2.6 The economy: Government, firms, households, and the environment

The case of Kellogg illustrates how people interact with each other and with their natural environment in producing their livelihoods. It captures some of the main themes in economics, including the following:

• We often benefit by working together with other people—cooperating—compared to going it alone.
• When we work together, there is typically a conflict over how the benefits of cooperation will be divided among the participants.
• Our opportunities for cooperation and how the benefits of cooperation are divided up are determined by the institutions governing our interactions, that is, the rules of the game.
• We can often use game theory and the principle that people do the best they can to understand the likely outcomes of interactions.
• The rules of the game also determine how our economic interactions affect the environment.
• Important aspects of the rules of the game include who the first mover is and what people’s outside options are.
• Governments and citizens exercising their democratic rights can alter the rules of the game.

We introduced Kellogg as a miniature version of the whole economy. In the whole economy, the players are not a particular company, the government of a single town, and a citizen or worker, but instead millions of households and firms and many levels of government (including city, state, and national). The “map” of the whole economy in Figure E2.1 expands the map of the local economy in Figure 1.1.

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https://books.core-econ.org/uoe-101/02-06.html#figure-2-7

Figure 2.7 Players and their interactions: a map of the whole economy.

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https://books.core-econ.org/uoe-101/02-06.html#figure-2-7a

The biosphere and physical environment

The starting point is the biosphere and the environment. They contain the energy, minerals, air, water, plants, animals, land, and soil on which the economy relies.

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https://books.core-econ.org/uoe-101/02-06.html#figure-2-7b

Adding households

Now we add households. Households both use the resources from the environment and pollute the environment. Before any other work, households engage in care work and household production to look after family members and, sometimes, to provide subsistence needs for the household. (Subsistence needs are the needs we have for everyone to have just enough food, water, shelter, and so on.)

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https://books.core-econ.org/uoe-101/02-06.html#figure-2-7c

Introducing firms and production

Households and firms interact with each other. Firms also use natural resources and pollute the environment. Firms hire workers and pay them a salary. Workers use the resources that firms can access to engage in production of goods and services that firms sell back to households or to other firms.

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https://books.core-econ.org/uoe-101/02-06.html#figure-2-7d

The role of the government

Finally, we add the government. The government taxes households and firms and provides public goods and services to both, such as the roads on which we drive, the laws that govern our economies, and education for the children in the households. The government hires workers from the households and pays them salaries, and the government buys goods and services from the firms.

Like all maps, this one is a simplification. A more complete picture would include firms, households, and governments in other countries, men and women, people of different ages, ethnic communities among the households, and private organizations other than firms (such as trade unions, churches, and community groups). Some households would be poor, living on low wages and transfers from the government, and others would be very wealthy, owning the firms and not being employed by anyone. Transfers are payments from the government that typically help poor households or people who qualify for the transfer for other reasons, such as social security benefits, Medicaid, and the earned income tax credit.

The relationships (shown by the arrows) among the actors differ. In some situations, people make choices on their own and in other situations they take directions or obey regulations imposed by others. The goods and services that firms sell to each other and to households are exchanged by people choosing what they would like to buy or sell on markets. The labor that households provide to firms is directed by managers and owners, not chosen by workers. Taxation policy and other government policies are implemented by governments that in a democracy are elected by the votes of household members.

In later units, we will use the same ideas from game theory to explain how individuals and households do the best they can and how this often involves caring about others and valuing fairness. We also explain how firms make decisions about hiring household members, and how they set prices and make other decisions when they compete with other firms in selling their goods. And we explain the activities of governments as economic actors, because well-designed public policies are essential to facilitating our economic interactions with others in ways that result in fair outcomes and environmental sustainability.