Lecture 10 Notes

The circular flow diagram shows the interactions among the various actors and sectors of the economy. An economic actor is any entity that makes an economic decision.

Households

Business Firms

Businesses produce goods and services using the economic resources supplied by households. There are approximately 29 million businesses in the U.S. The most numerous are proprietorships. A proprietorship is owned by one person who receives all the profits and is responsible for all the debts incurred by the business (unlimited liability). The advantages of a proprietorship are (1) the owner has complete control of the business, (2) there is little legal complication involved in starting a proprietorship, and (3) the profits of the business are part of the income of the proprietor and, therefore, are taxed under the personal income tax. The disadvantages of a proprietorship are (1) since there is just one owner, the difficulty in raising funds for the business and (2) the proprietor's unlimited liability for the debts of the business.

A second form of business is the partnership. A partnership consists of two or more owners who share the profits and responsibility for the firm's losses. A partnership has the same tax advantage as a proprietorship: the profits of the business are treated as the personal income of the partners. More owners also gives partnerships access to a larger source of funds for the business. On the disadvantage side, partnerships are legally complicated: whenever there is a change in ownership the partnership is automatically dissolved. Also, the partners have unlimited liability for the debts of the business.

Most large businesses are organized as corporations. A corporation is a legal entity owned by shareholders whose liability for the firm's debts is limited to the value of the stock they own (limited liability). A corporation has the legal standing of a fictional individual. Because its owners enjoy limited liability for the debts of the business, a corporation can raise huge amounts of funds by selling stock. One disadvantage faced by a corporation is that it is subject to double taxation: dividends paid to shareholders are taxed once under the corporate income tax and then again under the personal income tax. A second disadvantage is the separation of ownership from control. Those managing the corporation may not act in the best interests of the shareholders.

Government

The government taxes, spends (partly on public goods), and regulates (to correct for externalities). All levels of government together purchase about 20% of all the goods and services produced each year.

Financial Sector

The financial sector acts as an intermediary between savers and investors. The financial sector includes financial markets such as stock and bond markets and financial intermediaries like banks, mutual funds, and insurance companies.

International Sector

The American economy has extensive interactions with the rest of the world. Trade in goods, services, and income is one such interaction. Exports are products made in this country and sold abroad; imports are foreign made products purchased by Americans.

A trade deficit occurs when a country imports more than it exports. The country receives fewer funds from its exports than it paid out for the imports. As a result, the nation must borrow from abroad to obtain the additional funds necessary to purchase the foreign goods.

David A. Latzko
Business and Economics Division
Pennsylvania State University, York Campus
office: 13 Main Classroom Building
phone: (717) 771-4115
fax: (717) 771-4062
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