Economic Rationality: Households, Firms, and Public Sector Roles
Economic Rationality: Core Principles
This concept describes the behavior of households and firms, considering they use their scarce resources to maximize their own utility or benefits.
Households or Families
The domestic economy is composed of individuals, singly or grouped into families, whose primary function is to satisfy their needs through the consumption of goods and services. With their income (household income), families must decide how to distribute it: how much to spend and on what types of goods or property, how much to save, and for what reasons.
Businesses
Businesses are economic agents whose basic function is to produce goods and services that society demands. They need to hire workers, purchase capital goods, and procure raw materials to transform these factors into goods and services fit for consumption. The economic rationality of firms aims to maximize profits.
The Public Sector
This area of the economy is directly controlled by political power. It comprises both government and public bodies, such as state-involved companies.
Key Functions of the Public Sector:
- Provide Basic Goods and Services: There are certain goods that private companies do not offer, either because they are not profitable or because not all people have the resources to acquire them. The state intervenes to provide public works and infrastructure necessary for the country, and offers services to the population, such as education and health.
- Correct Inequalities: In society, there are large differences in the income received by individuals and the wealth they possess. The state uses its budget, whose revenue (primarily from taxes) often comes proportionally more from those who earn more, to address these disparities.
Circular Flow, Supply, and Demand
Transactions performed in the market involve two sides or dimensions. For example, we offer our work in the factor market in exchange for a wage, but we demand goods when shopping at the supermarket for cash.
Objectives of Economic Agents:
- Families (Consumption): Maximize their own welfare by choosing assets that satisfy them according to their preferences and limited budget.
- Businesses (Production): Maximize profits by efficiently using available resources to produce goods and services more profitably.
- Public Sector (Regulation): Maximize general welfare by using available resources to produce necessary public goods and services and reduce inequalities.
Market Factors
This is where resources used in the production process (labor, land, and capital) are exchanged for a price or income, such as wages, rents, interest, and profits.
Product Market
This involves the trade of goods and services that satisfy a need, in exchange for a fee.
Relationship: Households and Firms
- The first relationship occurs in the product market. Here, goods and services sold by companies are traded for money paid by families.
- The second relationship occurs in the factor market. In this market, families offer their labor to companies in exchange for a wage, which allows them to buy the goods and services they need.
The Circular Flow of Income
This consists, on one side, of the flow of goods, services, and factors between families and businesses, and on the other side, by their corresponding cash payments.