Output Income You $20 $15 YourBoss $0 $5. Total $20 $20

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1 1. Output and Income Every day, people go to work and produce things apples, stereo equipment, haircuts. So far, we ve been studying the markets for these individual goods and services. Now, we ll look at a bigger picture the market for stuff in general, including apples, stereo equipment, haircuts, and economics textbooks. The first thing we need is a way to measure quantities of stuff. How do you add three apples to four economics textbooks? Answer: By measuring everything in dollars worth. Three dollars worth of apples plus ten dollars worth of textbooks plus five dollars worth of haircuts is eighteen dollars worth of stuff. Now, then: Every day, people produce stuff. Think of all the stuff that got produced today as sitting in one enormous pile. (This is a quite metaphorical pile, because it includes services like haircuts that you can t actually pick up or weigh.) When you produce stuff by building a radio or giving someone a haircut you re adding stuff to the pile. When you consume stuff by taking home a new radio or getting a haircut you re taking stuff out of the pile. Ordinarily, when you add to the pile by producing something, you are rewarded with income, which gives you the right to subtract from the pile. If you build a $20 radio, and sell it for $20, your reward is the right to take out $20 worth of stuff not necessarily radios; anything you want to spend your income on. In that example, your income is equal to the value of your output. But that s not always true. Suppose, for example, that you work for a boss who contributes absolutely nothing to your productivity. You go to work and build a $20 radio. Your boss sells the radio for $20, pays you $15, and pockets the remainder. In this case your output is worth $20, but your income is only $15. On the other hand, your boss s output is zero, while his income is $5. If we add up over both you and your boss, we have: 1

2 Output Income You $20 $15 YourBoss $0 $5 Total $20 $20 So that in the aggregate, output still equals income. For another example, suppose you produce no output at all today, but you re walking around with a $100 bill in your pocket (presumably from income that you earned in the past), which is taken from you by a robber. The robber has produced nothing he s added nothing to the pile of goods and services, and neither have you. Between the two of you, output is zero. The robber s income is $100, but your income is minus $100. Between the two of you, total income is zero the same as your total output. The bottom line is that in the aggregate which means after adding up over everyone in the economy Output = Income. That s so important we ll highlight it: In the aggregate, Output = Income. 2. Where Output Goes Once all the output is produced, where does it go? Answer: Some is claimed by households, some is claimed by firms, and some is claimed by the government. So you can think of the big pile of output as being divided up like this: 2

3 To Households To Firms To Government Households claim everything from Rice Krispies to Sony Playstations to haircuts. All of the goods and services claimed by households are collectively referred to as Consumption, and the total dollar value of all that consumption is designated by the letter C. In an economy with three households, where the first purchases $100 worth of goods and services, the second purcahses $200 worth, and the third purchases $350 worth, we have C = $550. Not all of the Rice Krispies are claimed by households. Some are claimed by firms called grocery stores, which put the Rice Krispies on the shelf (presumably in the hope that some household will claim them eventually). The goods claimed by firms are called investments, and their total value is denoted by I. What if a grocery store buys a box of Rice Krispies, and later on a household buys the Rice Krispies from the grocery store? Do those Rice Krispies count as consumption or investment? Answer: It depends where they are at the end of the day. When the day ends, if the Rice Krispies are still on the store shelf, they are part of today s investment (even though they might be part of tomorrow s consumption). If, before the day ends, the Rice Krispies have already landed in your pantry, they are part of today s consumption. Our decision to measure time in days is quite arbitrary. In fact, when government 3

4 agencies gather data on consumption or investment, they are more likely to measure time in months, quarters (that is, three-month periods) or years. In that case, what matters is where the Rice Krispies are at the end of the month, quarter or year. Firms claim more than just goods to put on their shelves. They also claim factories and assembly lines. In our metaphor, one of the things someone (or a whole bunch of someones) built today was a factory; that s part of the big pile of output, and some firm came along and claimed the factory out of the pile. Of course real life is slightly different; usually the firm asks to have the factory built. But we ll still think of that as people building the factory, tossing it in the pile, and letting the firm take it out. So investment includes cereal on store shelves and it also includes new factories and assembly lines. In everyday language but not in the language of economists investment also includes the purchase of financial instruments, like stocks and bonds. It is important to recognize that to an economist, thos things are not investments. Instead, investment means acquiring goods and services for the purpose of producing future goods and services. The box of Rice Krispies on the shelf today produce a future good, namely a box of Rice Krispies on the shelf tomorrow. The Rice Krispies factory produces even more Rice Krispies tomorrow. Those are the only things we count as investment. Besides households and firms, there is also the government, which claims goods like tanks, missiles, and rest rooms for public parks, as well as services like meat inspection and (in some localities) trash collection. The dollar value of all these goods and services is called government spending. Like investment, government spending means something different to an economist than it does in everyday language. If the government hands out $100 million in welfare checks, the newspapers call that an example of government spending. Economists don t, because it doesn t involve the claiming of any goods or services. In this case, all the government has done is shuffle a bunch of paper around. If the government hired someone to stuff the envelopes, that s an actual service, so it counts in government spending. But the money sent out is not part of government spending. 4

5 The reason for that distinction is that we re trying to account for where all the physical goods and services produced in the economy end up. Anything that just involves shuffling money sheds no light on that question, so it doesn t count. Of course, if the recipients spend that money to buy oranges, then those oranges are real physical goods but they end up in households, so they re part of consumption, not government spending. In summary, then, all goods end up either in households, in which case they count as consumption, or in firms, in which case they count as investment, or with the government, in which case they count as government spending. Those three categories account for all the economy s output. So if we write C for the total value of all households consumption, I for the total value of all firms investment, and G for the total value of all government spending, then we must have: Output = C + I + G The following picture will help you remember this equation: 5

6 OUTPUT: Consumption (C) Investment (I) Government Spending (G) To Households To Firms To Government 3. Where Income Goes. As we ve seen in Section 1, individuals (who reside in households) receive income which, in the aggregate, is equal to the value of their output. What can you do with your income? Answer: Three things. First, you can buy stuff, which you bring home to your household. That s called consumption. Second, you can save part of your income, presumably to spend in the future. Another word for saving is lending. If you save by putting money in the bank, you ve lent money to the bank. If you save by purchasing corporate stocks and bonds, you ve lent money to the corporation. If you save by putting a thousand dollar bill under your mattress, we ll think of that as lending to yourself which makes sense, because, just as when you put money in the bank, you re giving up an opportunity to spend today in exchange for an 6

7 opportunity to spend more tomorrow. Saving can be either positive or negative. If you borrow money, or withdraw money from your savings account, we count that as negative saving. Besides consumption and saving, the third thing you do with your income is pay taxes. So your income is divided among consumption (C), saving (S) and taxes (T ), which gives us the equation Income = C + S + T The following diagram will help you remember this: INCOME: Saving (S) Consumption (C) Taxes (T) 4. Putting It All Together. In section 1, we learned that in the aggregate Income = Output In section 2, we learned that Output = C + I + G 7

8 In section 3, we learned that Income = C + S + T Therefore, in the aggregate (which, again, means after adding up over everyone in the economy), we have C + S + T = Income = Output = C + I + G More simply, we can write C + S + T = C + I + G Although these equations hold in the aggregate, they need not hold for any individual. Indeed, for an individual, the C on the left side of the equation need not be the same as the C on the right side of the equation. For example: Suppose you go to work and produce $100 worth of scotch tape, of which $50 worth is bought by households, $30 worth is bought by firms, and $20 worth is bought by government. Then on the right side of the equation, you ve contributed $50 to C, $30 to I, and $20 to G. None of that has anything to do with how you spend your own income. You might decide to spend $50 today, or $100 today, or $0 today, or even $1000 today (presumably by borrowing or drawing down your saving). Your contribution to the C on the left side of the equation is then $50 or $100 or $0 or $1000. But in the aggregate, after we add up over everyone in the economy, the C on the left and the C on the right must be equal. Each of them measures the total value of goods claimed by households. Therefore we can cancel one C with the other, so our equation C + S + T = C + I + G simplifies to S + T = I + G 8

9 which we can rearrange as S = I + (G T ) 5. The Riddle. We ve seen that S = I + (G T ) Of course each of those letters stands for a number. numbers are determined. Let s think about how those S is saving. Households decide how much to save, so households choose S. I is investment. Firms decide how much to invest, so firms choose I. G T is called the government budget deficit. It s equal to what the government spends minus what the government collects in taxes. In other words, it s the amount the government must borrow in order to carry on its activities. (After all, all spending has to be paid for.) The government decides how much to spend, how much to tax, and (consequently) how much to borrow, so the government chooses G T. In other words, S, I and G T are all chosen by different decision makers. Which leads to a riddle: If each of these numbers is chosen independently, what guarantees that they ll add up correctly so that S = I + (G T )? To understand the answer, think about a simpler riddle: Demanders decide how much coffee to buy. Suppliers decide how much coffee to sell. Yet the quantity bought and the quantity sold must be equal. If these numbers are chosen by different decision makers, what can force them to be equal? The answer, as we know, is that if they re not equal, the price of coffee adjusts until they become equal. If suppliers want to sell more coffee than demanders want to buy, the price gets bid down, which both reduces the quantity supplied and increases the quantity demanded. This process continues until the quantities supplied and demanded are equal, even though they re being chosen by different people. 9

10 Exactly the same is true of the equation S = I + (G T ). Three different groups determine the three numbers S, I and G T. If the numbers don t add up, then some price must adjust, causing the decisionmakers to revise their choices until the equation holds. In this case, the relevant price is the interest rate. Our next task is to understand exactly how this works. 10