We all have an understanding of the concept of income on an individual level and what our own income is. But how should we measure the income of a whole economy? What is the relation between our income and the value of what we produce? To find the nation’s income do we just add up the incomes of the household, business, and government sectors? And how does the rest-of-the-world enter the picture? What does the nation spend its income on, and what does it save? How does savings relate to investment?

These are all questions we will answer in this chapter, starting with the simplest kind of society, Robinson Crusoe. By understanding that case we can readily grasp the national income concepts for a complex economy. Finally, we will look at the national income of the U.S., find out the major sources of that income and what Americans spend it on.

In Daniel Defoe's classic adventure novel, Robinson Crusoe is shipwrecked alone on a tropical island. He sets about gathering food and making things that he needs using the few tools and materials that he is able to salvage from the shipwreck. Robinson Crusoe is a one person economy. His income is what he produces. It is not money but the coconuts he gathers, the fish he catches, and the objects that he makes.

Crusoe spends part of his time producing things for immediate use: fish caught in the lagoon, coconuts gathered nearby, and furniture to make his life more comfortable. Crusoe also puts part of his effort into making tools which will enhance his productivity in the future, for example a raft that takes him out to better fishing spots. Finding evidence that cannibals visit his island, Crusoe also builds a stockade to protect himself. We see that his time is divided between producing consumption goods for his immediate use, capital goods that are an investment in an improved standard of living in the future, and goods that would be purchased by government in a more complex society.

Crusoe is obliged to decide how much of his income, the things he produces, will be allocated to consumption now, how much to investment so he can consume more in the future, and how much to defense. His opportunities to consume, invest, and defend are limited by his ability to produce. The portion of his income that is not consumed or expended on defense is his savings, and that is invested in capital goods which will increase his income in the future.

Even though Crusoe's economy is just a one person economy (until he finds a native he calls Friday who has just narrowly escaped being a consumption good for the cannibals) and uses no money, it teaches us some fundamental rules that apply even to the most complex modern economies. These are:

  • The income of a society is the value of what it produces.

  • Income is divided between three alternative uses: consumption, investment, and government.

  • To increase any one of these uses, society must either increase its income or reduce one or both of the others.

  • An increase in income requires investment in capital goods that make the economy more productive.

  • Savings, the amount of income that is not consumed by households or government, is equal to the investment in new capital goods.

The choices facing any society are basically the same that Crusoe faced, and they are reflected in the issues that occupy public debate today: Are we investing enough in modern factories and equipment to produce the growth in income that we would like? Or are Americans on a consumption binge that is reducing economic growth? Should something be done to encourage Americans to save and invest more? What effects does government spending have on our economy? What will be the economic fall-out from the defense build-up we see today?

Crusoe alone decided how to allocate his income between consumption, investment, and defense, but in our economy these decisions are made separately by the four sectors of the economy. The household sector makes consumption decisions while firms decide how much to invest in capital goods. Households do not receive the goods they produce directly, but rather they receive money which they can spend or save. Similarly, government through legislative bodies makes spending decisions and levies taxes to pay for them. While these decisions are made by different agents in different sectors of the economy, they must always obey the rule that in any economy the amount consumed by households, plus government purchases, plus investment in capital goods is equal to total income. Income, in turn, cannot exceed the productive capacity of the economy.

Now let's see how a simple model of the economy can help us understand how the sectors of a complex economy interact. A model in economics is much like a model in architecture or car design: it is a representation of the real thing which is useful for exploring some of the properties of the real thing but is vastly less complex. From a scale model of a proposed office building we can learn a lot about how the building will function for the people who will work in it, even though the model leaves out much of the complex structural detail of the real building.

Similarly, economic models can help us see important aspects of an economy that is far too complex for humans to understand in all its details. A good strategy in using models is to start with the simplest version we can think of, and then make the model progressively more realistic and complex as we need to.

Exercises 2.1

A. Classify each of the following goods produced by Robinson Crusoe as consumption, investment, or "government:" a fishing net, a fish, a chair, a spear, a look-out tower, a cleared garden plot. Similarly, classify a theater ticket, a car, a taxi, a Boeing 747, a stealth fighter.

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