those choices appear?

2. How do the actions of governments modify what, how, and for whom good

and services are produced? Where, in the circular flow model, do thosechoices appear?

Solution to Practice Problem 2.4The real flows are the services of factors of production from households to firmand the goods and services from firms to households and from firms to governments. The money flows are factor incomes, household expenditures, governmenexpenditures, taxes, and transfers.


Study Guide pp. 3032

Practice Online 2.4

Percentage of world

United States

Other advanced economies

Central and South America

Countries in transition

Middle East

China

Other developing Asia

India

Africa

Production

Population

0 10 20 30 40

SOURCE: International Monetary Fund, World Economic Outlookdatabase.

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Key Points

1 Describe the patterns and changes in what goods and services are pro-

duced in the United States. Medical care, housing, transportation, food, and recreation are the largest

expenditure items. Real estate services, retail and wholesale trades, healthservices, and education are the largest production items.

Food and other necessities are a decreasing component, and services arean increasing component of total production.

2 Describe the patterns and changes in howgoods and services are pro-duced in the United States.

A small and slowly increasing proportion of land is being built up.

Increased employment of women and a better-educated population have

increased the quantity and quality of labor. The quantity of capital increases over time.

Some highly visible entrepreneurs and thousands of small entrepreneursorganize the other factors of production and create the new ideas thatkeep changing what and how goods and services are produced.

3 Describe for whom goods and services are produced in the United States.

People earn incomes from the factors of production they own: rent forland, wages for labor, interest for capital, and profit for entrepreneurship.

More than 70 percent of total income comes from labor.

The richest 20 percent of the population consumes half of the goods andservices produced, and the other 80 percent share the remaining half.

4 Use the circular flow model to provide a picture of how households,firms, and governments interact to determine what,how, and for whom


The circular flow model shows the real flows of factors and goods and thecorresponding money flows of incomes and expenditures.

Governments in the circular flow model receive taxes, make transfers,and buy goods and services.

Key Terms

C H A P T E R C H E C K P O I N T


Capital, 41

Circular flow model, 46

Entrepreneurship, 42

Factor markets, 46

Factors of production, 38Firms, 46

Functional distribution of income, 44

Goods markets, 46

Households, 46

Human capital, 40

Interest, 44

Labor, 40Land, 38

Market, 46

National debt, 50

Personal distribution of income, 4

Profit (or loss), 44

Rent, 44

Wages, 44

Practice Online

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Critical Thinking9. Youve seen in this chapter that the United States is increasingly becoming a

service-producing economy. The production of food and manufactured goodsis a shrinking proportion of total production. We continue to consume largequantities of food and manufactured goods, but these items increasingly are

produced in other parts of the world and imported into the United States.Reflecting on these facts, do you think that we should be concerned thatmuch of our food and most of our clothing, electronic goods, and othermanufactured goods come from abroad? Organize your answer around thefollowing five points:a. In what ways should we be concerned?b. Who in the United States do you think benefits from the availability of

cheap foreign-produced food, clothing, electronic goods, and other manu-factured goods?

c. Who in the United States do you think bears the cost of cheap foreign-pro-duced food, clothing, electronic goods, and other manufactured goods?

d. Who in the rest of the world do you think benefits from the United States

buying foreign-produced food, clothing, electronic goods, and other man-ufactured goods?e. Who in the rest of the world do you think bears the cost of the United

States buying cheap foreign-produced food, clothing, electronic goods,and other manufactured goods?

10. Although our urban areas use only a bit more than 100 million acres of our1,944 million acres of land, urban use has increased by 35 million acres injust 20 years. In light of this change, do you think that we should be con-cerned that too much of our land is becoming urban? Organize your answeraround the following five points:a. What type of land gets transferred to urban use?b. Who benefits from the transfer of an acre of farmland to an acre of subur-

ban housing?c. Who bears the cost of the transfer of an acre of farmland to an acre of

suburban housing?d. What steps could be taken to slow the transfer of farmland to urban use?e. Is there a case for not just slowing the transfer of farmland to urban use

but either stopping it completely or even trying to reverse the trend?

11. If the trends in schooling continue, at some point in the future, everyonewill have a college degree and no one will be available to work as a janitoror garbage collector. Critically evaluate this statement.

12. Income is unequally distributed, but because wages account for more than70 percent of total income, any redistribution from the rich to the poor

means taking from wage earners to give to others. What is wrong with thereasoning in this statement?

13. The government grew larger through the mid-1980s and shrank slightlyafter that time. Do you think the government is too big or too small? Provideyour reasons.

14. Youve seen that all levels of government get only a small part of their rev-enues from taxing businesses. Why do you think businesses pay a smallshare of taxes? Wouldnt it be better if businesses paid more taxes and indi-viduals paid less? Explain your answer.


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Web ExercisesUse the links on your Foundations Web site to work the following exercises.

15. Review the special 20th Century Statistics section of the 1999 StatisticalAbstract of the United States and find the table that describes the trends infood consumption.

a. Describe the trends in the consumption of the eight categories of foodand drink shown in the table since 1970. Which item has increased most?Which item has increased least?

b. Can you think of reasons for the trends that youve found?

16. Review the special 20th Century Statistics section of the 1999 StatisticalAbstract of the United States and find the table that describes trends in thecharacteristics of housing and the items that people own.a. Describe the trend in the ownership of homes. Do more people own or

rent their homes today than the proportions in 1940?b. Describe the trend in the ownership of mobile homes and trailers.c. Describe the trend in plumbing facilities.d. Describe the trend in vehicle ownership.e. Describe the trend in telephone ownership.f. Can you explain the trends that youve found?

17. Review the special 20th Century Statistics section of the 1999 StatisticalAbstract of the United States and find the table that describes trends in trans-portation.a. Describe the trend in air travel.b. Describe the trend in the price of air travel.c. Can you explain the trends that youve found?d. How might these trends be influenced by the events of September 11,

2001?

18. Review the special 20th Century Statistics section of the 1999 StatisticalAbstract of the United States and find the table that describes trends in trans-portation.a. Describe the trend in road travel.b. Can you explain the trend that youve found?c. How might this trend be influenced by the events of September 11, 2001?

19. Visit regional income pages of the Bureau of Economic Analysis at the U.S.Department of Commerce.a. Obtain data on per capita personal income for the states as a percentage

of U.S. per capita personal income.b. Which state has the highest per capita income and which has the lowest?c. Where in the ranking does your state stand?

d. Can you think of reasons for the ranking that youve found?e. Does the ranking change much from year to year? Why or why not?

20. Visit the University of Michigans Statistical Resources on the Web.a. Find data that interest you and that provide information about what,

how, and for whom goods and services are produced.b. Find data that tell you about the size and the growth of government.c. Find data that tell you about the scale and trends in international trade.


Practice Online

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