This chapter begins the study of microeconomics. While microeconomics and macroeconomics are the two major divisions in studying the field and share the common language and model-building techniques of economics, their focus is quite different. Macroeconomics looks at the total economy and how it functions, and studies the economic behavior of groups such as households, businesses, and government units. Microeconomics looks at decision making and how it influences the behavior of individuals in households and businesses.

This chapter is designed to give you background information about households and businesses before we do an in-depth study of microeconomic concepts. It is helpful first to know some basic terminology, explore some data, and understand the economic objectives of decision making within households and businesses.

OVERVIEW OF HOUSEHOLDS

When economists and others collect and analyze information about the U.S. population they often categorize these data by individuals, families, or households. For example, data tell us that in 2010, the population of the United States was about 309 million persons: 152 million men and 157 million women. The average age was 37 years old and most people lived in urban areas.¹

People are included in family statistics only when two or more related individuals live together. As a consequence, many people are left out of family data. Household data are more inclusive, and usually preferable, since a household is made up of a person living alone or a group of related or unrelated persons who occupy a “housing unit,” such as a house or an apartment. (Jails, military barracks, and college dorms do not count.)

In 2010, there were about 118 million households in the United States. The average size was about 2.6 persons (a slight decline in size over the past two decades) and about 27 percent of all households had just one person (a slight increase over the past two decades).²

Household Income and Expenditures

Do you remember the circular flow model in Chapter 2? In this model, households sell factors of production, like labor, for income, and use that income to buy goods and services. Since much economic decision making in household units revolves around these two areas, it is helpful to know something about the sources and sizes of household income and the types of expenditures that households make.

Household Income Table 10.1 lists the sources of household pretax income, or personal income, on a percentage basis for selected years. The figures show that labor income is the primary source of household income and that fluctuations have occurred over the past few decades in the relative importance of all other income sources.

Table 10.1 also shows the importance of transfer payments in providing income: They were over 18 percent of personal income in 2010, a large bump over previous years due to recessionary conditions. Recall from Chapter 5 that transfer payments are money received from the government for which no direct work is performed in return. Government transfer payments include Social Security, unemployment, temporary disability, veterans' and public retirement benefits, public assistance, and others. A large amount of transfer payments in any given year goes to those covered under the Social Security Act.

TABLE 10.1 Sources of Personal Income (Percentage Distribution for Selected Years)

How large is average household income? How much does it differ from household to household because of the gender, age, or education of the head of the household? The answers are in Table 10.2. The average income for all households in 2009 was $49,777, and there were significant differences among the average incomes for households when certain characteristics were observed. For example, family households headed by a married couple averaged $71,830, while families headed by a female (with no spouse present) averaged $32,597. Not surprisingly, household income was lower for older adults who may be retired from the labor force. It is also important to notice the effect of education on average income. Households headed by a person with a bachelor's degree on average earned almost twice as much as households headed by a high school graduate.

Household Expenditures Basically, households use their incomes for three purposes: spending, paying taxes, and saving. The majority of income goes to spending: In 2010 households used about 82 percent of their gross or personal income for the purchases of goods and services. That same year, over 9 percent went for personal taxes and almost 6 percent for saving.³ These figures, however, are on the aggregate and can be misleading. Households with higher incomes pay more taxes and save more, while households with lower incomes pay fewer taxes and may not save at all.

There is a wealth of data about the annual expenditures of consumer units which is frequently mined by researchers on consumer spending patterns, by macroeconomists, and by analysts for companies looking to increase their sales of a product. For example, we know that in 2009, the average consumer unit used 13 percent of its expenditures for food, 16 percent for transportation, 34 percent for housing (including utilities), and 11 percent for pensions and social security among other expenditures.⁴

TABLE 10.2 Average Money Income of Households^a

When we look at how households spend their money, a popular way to classify expenditures is by whether they are for durable goods, nondurable goods, or services. A durable good has a useful lifetime of more than one year—a car, musical instrument, or furniture, for example. A nondurable good has a short span of use, such as food or gasoline. In recent years, the largest portion of household expenditures has gone for services—medical care, for example. In 2010, people, on average, used about 67 percent of total expenditures for services, 22 percent for nondurable goods, and 11 percent for durable goods.⁵ The percentages in these categories have not stayed constant over time; spending for services has been continually increasing.

Goals and Decisions of Individuals in Households

Think about all of the economic decisions that you make during a semester. Many of them are minor, like the choices between water and soda or chips and cookies from a vending machine; and many are major, like the choice of coursework, a place to live, or the kind of job to take on. During our lives all of us are constantly faced with decisions about how to use our money and our time. What is it that we are looking for as we make all of these decisions?

At first it might appear that there are a lot of different objectives that individuals could have when making economic decisions. But economists see all these decisions as ultimately coming down to one basic objective: Individuals try to obtain the most satisfaction possible from their decisions. In other words, people are out to maximize their economic well-being.

What do we mean by maximizing our economic well-being? Does it mean that we try to acquire all the goods and services that can possibly be obtained or that every waking hour is spent working in order to make lots of money? We derive satisfaction from the things we buy, the things we do, and the decisions we make. Some students really enjoy a cup of coffee in the morning; some dislike coffee. Some people enjoy their work; others find it mildly satisfying. Some students find economics fascinating; some find communications more attractive. And we can go on with many examples. The point is that everyone has things they enjoy more than others and things they dislike.

Maximizing economic well-being is a balancing process. It involves weighing the advantages, or benefits, and the disadvantages, or costs, of different courses of action and selecting the one that contributes most to economic satisfaction. In other words, people compare the satisfaction they get from various actions with the cost of those actions in making their choices. This notion of balancing costs and benefits in order to maximize economic well-being should become clearer as we apply it to basic spending and earning decisions.

Maximizing Satisfaction from Consuming Goods and Services With limited incomes, people can't have all of the goods and services they want. This is the individual's own version of the basic economic problem of scarcity: limited resources in comparison to the wants and needs to be satisfied. In Chapter 1 we learned that scarcity imposes decisions and choices: Individuals must choose how to use their limited incomes.

Economists refer to the satisfaction received from consuming (buying) a good or service as utility. When you buy a lunch or put gas in your car, for example, you receive utility. The goal of an individual in making spending decisions is to choose the combination of goods and services that gives maximum total satisfaction, or maximum total utility, for a given amount of income spent. To maximize total utility, a person must, for each good or service that could be purchased, weigh the satisfaction that can be obtained from consuming that good or service against its price. This decision-making process can be illustrated through some simple examples.

Suppose that you are at a sporting event and would like a large, hot pretzel and a soda. All you have is $3, and the pretzel costs $3 and the soda costs $3. What will you buy? Obviously, you will spend your money on the good that adds the greatest amount of satisfaction. If it's the pretzel, you spend $3 for the pretzel; if it's the soda, that is where your money goes. To maximize satisfaction, your $3 will be spent on the thing that adds the most for the money to your total utility.

In this example, the choice is easy because the prices are the same. But what happens when a person is choosing among goods with different prices? Suppose that someone has $100 to spend and would like to get a pizza for $20, go out to dinner for $25, buy $50 worth of hockey tickets, get a new cell phone for $100, and buy a $10 paperback. With so many choices and just $100, what should this person buy?

Before making a decision, this person will weigh the added satisfaction from each item in comparison to the dollars spent on that item. If the entire $100 is spent for a cell phone, satisfaction will be maximized only if that phone adds more than twice the satisfaction from the $50 hockey tickets, more than five times the satisfaction from the $20 pizza, more than four times the satisfaction from the $25 dinner, and so on.

The Utility–Price Rule A simple rule emerges from the two preceding examples. To maximize total utility from spending a given income, a buyer must weigh the utility received from each good against the money spent on that good. In deciding between a pretzel and soda, you would have spent your $3 on the item that gave the greatest satisfaction for the money. In allocating $100 among the various alternative goods that could have been purchased in the previous example, the buyer would have weighed the added utility received from each item against its price.

Maximizing utility is not simply a matter of receiving more satisfaction from one item than another: It is a matter of receiving more satisfaction for the money. While a person who is car shopping might get a lot of satisfaction from a new hybrid, the price tag is higher than that of a used car. Total satisfaction might be greater by buying a used car plus all of the other goods and services that the lower-priced car allows the person to purchase. Again, in making spending decisions, a maximizing person will consider both the added utility received from the item and the price of the item.⁶

Can this utility–price rule be seen at work in the real world? Do people really use this balancing principle in making purchasing decisions? The answer is yes, they do. The process might not be quite as precise as in the examples presented here, but basically consumers compare the price of an item with the expected addition to satisfaction from acquiring the item. Watch people at a vending machine or in line at a fast-food restaurant trying to choose the items that would give them the most satisfaction for their money. Or think of yourself as you grumble about, but do pay, the electric and other utility bills. Those bills are paid and the services continue because the satisfaction from having light, heat, and water is worth it. Can you see this balancing process at work in Application 10.1, “Family Gossip?”

Maximizing Satisfaction from Earning Income As with spending decisions, maximizing satisfaction from working involves balancing benefits and costs. There are many considerations that go into the choice of a job: its mental and physical demands, pay, flexibility, availability of overtime work, full-time versus part-time, location, and such. Each of these considerations carries benefits and costs: A flexible-time job that accommodates a decent semester course schedule might pay less than a job with inflexible hours.

Consider the decision to work overtime. Putting in more hours provides additional income that can be spent on goods and services, but extra hours at work mean less time for other activities. The choice that a person makes is this: Is the extra income and satisfaction from working overtime enough to justify the dissatisfaction from forgoing other activities as a result of the extra work? For example, a student who works overtime might afford a better car and get away to Cancun over spring break, but at the cost of a higher GPA. This student must determine whether the extra income is worth the cost. Application 10.2, “You Decide,” gives three examples of people doing the cost-benefit balancing act when making career decisions. What is your opinion of each of these choices?

APPLICATION 10.1

In summary, both spending and earning decisions involve the goal of maximizing economic well-being. The decision maker weighs the advantages, or benefits, and disadvantages, or costs, of different strategies to choose the one that comes closest to accomplishing that objective. This weighing, or balancing, which is at the heart of the individual decision-making process, is covered in detail in the next chapter.

OVERVIEW OF BUSINESS

Since several of the following chapters focus on business decision making, it is important to have some basic knowledge about the business sector. A business is an organization established to produce and sell goods and services. In the United States there are over 31.6 million legally organized business firms. Well over one-half are small operations with annual receipts under $25,000; others are huge enterprises selling billions of dollars worth of goods and services each year.

Business decisions, especially about output and prices, have a powerful influence on the economy. A very large firm, like Wal-Mart, which employed more than 2 million people in 2011, or one of the other firms listed in Table 10.3, can have a significant impact on employment conditions in an industry or region. A few large firms with a substantial share of a market that accounts for a significant amount of consumer spending could contribute to inflation by raising their prices. Product development, labor relations, concern for the environment, and community involvement are also areas that are affected by business decisions.

APPLICATION 10.2

Before we explore the specifics of business decision making, let us examine the legal forms of business and some structural aspects of U.S. businesses.

Legal Forms of Business

A business must take on a legal form before it can operate. It may be a

• proprietorship,
• partnership, or
• corporation.

Proprietorship A one-owner business that is typically small—such as an antique shop or an independent consultant—is called a proprietorship. Usually in a proprietorship the owner is the manager and a jack-of-all-trades, performing the functions of a bookkeeper, financial analyst, and marketing specialist among others. For the owner of the business, this legal form has two advantages: It is relatively easy to start a business that is organized as a proprietorship, and there is independence in decision making. The owner is not responsible or answerable to anyone.

TABLE 10.3 The 10 Largest U.S. Corporate Employers: 2012

A proprietorship, however, has several limitations: particularly, difficulty in raising money and unlimited liability. The sole proprietor who wants to raise money for expansion, remodeling, or other purposes can do so only by borrowing from private sources, such as family or friends, or from financial institutions like commercial banks, or through certain government programs. Because proprietorships cannot issue stocks and bonds, a large source of money capital cannot be readily tapped by the single-owner business.

A proprietorship is also subject to unlimited liability; that is, the owner's personal assets are subject to use as payment for business debts. If a creditor cannot be fully paid from the assets of the business, the courts may take the owner's personal property to satisfy such debts.

Partnership A business similar to a proprietorship with two or more (perhaps hundreds of) owners is a partnership. This arrangement permits the pooling of money, experience, and talent. For example, a person who is skilled in cooking and kitchen administration and a person who is adept at management and finance might create a successful restaurant. Unfortunately, partnerships often lead to dissension between partners and dissolution of the business.

Unless it is legally documented, all owners in a partnership are general partners. A general partner is one who has the burden of unlimited liability, and each partnership must have at least one general partner. If misunderstood, unlimited liability can create problems for a partner. In a partnership, each general partner is responsible for 100 percent of the business's debts. In case of default, liability is not necessarily divided in halves, thirds, or other equal amounts. Instead, the debts beyond those covered by the business's assets will be paid through the personal assets of whichever partners possess the means. If one general partner is penniless and the other wealthy, the partner with the assets will pay the debts.

Corporation A corporation is a “legal person” created by law: It can sue or be sued, make contracts, pay fines, and carry on other aspects of business normally performed by individuals. Unlike humans, a corporation can continue indefinitely. To form a corporation, a charter, which involves some cost and red tape to acquire, must be obtained from a state.

As a corporation is established, shares of stock are sold (additional shares may be sold later), and the holders of those shares become the owners of the corporation. One major advantage for corporation owners is limited liability: Personal assets are not subject to payment for business debts. In case of bankruptcy, an owner can lose only the money used to purchase the stock. This sum, however, could be considerable.

The owners of a corporation receive profits through quarterly corporate dividend checks. How much profit a stockholder receives depends on the corporation's profitability, the type of stock the owner holds, and the amount of profit that is retained by the business. Corporations can issue both preferred and common stock. Preferred stock carries a stated dividend, and preferred stockholders are entitled to their dividends before common stockholders are paid. Common stock pays a dividend dependent on the profit position of the firm after creditors and preferred stockholders have been paid. A quarter with healthy sales and sizable profits might yield a healthy return on common stock, and a quarter with no profit will yield no dividend check.⁷

Each share of common stock entitles its owner to one vote on some corporate policies and, most importantly, to elect a board of directors. The corporate board of directors is the governing body of a corporation and makes many major decisions, including the selection of the corporation's CEO (chief executive officer) and other top management. These managers run the corporation on a day-to-day basis. Figure 10.1 outlines the structure of a corporation.

With each share of common stock carrying a vote, control of a corporation rests with those who hold a large portion of the stock. These stockholders have the power to elect themselves or their candidates to the board of directors. A person with a few thousand shares in a small corporation might have control over that business, but a few thousand shares in a company like Starbucks would be negligible. Test Your Understanding, “The Price of Stock Shares,” discusses how the price of a share of stock is determined by supply and demand, and provides an opportunity to evaluate how changes in supply and demand affect a stock's price.

No discussion of a corporation is complete without some mention of bonds. Corporations can borrow large amounts of money for building, expansion, and other purposes by selling bonds. Bonds provide a corporation with an avenue other than stocks to tap other corporations, private individuals, and organizations for funds. Corporate bonds are typically sold in $1,000 denomination blocks and have a specified interest rate and maturity date. A bondholder is a creditor of the company and not an owner.

Since the late 1970s there has been growing interest in the United States in forming Limited Liability Companies, or LLCs, which combine characteristics of the three legal forms of business we have just discussed. Like corporations, LLCs protect their members with limited liability. But like proprietorships and partnerships, they also allow greater decision-making flexibility than is typically found in corporations. Depending on its legal form and for tax purposes, an LLC can be classified as a proprietorship, partnership, or corporation.

FIGURE 10.1 Structure of a Corporation

Numbers and Sizes of Businesses

How many businesses are there in the United States? How are they organized? Table 10.4 gives the number of legally organized businesses in the United States and the size of business receipts (sales) in 2008. There were about 32 million businesses, with the vast majority, about 72 percent, organized as proprietorships. Only 19 percent were corporations.

Table 10.4 also shows that most of the business receipts went to corporations. Of the $33.6 trillion in total sales, corporations accounted for about $27 trillion (or about 81 percent). Proprietorships received about 4 percent of the total sales. While the vast majority of businesses are proprietorships, they account for only a small percentage of the total sales of the economy. Corporations, which tend to be larger, account for most business sales.

Business Ownership of Business

Corporate stock is owned by funds, such as pension, endowment, and mutual funds, as well as directly by individuals. And, in many cases the controlling shares of stock in one corporation are owned by another corporation. In these cases, the corporation that owns the stock is said to own the other corporation. It is often not readily apparent that one corporation owns another because both may retain separate identities and operate as separate businesses.

The buying of controlling shares of stock in one corporation by another corporation is referred to as a merger or acquisition. Merger activity in the United States has been high since the 1980s but has slowed down in recent years as has the economy. The price tags on many corporate acquisitions are in the billions of dollars. For example, in 2008 InBev acquired Anheuser-Busch for $52 billion. In 2009 Pfizer, the world's largest drug maker, purchased its rival Wyeth for $68 billion.⁸

TEST YOUR UNDERSTANDING

TABLE 10.4 Number and Receipts of Proprietorships, Partnerships, and Corporations: 2008

When one corporation acquires another corporation and there is no relationship between the goods and services that the two corporations produce, the acquisition is called a conglomerate merger. A manufacturer of toys could acquire a carburetor company, or an electronic components producer could acquire a wallpaper firm. General Electric, for example, in addition to manufacturing major household appliances, jet engines, and other products, owns the media giant NBC Universal and GE Commercial Finance, which provides loans, leasing, insurance and other services, and a 49 percent stake in the media giant NBC universal.⁹

In some cases, a corporation may acquire other corporations that are closely related to it or to each other in some way. Pepsico, for example, owns, or has owned, Pepsi-Cola companies, Tropicana, Frito-Lay, Pizza Hut, Taco Bell, Kentucky Fried Chicken Corporation, and Quaker Foods.¹⁰ When a corporation acquires another corporation that supplies its inputs or distributes its products, such as a supplier-distributor relationship between Pepsi Cola and Pizza Hut, a vertical merger has occurred. When a corporation acquires another firm that competes in the same market, as do some Pepsi and Tropicana products, a horizontal merger has taken place.

Sometimes a corporation is formed specifically for the purpose of owning or holding stock in other corporations. This type of company, which produces nothing itself, is termed a holding company. Figure 10.2 shows a hypothetical example of a bank holding company, Alltown Bank Corporation, which exists only to own controlling shares of stock in Hometown Bank, Downtown Bank, and other banks.

There are many reasons why one firm may seek to merge with another: to fill out a product line or move into a new geographic market, to acquire a company with large amounts of cash, to diversify, to avoid a hostile takeover from yet another company, or some other reason. Mergers and acquisitions are covered in more detail in Chapter 14.

FIGURE 10.2 The Alltown Bank Holding Company

Application 10.3, “Two Profiles: Starbucks and Kraft Foods,” provides short profiles of two corporations that all of us know, and are increasingly growing into a major global presence. It is interesting to see how these two companies differ with regard to mergers, ownership, and growth. Notice the holding company arrangement with Kraft Foods and the growth of Starbucks without major acquisitions.

Goals and Decisions of Business Firms

A typical business, large or small, is faced with many decisions about how to legally organize, what products to sell, how to price, whether to expand and perhaps go global, and such. What is a business really trying to accomplish? What is the ultimate purpose of its decisions?

In the study of economics, as well as other areas, it is generally assumed that the fundamental objective of business decision making is to maximize a firm's profit or minimize its loss. This doesn't mean just earn any profit or avoid a loss, but rather earn the largest profit possible or take the smallest loss.

How does a firm measure profit or loss? When a business sells a product, the money received from its sales is called revenue. For example, when a doughnut shop sells 1,000 dozen of doughnuts a week for $7 per dozen, it receives a revenue of 1,000 times $7, or $7,000. Also, in producing a good or service, a business incurs costs for labor, materials, transportation, insurance, and other inputs. These costs are charged against revenue to determine whether a profit or loss has been made. So, for a business firm:

If revenue is $7,000 and costs are $5,000 the business earns a profit of $2,000. If revenue is $7,000 and costs are $7,500, there is a loss of $500.

Profit goes to the owners of a firm who bear the risk of its success or failure. In a proprietorship or partnership, profit goes to the owner(s) who organize and operate the business, and in a corporation it goes to the stockholders.

Profit maximization or loss minimization for a business is a balancing process, just as spending and earning decisions are for individuals. A firm weighs or balances the expected revenue and expected costs of each of the operating strategies from which it can choose, and then picks the strategy that contributes most to its profitability. This balancing of revenues and costs is covered in detail in the next chapter.

Questions about Profit Maximization The goal of profit maximization or loss minimization raises some interesting issues and debates. What does profit maximization mean? Does maximizing mean that a business maintains the quality of its product, meets the needs of its workforce, and generally is a good citizen of the community as it seeks the largest profit possible? Or does it imply operating with minimum regard for quality, the environment, working conditions, and wages for the sake of a larger profit?

APPLICATION 10.3

The relationship between profit-maximizing and socially responsible behavior is of great importance and is addressed in many political and legislative arenas. For example, today there are laws which penalize companies that in the quest for more profit destroy the environment, produce unsafe products, give misleading claims about their products, or disregard the rights of their workers.

Another issue centers on whether a business may actually seek some alternative goal other than profit maximization. For example, a company might sacrifice profits over the short run to introduce a new product into an untapped region of the country, or to get a head start in developing new technology that could revolutionize its industry, or to purchase another company. Is sacrificing profit in the short run in order to increase profit in the future inconsistent with the goal of profit maximization?

UP FOR DEBATE

Debate also occurs over the importance of profit maximization to owners in the different forms of business. It is easy to see how profit maximization can explain the motivation of a sole proprietor or general partner, where the owner is directly involved in decision making. Sometimes it is more difficult to understand profit maximization in a large corporation, where stockholders are typically not directly involved in the decision-making process and where managers who receive fixed salaries run the firm.

Why would the managers of a large corporation be motivated to maximize profit? If the profit performance of a company is unsatisfactory, stockholders can replace the corporation's top management. In addition, the fear of a hostile takeover by another corporation could also motivate managers, since a decline in the profitability of a corporation could lead to a drop in the price of its stock, making it cheaper for another firm to acquire shares and gain control. And with new ownership often comes new management of the acquired firm. Also, in many instances top managers might be motivated to maximize profit because they themselves have significant holdings of the company's stock.

Questions about profit-maximizing behavior are also raised in Up for Debate: “Should Profitable Businesses Be Expected to Actively Participate in Improving Their Communities?.” What is your opinion of the arguments on each side, and which side do you think makes the better case? Do you have any examples of companies in your hometown that are active in community projects and events?

Summary

1. A household is made up of an individual living alone or several persons living in a group. The majority of household income comes from the sale of resources, particularly labor. Unearned income from government transfer payments is an important source of income. Of the different types of cash benefit transfer payments, Social Security is the largest.
2. The average income of all households taken as a group differs from the average incomes of various subgroups of households. This difference may be related to such factors as the education, age, or gender of the household head. Household income can be saved, used for paying taxes, or spent, with the vast majority going to purchase goods and services. Purchases of goods can be divided between expenditures on durable and nondurable goods.
3. The main economic objective of an individual's spending and earning decisions is to maximize economic well-being. Realizing this objective requires weighing alternatives and choosing the course of action that contributes most to economic satisfaction.
4. The satisfaction from buying a good or service is called utility. To maximize the total utility from spending a given sum of money, a purchaser must weigh the additional satisfaction from each unit of an item consumed against that item's price and compare that to the additional satisfaction and price of alternative goods and services.
5. Earning decisions involve weighing and balancing costs and benefits. In the case of working more hours, the added satisfaction from more income is weighed against the added dissatisfaction from forgoing alternatives such as time to study or work out in order to earn that income.
6. A business is an organization established to produce and sell goods and services. A firm may be legally organized as a proprietorship, partnership, or corporation. Each of these legal forms of organization has certain advantages and disadvantages, such as the ease of starting the business, the nature of the owner's liability, and the ability to borrow funds. Numerically, there are more proprietorships in the U.S. economy than there are partnerships and corporations, but most receipts go to corporations.
7. Many corporations have a controlling share of their stock owned by another corporation. When a corporation buys the controlling shares of stock in another corporation, a merger or acquisition has taken place. Because two firms are related through ownership is no reason to assume that the goods and services they produce are related in any functional way.
8. The basic objective of a business firm is to maximize profit or minimize loss. Profit or loss equals revenue minus costs. As is the case with a household, business profit maximizing requires balancing: in this case, the expected revenues and costs from different operating strategies.
9. There are some questions concerning the profit-maximizing objective. These include the relationship between profit-maximizing and socially responsible behavior, and the extent to which a firm's other short-term goals are compatible with long-term profit maximization.

Key Terms and Concepts

Microeconomics

Household

Personal income

Transfer payment

Durable good

Nondurable good

Maximizing economic well-being

Utility

Total utility

Utility maximization

Business

Proprietorship

Unlimited liability

Partnership

General partner

Corporation

Preferred stock

Common stock

Corporate board of directors

Bond

Limited Liability Companies (LLCs)

Merger or acquisition

Conglomerate merger

Vertical merger

Horizontal merger

Holding company

Revenue

Profit or loss

Profit maximization

Review Questions

1. What are the main sources of household income and the different uses to which household income can be put? How is household income affected by the head of household's age, gender, education, and other factors?
2. Would a person maximize satisfaction by buying a $15 product that adds twice as much satisfaction as a $5 product? Why? Would the person maximize satisfaction by buying the $15 product if the price of the other product was $10? Why? Explain the utility–price relationship that buyers use in maximizing their economic well-being.
3. An individual maximizes economic well-being by making spending and earning decisions, and a business maximizes profit by deciding how much of its product to produce and sell. These decisions are similar in that they involve a balancing process.
   1. Generally, what is common to the balancing processes in decisions made by households and businesses?
   2. How do their decisions differ in terms of what is balanced?
4. Explain differences in the three basic forms of business: proprietorship, partnership, and corporation. What are the advantages and disadvantages of each form for the owners?
5. What is the difference between a stock and a bond? Why might it be necessary for a firm to issue bonds in order to acquire another firm? What are some factors that would cause the price of a corporation's stock shares to fluctuate?
6. What is the difference among a conglomerate merger, horizontal merger, and vertical merger? Give some examples of each.
7. Suppose a co-worker says, “What's required for a business to maximize profit is very simple: Produce the lowest-quality product you can, don't worry about the environment, and pay the lowest wages you can get away with.” Do you think this is what profit maximizing is all about? Why?

Discussion Questions

1. Students who rent apartments close to college campuses often complain that they have to pay a lot for what they get. Explain, in terms of what you have learned in this chapter, why students, despite a limited income, will continue to rent at these high prices.
2. Over the years, the amount of income spent on services in the United States has grown to the point where it is larger than the amount spent on both durable goods, such as automobiles, and nondurable goods, such as food, combined. How might this growth in the demand for services be explained by increases in the general standard of living, the increase of women into the labor force, technology, and the aging of the population? What other explanations might there be?
3. Can you explain in economic terms why someone with a so-called sweet tooth might be more than willing to buy an expensive chocolate mousse cake but would not consider buying a high-quality steak?
4. What factors should a person consider when choosing between two job offers?
5. Suppose that you are a business organization consultant, and three people come to you, each wanting to start a business. The first person wants to start an organic vegetable farm with her sister, the second a store selling musical instruments, and the third a barge line for moving coal on rivers. Each is seeking your advice on whether to organize as a proprietorship, partnership, or corporation. How would you advise each of them? Does it make any difference which form of organization each person chooses?
6. “Paying higher salaries to its workers, or incurring higher costs to increase its share of the market, does not mean that a firm is giving up the objective of maximum profit. Instead, it means that the firm is taking steps now to ensure that it will be able to maximize profit in the future.” Do you agree or disagree with this statement? Explain your reasoning.
7. In a proprietorship, the owner is often the manager, but in a corporation the owners are often different from the managers. What advantages and disadvantages might there be in having a separation of ownership and management?
8. Companies sometimes provide funds to colleges and universities for buildings or stadiums. Do you think this is done because of a civic motivation or is it a marketing tool?

Critical Thinking Case 10

¹ U.S. Bureau of the Census, Statistical Abstract of the United States: 2012, 131st ed. (Washington, DC: U.S. Government Printing Office, 2012), pp. 11, 36.

² Statistical Abstract of the United States: 2012, 131st ed., pp. 54, 55.

³ Statistical Abstract of the United States: 2012,131st ed., p. 443.

⁴ Ibid, p. 451.

⁵ Economic Report of the President (Washington, DC: U.S. Government Printing Office, 2012), Table B-16.

⁶ The utility-maximizing rule can be stated more precisely by comparing the added utility from consuming one more unit of each item to the item's price. Economists refer to the additional utility from consuming one more unit of an item as marginal utility. (Marginal utility is discussed more fully in Chapter 11.) If we divide the marginal utility from consuming one more unit of an item by the item's price, we can determine how much is added to total utility per dollar spent on that item.

Assume that a person is considering whether to buy Good X or Good Y. The marginal utility from consuming one more unit of Good X is 15 units of satisfaction and the price of Good X is $5.00. If MUx and Px stand for the marginal utility and price of Good X, then MUx/Px = 15/$5 = 3 units of satisfaction for every dollar spent on that unit of Good X. One more unit of Good Y can be purchased for $8.00 and the marginal utility is 16 units of satisfaction. Comparing the marginal utility and price gives us MUy/Py = 16/$8 = 2 units of satisfaction for every dollar spent on that unit of Good Y. Each dollar spent on the last unit of Good Y adds only two units of satisfaction, while every dollar spent on the last unit of Good X adds three. This person would be better off buying one more unit of Good X than Good Y.

When does a person pick exactly the right combination of goods and services to maximize total utility? Maximization occurs when the MU/P ratio is the same for the last unit of each of the items a person buys, or when:

When all the MU/P ratios are equal for the last unit of each good purchased, the expenditure on the last unit of each item adds as much to total utility as is added by the expenditure on the last unit of each other item. If the MU/P ratio for an item is greater than that of other items, a person should buy more of that item because it adds more per dollar to total satisfaction. If the MU/P ratio for an item is less than that of other items, a person should buy less of that item because it adds less per dollar to total satisfaction than other items.

⁷ Preferred stock does not guarantee a dividend. If the company has not made enough profit for a return to the preferred stockholders, they will not receive a dividend. However, if the preferred stock is cumulative, the stockholders are entitled to receive the return at some future point when profit is made.

⁸ David Nicklaus, “Once-Bold A-B Folds in Face of Bigger Risk Taker,” St. Louis Post-Dispatch, July 20, 2008, p. E1; Andrew Ross Sorkin and Duff Wilson, “Pfizer Agrees to Pay $68 Billion for Rival Drug Maker Wyeth,” The New York Times, January 26, 2009, www.nytimes.com.

⁹ GE Products & Services, www.ge.com.

¹⁰ Mergent FIS, Moody's Industrial Manual: 2000 (New York: Mergent FIS, Inc., 2000), Vol. 1, p. 2642; Vol. 2, p. 6325; www.pepsico.com. Some of these acquisitions have subsequently been sold.