ECONOMIC SECTORS, PRIVATE SECTOR AND CIRCULAR FLOW

by modi Sun Oct 27, 2013 12:54 pm

ECONOMIC SECTORS, PRIVATE SECTOR AND CIRCULAR FLOW

The U.S. economy and economies of other countries are grouped into what are called sectors.

These sectors are groupings of buyers and sellers according to the specific functions they

perform. There are four basic sector classifications: the (1) HOUSEHOLD or CONSUMER

sector , the (2) BUSINESS sector, the (3) PUBLIC or GOVERNMENT sector and the (4)

INTERNATIONAL or FOREIGN sector.

          Household or Consumer Sector

                   The market participants (buyers and sellers) in this sector are individuals that

                    consume final products. These individuals are buyers in the product market and

                    sellers in the resource market.

          Business Sector

                  The market participants in this sector are business organizations that hire resources

                   and produce products. These organizations are buyers in the resource market and

                   sellers in the product market.

          Public or Government Sector

                   The market participants in this sector consist of federal, state and local governments.

                   Governments are buy both products and resources and sell both products and

                   resources as well.

          International Sector

                   The market participants in this sector are U.S. and foreign entities that buy and sell

                   each other products and resources.

In addition, economists frequently refer to the following sector or economy classifications.

-       PRIVATE sector (or economy): Household + Business sectors.

-       CLOSED economy: Household + Business + Government Sectors (excludes the
             International sector, i.e. no foreign trade).

-       OPEN economy: Closed economy + International sector

PRIVATE SECTOR – CONSUMER/HOUSEHOLD SECTOR + BUSINESS SECTOR

Consumer/Household Sector

   Definition of a Household
       One or more persons occupying a housing unit.

   Households as Sellers of Resources (Receivers of Income)
       The question of “For Whom” (who gets the goods/services?) in Economics as discussed earlier
       is a question of income distribution. The two measures on income distribution are listed below.

              Functional Distribution of Income
-       Households receive income in the form of wages, rent, interest and profits. When

income is broken down this way, i.e. by the way it is earned, it is referred to as the “function

distribution of income”.

-       Approximately 80% of income earned is in the form of wages, while approx. 20 % is earned in the form of interest rent and profits.

-       Trend in the functional distribution of income is increasing % of wages including proprietorship share.

               Personal Distribution of Income
-       Income distribution can also be measured by dividing households into five numerically equal groups which are ranked from highest to lowest income and then showing the % of total income earned by each of the groups or quintiles.

-       Shows income in U.S. is unequally distributed among households. The highest
income group earns over 50% of total income, while the lowest income group earns
                        less than 4% of total income.

-       Distribution of wealth is more unequal as fewer people control more of the wealth in the U.S.

   Households as Buyers of Products (Spenders of Income)

Income of households is disposed of or used in the following ways:

          Personal Taxes
-       Federal income tax is the major tax payment coming out of household income.
                        (approx.13%).

             Personal Saving (S)
-       The part of after tax personal income not spent. The top 10 % of income receivers account for most of personal saving.

               Personal Consumption Expenditures
-       After tax personal income spent on consumer products which consist of

                         1). Durable goods – 3 years or more of expected life.
                          2). Non-durable goods – consumer goods with less than 3 years life.
                          3). Services – account for 59% of consumer expenditures and the trend in service
                               expenditures is that this percentage will increase.

Business Sector

    Important terminology in the business sector follows.
         - Plant: A physical location of a business. More than one function can be performed at a plant.
         - Firm: A business organization that owns and operates a plant or several plants.
        - Industry: A group of firms that produce the same or similar products.
         - Horizontally Integrated Firms: Multi-plant firms that perform much the same function at each
              plant
         - Vertically Integrated Firms: Multi-plant firms that perform different functions in the various
              stages of the production process at each plant.

    Legal Forms of Business Ownership
            Sole Proprietorships
-       Business owned and operated by a single person.
-       Easy and inexpensive to set up
-       Unlimited liability. Owner is personally responsible for debts of business.
-       Limited ability to raise money
-       The benefits of specialization are limited because owner has to wear many hats.
             Partnership
-       Business owned and operated by two or more persons.
-       Set up is more involved and expensive.
-       Unlimited liability on part of owners
-       More ability to raise money than sole proprietorship, but still limited.
-       More ability to specialize, but still limited.

            Corporation
-       Business owned by shareholders and operated by management that is hired by the
                        owners.
-       Most difficult and expensive form of ownership to set up.
-       Liability of owners (shareholders) is limited to their investment.
-       Able to raise large amounts of financial capital.
-       Extensive ability to specialize.
-       Double taxation problem. Both corporate income and dividends to shareholders are taxed.

               Limited Liability Corporation
-       Ownership form that has characteristics of sole proprietorship/partnership and corporation.
-       Owners are only taxed once like a partnership when they receive dividends.
-       Owners liability is limited to their investment as in a corporation.

               S or Sub-Chapter S Corporation
                 -     75 or less shareholders who are only taxed once.
                 -     Limited liability on part of owners.

Principal-Agent Problem

      Principals are the owners or stockholders of a business. Agents are the managers of a business

      who are hired by the owners to run the business. The problem: the interests of the agents

      (managers) don’t always coincide with the interests of the principals who hired them.

-       Principals are interested in maximizing profits and stock price.
-       Agents may decide they are more interested in personal power, prestige and pay than in profits and stock price.
-       Solution to the Principal-Agent problem that was developed during the 1980’s:
Giving agents stock options to tie agent pay to stock prices. Stock options had an unexpected side effect, however. Executive agents created artificially high stock prices by overstating profits and then cashed in their stock options earning exorbitant personal fortunes. And with the decline in stock prices in the 1990’s, the manipulations of profit figures and fraudulent accounting practices were exposed.

SIMPLE TWO PRIVATE SECTOR CIRCULAR FLOW

The diagram below shows simple two private sector circular flow.


                                     SIMPLE TWO SECTOR CIRCULAR FLOW

                        ------>----- $ Sales of Final Goods/Services -------- >-----------------
                        |                                                                                                           |
                       ^                                                                                                           |
PRODUCT            |                                                                                                                                                v
MARKET              |                                                                                                                                                |
EXCHANGES:     |                                                                                                                                                 |
                        |      -< $ Expenditures to Buy Final Goods/Services ---- <-----
                        |      |                                                                                              ^     |
                       ^     v                                                                                              |     v
                        |      |                                                                                              ^     |
                        |     v                                                                                              |      |
___________ _______________                                  ____________________________
BUSINESSES/PRODUCERS                                     CONSUMERS/HOUSEHOLDS
_________SECTOR________                                    ________ SECTOR____________
                       |       |                                                                                               |      |
                      v      ^                                                                                              |      ^
                       |       |                                                                                              v      |
                       |      ^                                                                                               |      |
                       |       |                                                                                              v      |
                      v       |       $ Sale of resources/factors to Businesses                  |      ^
                       |        --<--(land, labor, capital, entrepreneurship) --<---- <-- --       |
RESOURCE/        |                                                                                                                                                   |
FACTOR            |                                                                                                                                                   |
MARKET       v                                                                                                             ^
EXCHANGES:   |                                                                                                               |
                       |                                                                                                               |
                       ----- >------ $ income paid to resources/factors ----------- >------------
                                                (rent, wages, interest, profits)

   Assumptions Underlying Two Sector Circular Flow

      1). no government sector or international sector is included. This economy is called

            a private, closed economy.

      2). all goods and services produced by business sector are sold (no unsold inventory)

      3). all income received by consumer/household sector is spent (no income is saved)

      4). only the value of “final” goods and services is included


   Important Circular Flow Observations

      1). Product Market – market in which goods and services are traded or exchanged

      2). Resource or Factor Market – market in which land, labor, capital and

            entrepreneurship are traded or exchanged


      3). Businesses sell in the product market and buy in the resource market

      4). Households/consumers buy in the product market and sell in the resource market


      5). The income earned in the resource market consists of rent, wages, interest and

            profit which are the payments made for the use of the four resources.