U.S. Economy

БОЛЬШАЯ ЛЕНИНГРАДСКАЯ БИБЛИОТЕКА - РЕФЕРАТЫ - U.S. Economy

U.S. Economy

United States (Economy)

INTRODUCTION

The U.S. economy is immense. In 1998 it included more than 270 million

consumers and 20 million businesses. U.S. consumers purchased more than

$5.5 trillion of goods and services annually, and businesses invested

over a trillion dollars more for factories and equipment. Over 80 percent

of the goods and services purchased by U.S. consumers each year are made

in the United States; the rest are imported from other nations. In

addition to spending by private households and businesses, government

agencies at all levels (federal, state, and local) spend roughly an

additional $1.5 trillion a year. In total, the annual value of all goods

and services produced in the United States, known as the Gross Domestic

Product (GDP), was $9.25 trillion in 1999.

Those levels of production, consumption, and spending make the U.S.

economy by far the largest economy the world has ever known—despite the

fact that some other nations have far more people, land, or other

resources. Through most of the 20th century, U.S. citizens also enjoyed

the highest material standards of living in the world. Some nations have

higher per capita (per person) incomes than the United States. However,

these comparisons are based on international exchange rates, which set

the value of a country’s currency based on a narrow range of goods and

services traded between nations. Most economists agree that the United

States has a higher per capita income based on the total value of goods

and services that households consume. American prosperity has attracted

worldwide attention and imitation. There are several key reasons why the

U.S. economy has been so successful and other reasons why, in the 21st

century, it is possible that some other industrialized nations will

surpass the U.S. standard of living. To understand those historical and

possible future events, it is important first to understand what an

economic system is and how that system affects the way people make

decisions about buying, selling, spending, saving, investing, working,

and taking time for leisure activities.

Capital, savings, and investment are taken up in the fourth section,

which explains how the long-term growth of any economy depends upon the

relationship between investments in capital goods (inventories and the

facilities and equipment used to make products) and the level of saving

in that economy. The next section explains the role money and financial

markets play in the economy. Labor markets, the topic of section six, are

also extremely important in the U.S. economy, because most people earn

their incomes by working for wages and salaries. By the same token, for

most firms, labor is the most costly input used in producing the things

the firms sell.

The role of government in the U.S. economy is the subject of section

seven. The government performs a number of economic roles that private

markets cannot provide. It also offers some public services that elected

officials believe will be in the best interests of the public. The

relationship between the U.S. economy and the world economy is discussed

in section eight. Section nine looks at current trends and issues that

the U.S economy faces at the start of the 21st century. The final section

provides an overview of the kinds of goods and services produced in the

United States.

U.S. ECONOMIC SYSTEM

An economic system refers to the laws and institutions in a nation that

determine who owns economic resources, how people buy and sell those

resources, and how the production process makes use of resources in

providing goods and services. The U.S. economy is made up of individual

people, business and labor organizations, and social institutions. People

have many different economic roles—they function as consumers, workers,

savers, and investors. In the United States, people also vote on public

policies and for the political leaders who set policies that have major

economic effects. Some of the most important organizations in the U.S.

economy are businesses that produce and distribute goods and services to

consumers. Labor unions, which represent some workers in collective

bargaining with employers, are another important kind of economic

organization. So, too, are cooperatives—organizations formed by producers

or consumers who band together to share resources—as well as a wide range

of nonprofit organizations, including many charities and educational

organizations, that provide services to families or groups with special

problems or interests.

For the most part, the United States has a market economy in which

individual producers and consumers determine the kinds of goods and

services produced and the prices of those products. The most basic

economic institution in market economies is the system of markets in

which goods and services are bought and sold. That is where consumers buy

most of the food, clothing, and shelter they use, and any number of

things that they simply want to have or that they enjoy doing. Private

businesses make and sell most of those goods and services. These markets

work by bringing together buyers and sellers who establish market prices

and output levels for thousands of different goods and services.

A guiding principle of the U.S. economy, dating back to the colonial

period, has been that individuals own the goods and services they make

for themselves or purchase to consume. Individuals and private businesses

also control the factors of production. They own buildings and equipment,

and are free to hire workers, and acquire things that businesses use to

produce goods and services. Individuals also own the businesses that are

established in the United States. In other economic systems, some or all

of the factors of production are owned communally or by the government.

For the most part, U.S. producers decide which goods and services to make

and offer to sell, and what prices to charge for those products. Goods

are tangible things—things you can touch—that satisfy wants. Examples of

goods are cars, clothing, food, houses, and toys. Services are activities

that people do for themselves or for other people to satisfy their wants.

Examples of services are cutting hair, polishing shoes, teaching school,

and providing police or fire protection.

Producers decide which goods and services to make and sell, and how much

to ask for those products. At the same time, consumers decide what they

will purchase and how much money they are willing to pay for different

goods and services. The interaction between competing producers, who

attempt to make the highest possible profit, and consumers, who try to

pay as little as possible to acquire what they want, ultimately

determines the price of goods and services.

In a market economy, government plays a limited role in economic decision

making. However, the United States does not have a pure market economy,

and the government plays an important role in the national economy. It

provides services and goods that the market cannot provide effectively,

such as national defense, assistance programs for low-income families,

and interstate highways and airports. The government also provides

incentives to encourage the production and consumption of certain types

of products, and discourage the production and consumption of others. It

sets general guidelines for doing business and makes policy decisions

that affect the economy as a whole. The government also establishes

safety guidelines that regulate consumer products, working conditions,

and environmental protection.

Factors of Production

The factors of production, which in the United States are controlled by

individuals, fall into four major categories: natural resources, labor,

capital, and entrepreneurship.

Natural Resources

Natural resources, which come directly from the land, air, and sea, can

satisfy people’s wants directly (for example, beautiful mountain scenery

or a clear lake used for fishing and swimming), or they can be used to

produce goods and services that satisfy wants (such as a forest used to

make lumber and furniture).

The United States has many natural resources. They include vast areas of

fertile land for growing crops, extensive coastlines with many natural

harbors, and several large navigable rivers and lakes on which large

ships and barges carry products to and from most regions of the nation.

The United States has a generally moderate climate, and an incredible

diversity of landscapes, plants, and wildlife.

Labor

Labor refers to the routine work that people do in their jobs, whether it

is performing manual labor, managing employees, or providing skilled

professional services. Manual labor usually refers to physical work that

requires little formal education or training, such as shoveling dirt or

moving furniture. Managers include those who supervise other workers.

Examples of skilled professionals include doctors, lawyers, and dentists.

Of the 270 million people living in the United States in 1998, nearly 138

million adults were working or actively looking for work. This is the

nation's labor force, which includes those who work for wages and

salaries and those who file government tax forms for income earned

through self-employment. It does not include homemakers or others who

perform unpaid labor in the home, such as raising, caring for, and

educating children; preparing meals and maintaining the home; and caring

for family members who are ill. Nor, of course, does it count those who

do not report income to avoid paying taxes, in some cases because their

work involves illegal activities.

Capital

Capital includes buildings, equipment, and other intermediate products

that businesses use to make other goods or services. For example, an

automobile company builds factories and buys machines to stamp out parts

for cars; those buildings and machines are capital. The value of capital

goods being used by private businesses in the United States in the late

1990s is estimated to be more than $11 trillion. Roughly half of that is

equipment and the other half buildings or other structures. Businesses

have additional capital investments in their inventories of finished

products, raw materials, and partially completed goods.

Entrepreneurship

Entrepreneurship is an ability some people have to accept risks and

combine factors of production in order to produce goods and services.

Entrepreneurs organize the various components necessary to operate a

business. They raise the necessary financial backing, acquire a physical

site for the business, assemble a team of workers, and manage the overall

operation of the enterprise. They accept the risk of losing the money

they spend on the business in the hope that eventually they will earn a

profit. If the business is successful, they receive all or some share of

the profits. If the business fails, they bear some or all of the losses.

Many people mistakenly believe that anyone who manages a large company is

an entrepreneur. However, many managers at large companies simply carry

out decisions made by higher-ranking executives. These managers are not

entrepreneurs because they do not have final control over the company and

they do not make decisions that involve risking the companies resources.

On the other hand, many of the nation’s entrepreneurs run small

businesses, including restaurants, convenience stores, and farms. These

individuals are true entrepreneurs, because entrepreneurship involves not

merely the organization and management of a business, but also an

individual’s willingness to accept risks in order to make a profit.

Throughout its history, the United States has had many notable

entrepreneurs, including 18th-century statesman, inventor, and publisher

Benjamin Franklin, and early-20th-century figures such as inventor Thomas

Edison and automobile producer Henry Ford. More recently, internationally

recognized leaders have emerged in a number of fields: Bill Gates of

Microsoft Corporation and Steve Jobs of Apple Computer in the computer

industry; Sam Walton of Wal-Mart in retail sales; Herb Kelleher and

Rollin King of Southwest Airlines in the commercial airline business; Ray

Kroc of MacDonald’s, Harland Sanders of Kentucky Fried Chicken (KFC), and

Dave Thomas of Wendy’s in fast food; and in motion pictures, Michael

Eisner of the Walt Disney Company as well as a number of entrepreneurs at

smaller independent production studios that developed during the 1980s

and 1990s.

Acquiring the Factors of Production

All four factors of production—natural resources, labor, capital, and

entrepreneurship—are traded in markets where businesses buy these inputs

or productive resources from individuals. These are called factor

markets. Unlike a grocery market, which is a specific physical store

where consumers purchase goods, the markets mentioned above comprise a

wide range of locations, businesses, and individuals involved in the

exchange of the goods and services needed to run a business.

Businesses turn to the factor markets to acquire the means to make goods

and services, which they then try to sell to consumers in product or

output markets. For example, an agricultural firm that grows and sells

wheat can buy or rent land from landowners. The firm may shop for this

natural resource by consulting real estate agents and farmers throughout

the Midwest. This same firm may also hire many kinds of workers. It may

find some of its newly hired workers by recruiting recent graduates of

high schools, colleges, or technical schools. But its market for labor

may also include older workers who have decided to move to a new area, or

to find a new job and employer where they currently live.

Firms often buy new factories and machines from other firms that

specialize in making these kinds of capital goods. That kind of

investment often requires millions of dollars, which is usually financed

by loans from banks or other financial institutions.

Entrepreneurship is perhaps the most difficult resource for a firm to

acquire, but there are many examples of even the largest and most well-

established firms seeking out new presidents and chief executive officers

to lead their companies. Small firms that are just beginning to do

business often succeed or fail based on the entrepreneurial skills of the

people running the business, who in many cases have little or no previous

experience as entrepreneurs.

Markets and the Problem of Scarcity

A basic principle in every economic system—even one as large and wealthy

as the U.S. economy—is that few, if any, individuals ever satisfy all of

their wants for goods and services. That means that when people buy goods

and services in different markets, they will not be able to buy all of

the things they would like to have. In fact, if everyone did have all of

the things they wanted, there would be no reason for anyone to worry

about economic problems. But no nation has ever been able to provide all

of the goods and services that its citizens wanted, and that is true of

the U.S. economy as much as any other.

Scarcity is also the reason why making good economic choices is so

important, because even though it is not possible to satisfy everyone’s

wants, all people are able to satisfy some of their wants. Similarly,

every nation is able to provide some of the things its citizens want. So

the basic problem facing any nation’s economy is how to make sure that

the resources available to the people in the nation are used to satisfy

as many as possible of the wants people care about most.

The U.S. economy, with its system of private ownership, has an extensive

set of markets for final products and for the factors of production. The

economy has been particularly successful in providing material goods and

services to most of its citizens. That is even more striking when results

in the U.S. economy are compared with those of other nations and economic

systems. Nevertheless, most U.S. consumers say they would like to be able

to buy and use more goods and services than they have today. And some

U.S. citizens are calling for significant changes in how the economic

system works, or at least in how the purchasing power and the goods and

services in the system are divided up among different individuals and

families.

Not surprisingly, low-income families would like to receive more income,

and often favor higher taxes on upper-income households. But many upper-

income families complain that government already taxes them too much, and

some argue that government is taking over too many things in the economy

that were, in the past, left up to individuals, families, and private

firms or charities.

These debates take place because of the problem of scarcity. For

individuals and governments, resources that satisfy a particular want

cannot be used to satisfy other wants. Therefore, deciding to satisfy one

want means paying the cost of not satisfying another. Such choices take

place every time the government decides how to spend its tax revenues.

What Are Markets?

Goods and services are traded in markets. Usually a market is a physical

place where buyers and sellers meet to make exchanges, once they have

agreed on a price for the product. One kind of marketplace is a grocery

store, where people go to buy food and household products. However, many

markets are not confined to specific locations. In a broader sense,

markets include all the places and sources where goods and services are

exchanged. For example, the labor market does not exist in a specific

physical building, as does a grocery market. Instead, the term labor

market describes a multitude of individuals offering their labor for sale

as well as all the businesses searching for employees.

Traders do not always have to meet in person to buy and sell. Markets can

operate via technology, such as a telephone line or a computer site. For

example, stocks and other financial securities have long been traded

electronically or by telephone. It is becoming increasingly common in the

United States for many other kinds of goods and services to be sold this

way. For instance, many people today use the Internet—the worldwide

computer-based network of information systems—to buy airline tickets,

make hotel reservations, and rent a car for their vacation. Other people

buy and sell items ranging from books, clothing, and airline tickets to

baseball cards and other rare collectibles over the Internet. Although

these Internet buyers and sellers may never meet face to face the way

buyers and sellers do in more traditional markets, these markets share

certain basic features.

How a Single Market Works

Buyers hope to buy at low prices and will purchase more units of a

product at lower prices than they do at higher prices. Sellers are just

the opposite. They hope to sell at high prices, and typically they will

be willing to produce and sell more units of a product at higher prices

than at lower prices.

The price for a product is determined in the market if prices are allowed

to rise and fall, and are not legally required to be above some minimum

price floor or below some maximum price ceiling. When a product, for

example, a personal computer, reaches the market, consumers learn what

producers want to charge for it and producers learn what consumers are

willing to pay. The interaction of producers and consumers quickly

establishes what the market price for the computer will actually be. Some

people who were considering buying a computer decide that the price is

higher than they are willing to pay. And some producers may determine

that consumers are not willing to pay a price high enough for them

profitably to produce and sell this computer.

But all of the buyers who are willing and able to pay the market price

get the computer, and all of the sellers willing and able to produce it

for this price find buyers. If more consumers want to buy a computer at a

specific market price than there are suppliers are willing to sell at

that price—or in other words, if the quantity demanded is greater than

the quantity supplied—the price for the computer increases. When

producers try to sell more of their computers at a price higher than

consumers are willing to buy, the quantity supplied exceeds the quantity

demanded and the price falls.

The price stops rising or falling at the price where the amount consumers

are willing and able to buy is just equal to the amount sellers are

willing and able to produce and sell. This is called the market clearing

price. Market clearing prices for many goods and services change

frequently, for reasons that will be discussed below. But some market

prices are stable for long periods of time, such as the prices of candy

bars and sodas sold in vending machines, and the prices of pizzas and

hamburgers. Most buyers of these products have come to know the general

price they will have to pay for these items. Sellers know what prices

they can charge, given what consumers will pay and considering the

competition they face from other sellers of identical, or very similar,

products.

A System of Markets for All Goods and Services

How markets determine price is simple enough to understand for a single

good or service in a single location. But consider what happens when

there are markets for nearly all of the goods and services produced and

consumed in an economy, across the entire country. In that context, this

reasonably simple process of setting market prices allows an economic

system as large and complex as the U.S. economy to operate with great

efficiency and a high degree of freedom for consumers and producers.

Efficiency here means producing what consumers want to buy, at prices

that are as low as they can be for producers to stay in business. And it

turns out this efficiency is directly linked to the freedom that buyers

and sellers have in a market economy. No central authority has to decide

how many shirts or cars or sandwiches to produce each day, or where to

produce them, or what price to charge for them. Instead, consumers spend

their money for the products that give them the most satisfaction, and

they try to find the best deal they can in terms of price, quality,

convenience, assurances that defective products will be replaced or

repaired, or other considerations.

What consumers are willing and able to buy tells producers what they

should produce, if they hope to make a profit. Usually consumers have

many options to choose from, because more than one producer offers the

same or reasonably similar products (such as two or more kinds of cars,

colas, and carpets). Producers then compete energetically for the dollars

that consumers spend.

Competition among producers determines the best ways to produce a good or

service. For example, in the early 1900s automobiles were made largely by

hand, one at a time. But once Henry Ford discovered how to lower the cost

of producing cars by using assembly lines, other car makers had to adopt

the same production methods or be driven out of business (as many were).

Competition also determines what features and quality standards go into

products. And competition holds down the costs of production because

producers know that consumers compare their prices to the prices charged

by other firms and for other products they might buy. In markets where a

large number of producers compete, inefficient producers will be driven

out of the market.

For example, at one time most towns and cities had independently owned

cafes and drive-in restaurants that sold hamburgers, french fries, and

soft drinks. Some of these businesses are still operating, but many

closed down after larger fast-food chains began opening local franchises

all around the nation, with well-known product standards and relatively

low prices. The increased competition led to prices that were too low for

many of the old cafes and drive-ins to make a profit. The private cafes

that did survive were able to meet that level of efficiency, or they

managed to make their products different enough from the national chains

to keep their customers.

Prices for goods and services can only fall so far, however. Even the

most efficient producers have to pay for the natural resources, labor,

capital, and entrepreneurship they use to make and sell products. The

market price cannot stay below the level of those costs for long without

driving all of the producers out of this market. Therefore, if consumers

want to buy some good or service not just today but also in the future,

they have to pay a price at least high enough to cover the costs of

producing it, including enough profit to make it worthwhile for sellers

to stay in that market.

Once market prices for various goods and services are set, consumers are

free to choose what to buy, and producers are free to choose what to

produce and sell. They both follow their self-interest and do what makes

them as well off as they can be. When all buyers and sellers do that in

an economic system of competitive markets, the overall economy will also

be very efficient and responsive to individual preferences.

This economic process is extremely decentralized. For example, it is

likely that no one person or government agency knows how many corned beef

sandwiches are sold in any large U.S. city on any given day. Individual

sellers decide how many sandwiches they are likely to sell and arrange to

have enough meat and bread available to meet the demand from their

customers.

Consumers usually do not make up their mind about what to eat for lunch

or dinner until they walk into the restaurant, grocery store, or sandwich

shop. But they know they can go to several different places and choose

many different things to eat and drink, while individual sellers know

about how much they are likely to sell on an average business day.

Other businesses sell bread and meat and drinks to the restaurants and

grocers, but they do not really know how many different sandwiches the

different food stores are selling either. They only know how much bread

and meat they need to have on hand to satisfy the orders they get from

their customers.

Each buyer and seller knows his or her small part of the market very well

and makes choices carefully to avoid wasting money and other resources.

When everyone acts this carefully while facing competition from other

consumers or producers, the overall system uses its scarce resources very

efficiently. Efficiency implies two things here: taking into account the

preferences and alternative choices that individual buyers and sellers

face, and producing goods and services at the lowest possible cost.

How and Why Market Prices Change

Another advantage of any competitive market system is a high level of

flexibility and speed in responding to changing economic conditions. In

economies where government agencies and central planners set prices, it

often takes much longer to adjust prices to new conditions. In the last

decades of the 20th century, the U.S. market economy has made these

adjustments very quickly, even compared with other market economies in

Western Europe, Canada, and Japan.

Market prices change whenever something causes a change in demand (the

amount people are willing to buy at different prices) or a change in

supply (the amount producers are willing and able to make and sell at

different prices). see Supply and Demand. Because these changes can occur

rapidly, with little or no advance warning, it is important for both

consumers and producers to understand what can cause prices to rise and

fall. Those who anticipate price changes correctly can often gain

financially from their foresight. Those who do not understand why prices

have changed are likely to feel bewildered and frustrated, and find it

more difficult to know how to respond to changing prices. Market

economies are, in fact, sometimes called price systems. It is important

to understand why prices rise and fall to understand how a market system

works.

Changes in Demand

Demand for most products changes whenever there is a significant change

in the level of consumers’ income. In the United States, incomes have

risen substantially over the past 200 years. As that happened, the demand

for most goods and services also increased. There are, however, a few

products that people buy less of as income falls. Examples of these

inferior goods include low quality foods and fabrics.

Demand for a product also changes when the price of a substitute product

changes. For example, if the price for one brand of blue jeans sharply

increases while other brands do not, many consumers will switch to the

other brands, so the demand for those brands will increase. Conversely,

if the price for beef drops, then many people will buy less pork and

chicken.

Some products are complements rather than substitutes. Complements are

products that are consumed together, for example cameras and film, or

tennis balls and tennis rackets. When the price of a complementary good

rises, the demand for a product falls. For example, if the price of

cameras rises, the demand for film will fall. On the other hand, if the

price of a complementary good falls, the demand for a product will rise.

If the price of tennis rackets falls, for example, more people will buy

rackets and the demand for tennis balls will increase.

Demand can also increase or decrease as a product goes in or out of

style. When famous athletes or movie stars create a popular new look in

clothing or tennis shoes, demand soars. When something goes out of style,

it soon disappears from stores, and eventually from people’s closets,

too.

If people expect the price of something to go up in the future, they

start to buy more of the product now, which increases demand. If they

believe the price is going to fall in the future, they wait to buy and

hope they were right. Sometimes these choices involve very serious

decisions and large amounts of money. For example, people who buy stocks

on the stock market are hoping that prices will rise, while at least some

of the people selling those stocks expect the prices to fall. But not all

economic decisions are this serious. For example, in the 1970s there was

a brief episode when toilet paper disappeared from the shelves of grocery

stores, because people were afraid that there were going to be shortages

and rising prices. It turns out that some of these unfounded fears were

based on remarks made by a comedian on a late-night talk show.

The final factor that affects the demand for most goods and services is

the number of consumers in the market for a product. In cities where

population is rising rapidly, the demand for houses, food, clothing, and

entertainment increases dramatically. In areas where population is

falling—as it has in many small towns where farm populations are

shrinking—demand for these goods and services falls.

Changes in Supply

The supply of most products is also affected by a number of factors. Most

important is the cost of producing products. If the price of natural

resources, labor, capital, or entrepreneurship rises, sellers will make

less profit and will not be as motivated to produce as many units as they

were before the cost of production increased. On the other hand, when

production costs fall, the amount producers are willing and able to sell

increases.

Technological change also affects supply. A new invention or discovery

can allow producers to make something that could not be made before. It

could also mean that producers can make more of a product using the same

or fewer inputs. The most dramatic example of technological change in the

U.S. economy over the past few decades has been in the computer industry.

In the 1990s, small computers that people carry to and from work each day

were more powerful and many times less expensive than computers that

filled entire rooms just 20 to 30 years earlier.

Opportunities to make profits by producing different goods and services

also affect the supply of any individual product. Because many producers

are willing to move their resources to completely different markets,

profits in one part of the economy can affect the supply of almost any

other product. For example, if someone running a barbershop decided to

sign a contract to provide and operate the machines that clean runways at

a large airport, this would decrease the supply of haircutting services

and increase the supply of runway sweeping services.

When suppliers believe the price of the good or service they provide is

going to rise in the future, they often wait to sell their product,

reducing the current supply of the product. On the other hand, if they

believe that the price is going to fall in the future, they try to sell

more today, increasing the current supply. We see this behavior by large

and small sellers. Examples include individuals who are thinking about

selling a house or car, corn and wheat farmers deciding whether to sell

or store their crops, and corporations selling manufactured products or

reserves of natural resources.

Finally, the number of sellers in a market can also affect the level of

supply. Generally, markets with a larger number of sellers are more

competitive and have a greater supply of the product to be sold than

markets with fewer sellers. But in some cases, the technology of

producing a product makes it more efficient to produce large quantities

at just a few production sites, or perhaps even at just one. For example,

it would not make sense to have two or more water and sewage companies

running pipes to every house and business in a city. And automobiles can

be produced at a much lower cost in large plants than in small ones,

because large plants can take greater advantage of assembly-line

production methods.

All these different factors can lead to changes in what consumers demand

and what producers supply. As a result, on any given day prices for some

things will be rising and those for others will be falling. This creates

opportunities for some individuals and firms, and problems for others.

For example, firms producing goods for which the demand and the price are

falling may have to lay off workers or even go out of business. But for

the economy as a whole, allowing prices to rise and fall quickly in

response to changes in any of the market forces that affect supply and

demand offers important advantages. It provides an extremely flexible and

decentralized system for getting goods and services produced and

delivered to households while responding to a vast number of

unpredictable changes.

Creative Destruction

Taking advantage of new opportunities while curtailing production of

things that are no longer in demand or no longer competitive was

described as the process of creative destruction by 20th century Austrian-

American economist Joseph Schumpeter. For example, Schumpeter discussed

how the United States, Britain, and other market economies helped many

new businesses to grow by building systems of canals (such as the Erie

Canal) during the mid-19th century. But then the canal systems were

replaced or “destroyed” by the railroads, which in turn saw their role

diminished with the rise of national systems of highways and airports.

The same thing happened in the communications industry in the United

States. The Pony Express, which carried mail between Missouri and

California in the early 1860s, went out of business with the completion

of telegraph lines to California. In the 20th century, the telegraph was

replaced by the telephone. Time and time again, one decade’s innovation

is partially replaced or even destroyed by the next round of

technological change.

In the modern world, prices change not only as a result of things that

happen in one country, but increasingly because of changes that happen in

other countries, too. International change affects production patterns,

wages, and jobs in the U.S. economy. Sometimes these changes are

triggered by something as simple as weather conditions someplace else in

the world that affect the production of grain, coffee, sugar, or other

crops. Sometimes it reflects political or financial upheavals in Europe,

Asia, or other parts of the world. There have been several examples of

such events in the U.S. economy in the 1990s. Higher coffee prices

occurred after poor harvests of coffee beans in South America, and U.S.

banks lost large sums of money following financial and political crises

in places such as Indonesia and Russia.

The ability to respond quickly to an increasingly volatile economic and

political environment is, in many ways, one of the greatest strengths of

the U.S. economic system. But these changes can result in hardships for

some people or even some large segments of the economy. For example,

importing clothing produced in other nations has benefited U.S. consumers

by keeping clothing prices lower. In addition, it has been profitable for

the firms that import and sell this clothing. However, it has also

reduced the number of jobs available in clothing manufacturing for U.S.

workers.

Many people think the most important general issue facing the U.S.

economy today is how to balance the benefits of quickly adapting to

changing economic conditions against the costs of abandoning the old

ways. It is vital for the economy to adapt quickly to changing conditions

and to focus on producing goods and services that will meet the most

recent demands of the market place. However, when businesses close

because their products no longer meet the demands of the market, it is

important to make retraining or new jobs available to workers who lost

their means of making a living.

PRODUCTION OF GOODS AND SERVICES

Before goods and services can be distributed to households and consumed,

they must be produced by someone, or by some business or organization. In

the United States and other market economies, privately owned firms

produce most goods and services using a variety of techniques. One of the

most important is specialization, in which different firms make different

kinds of products and individual workers perform specific jobs within a

company.

Successful firms earn profits for their owners, who accept the risk of

losing money if the products the firms try to sell are not purchased by

consumers at prices high enough to cover the costs of production. In the

modern economy, most firms and workers have found that to be competitive

with other firms and workers they must become very good at producing

certain kinds of goods and services.

Most businesses in the United States also operate under one of three

different legal forms: corporations, partnerships, or sole

proprietorships. Each of these forms has certain advantages and

disadvantages. Because of that, these three types of business

organizations often operate in different kinds of markets. For example,

most firms with large amounts of money invested in factories and

equipment are organized as corporations.

Specialization and the Division of Labor

In earlier centuries, especially in frontier areas, families in the

United States were much more self-sufficient, producing for themselves

most of the goods and services they consumed. But as the U.S. population

and economy grew, it became easier for people to buy more and more things

in the marketplace. Once that happened, people faced a choice they still

face today: In terms of time, money, and other things that they could do,

is it less expensive to make something themselves or to let someone else

produce it and buy it from them?

Over the years, most people and businesses realized that they could make

better use of their time and resources by concentrating on one particular

kind of work, rather than trying to produce for themselves all the items

they want to consume. Most people now work in jobs where they do one kind

of work; they are carpenters, bankers, cooks, mechanics, and so forth.

Likewise, most businesses produce only certain kinds of goods or

services, such as cars, tacos, or gardening services. This feature of

production is known as specialization. A high degree of specialization is

a key part of the economic system in the United States and all other

industrialized economies. When businesses specialize, they focus on

providing a particular product or type of product. For instance, some

large companies produce only automobiles and trucks, or even special

parts of cars and trucks, such as tires.

At almost all businesses, when goods and services are produced, labor is

divided among workers, with different employees responsible for

completing different tasks. This is known as division of labor. For

example, the individual parts of cars and televisions are made by many

different workers and then put together in an assembly line. Other well-

known examples of this specialization and division of labor are seen in

the production of computers and electrical appliances. But even kitchens

in large restaurants have different chefs for different items, and

professional workers such as doctors and dentists have also become more

specialized during the past century.

Advantages of Specialization

By specializing in what they produce, workers become more expert at a

particular part of the production process. As a result, they become more

efficient in these jobs, which lowers the costs of production.

Specialization also makes it possible to develop tools and machines that

help workers do highly specialized tasks. Carpenters use many tools that

plumbers and painters do not. Commercial bakeries have much larger ovens

and mixers than those used by people who only bake bread and pies once a

year. And unlike a household kitchen, a commercial bakery has machines to

slice and package bread. All of these tools and machines help workers and

businesses produce more efficiently, and lower the cost of producing

goods and services.

The advantages of specialization have led to the creation of many very

large production facilities in the United States and other industrialized

nations. This trend is especially prevalent in the manufacturing sector.

For example, many automobile factories produce thousands of cars each

day, and some shipyards employ more than 10,000 workers. One open-pit

mine in the western United States has dug a crater so large that it can

be seen from space.

When the market for a product is very large, and a company can sell

enough goods or services in that market to support a very large

production facility, it will often choose to produce on a large scale to

take advantage of specialization and division of labor. As long as

producing more in larger facilities lowers the average costs of

production, the producer enjoys what are known as economies of scale.

But bigger is not always better, and eventually almost all producers

encounter diseconomies of scale in which larger plants or production

sites become less efficient and more costly to operate. Usually that

happens because monitoring and managing increasingly larger production

facilities becomes more difficult. That is why most large manufacturers

have more than one factory to make their products, instead of one massive

facility where they make everything they produce. In recent years, many

steel companies have found it more efficient to build and operate smaller

steel mills than they once operated.

Specialization and International Trade

Over the past few decades, international trade has led to greater

specialization and competition among producers in the United States and

throughout the world. By selling worldwide, companies in the United

States and in other countries can reach many more customers.

Specialization is ultimately limited by the size of the market for a good

or service. In other words, larger markets always allow for greater

levels of specialization. For example, in small towns with few customers

to serve, there is often only one clothing store that carries a small

selection of many different kinds of clothing. In large cities with a

million or more potential customers, there are much larger clothing

stores with many more choices of items and styles, and even some stores

that sell only hats, gloves, or some other particular kind of clothing.

International trade is a dramatic way of expanding the size of a firm’s

market. In markets where transportation costs are low compared with the

selling price of a product, it has become possible for producers to

compete globally to take full advantage of highly specialized production.

But international trade also means that businesses must compete more

efficiently against firms from all around the world. That competition

also makes them try to take advantage of greater specialization and the

division of labor.

In many cases, products are produced and sold by firms from two or more

countries that have large production and employment levels in the same

industry. Often, however, these firms still specialize in the kinds of

products they produce. For example, though many small cars and small

pickup trucks are made in Japan and sent to the United States, large

pickups and four-wheel drive sport utility vehicles are often exported

from the United States to Japan and other nations. Similarly, the United

States exports large commercial passenger jets to most countries, but

imports many small jets from Canada, Brazil, and other nations. While

this may seem strange at first glance, it allows greater specialization

in production for particular kinds of products.

Transportation costs can also help to explain the pattern of

international production and trade. It often makes sense to produce goods

close to the markets where they will be sold, or close to where the

resources used in the production process are found or made. In recent

years, the availability of a skilled and hard-working labor force has

become more important to producers in many different industries, so new

factories are often located in areas with large numbers of well-trained

workers and good schools that provide a future supply of well-educated

workers.

Production Patterns: Past, Present, and Future

Several dramatic changes in production patterns occurred in the United

States during the 20th century. First, most employment shifted from

farming in rural areas to industrial jobs in cities and suburbs. Then,

during the second half of the century, production and employment patterns

changed again as a result of technological advances, increased levels of

world trade, and a rapid increase in the demand for services.

Technological changes in the transportation, communications, and computer

industries created entirely new kinds of jobs and businesses, and altered

the kinds of skills workers were expected to have in many others. World

trade led to increased specialization and competition, as businesses

adapted to meet the demands of international competition.

Perhaps the greatest change in the U.S. economy came with the nation’s

growing prosperity in the years following World War II (1939-1945). This

prosperity resulted in a population with more money to spend on services

and leisure activities. More people began dining out at restaurants,

taking vacations to far-off locations, and going to movies and other

forms of entertainment. As family incomes increased, a wealthier

population became more willing to pay others for services.

As a result of these developments, the closing decades of the 20th

century saw a dramatic increase in service industries in the United

States. In 1940 about 33 percent of U.S. employees worked in

manufacturing, and about 49 percent worked in service-producing

industries. By the late 1990s, only 26 percent worked in goods-producing

industries, and 74 percent worked in service-producing industries. This

change was driven by powerful market forces, including technological

change and increased levels of world trade, competition, and income.

Some observers worried that this growth of employment in service-

producing industries would result in declining living standards for most

U.S. workers, but in fact most of this growth has occurred in industries

where job skill requirements and wages have risen or at least remained

high. That is less surprising when you consider that this employment

includes business and repair services, entertainment and recreation

occupations, and professional and related services (including health

care, education, and legal services). United States consumers and

families are, on average, financially better off today than they were 50

or 100 years ago, and they have more leisure time, which is one of the

reasons why the demand for services has increased so rapidly.

During the 20th century, businesses and their workers had to adjust to

many changes in the kinds of goods and services people demanded. These

changes naturally led to changes in where jobs were available, and in

what kinds of education, training, and skills employees were expected to

have. As the base of employment in the United States has changed from

predominantly agriculture to manufacturing to services, individuals,

firms, and communities have faced often-difficult adjustments. Many

workers lost jobs in traditional occupations and had to seek employment

in jobs that required completely different sets of skills. Standards of

living declined in some communities whose economies centered on farming

or around large factories that shut down. In recent decades, populations

have decreased in some states where agriculture provides a significant

number of jobs. While high-technology industries in places such as

California's Silicon Valley were booming and attracting larger

populations, some textile and clothing factories in Southern and Midwest

states were closing their doors.

Public Policies to “Protect” Firms and Workers

Historically in the United States, the government has rarely stepped in

to protect individual businesses from changing levels of demand or

competition. There have been some notable exceptions, including the

federal government’s guarantee of $1.5 billion in loans to the Chrysler

Corporation, the nation’s third-largest automobile manufacturer, when it

faced bankruptcy in 1980.

Although direct financial assistance to corporations has been rare, the

government has provided subsidies or partial protection from

international competition to a large number of industries. Economic

analysis of these programs rarely finds such subsidies and protection to

be a good idea for the nation as a whole, though naturally the companies

and workers who receive the support are better off. But usually these

programs result in higher prices for consumers, higher taxes, and they

hurt other U.S. businesses and workers.

For example, in the 1980s the U.S. government negotiated limits on

Japanese car imports, and the price of new Japanese cars sold in the

United States increased by an average of $2,000. The price of new U.S.

cars also rose on average by about $1,000. Although the import limits did

save some jobs in the U.S. automobile industry, the total cost of saving

the jobs was several times higher than what workers earned from these

jobs. When fewer dollars are sent to Japan to buy new automobiles, the

Japanese companies and consumers also have fewer dollars to spend on U.S.

exports to Japan, such as grain, music cassettes and CDs, and commercial

passenger jets. So the protection from Japanese car imports hurt firms

and workers in U.S. export industries. Still other U.S. firms and workers

were hurt because some U.S. consumers spent more for cars and had less to

spend on other goods and services.

It is simply not possible to subsidize and protect everyone in the U.S.

economy from changes in consumer demands and technology, or from

international trade and competition. And while most people agree that the

government should subsidize the production of certain types of goods

required for national defense, such as electronic navigation and

surveillance systems, economists warn against the futility of trying to

protect large numbers of firms and workers from change and competition.

Typically such support cannot be sustained over the long run, when the

cost of protection and subsidies begins to mount up, except in cases

where producers and workers represent a strong special interest group

with enough political clout to maintain their special protection or

subsidies.

When the special protection or support is removed, the adjustments that

producers and workers often have to make then can be much more severe

than they would have been when the government programs were first

adopted. That has happened when price support programs for milk and other

agricultural products were phased out, and when policies that subsidized

U.S. oil production and limited imports of oil were dropped in the 1970s,

during the worldwide oil shortage.

For these reasons, if public assistance is provided to a particular

industry, economists are likely to favor only temporary payments to cover

some of the costs of relocation and retraining of workers. That policy

limits the cost of such assistance and leaves workers and firms free to

move their resources into whatever opportunities they believe will work

best for them.

Most producers in the United States and other market economies must face

competition every day. If they are successful, they stand to earn large

returns. But they also risk the possibility of failure and large losses.

The lure of profits and the risk of losses are both part of what makes

production in a market economy efficient and responsive to consumer

demands.

CORPORATIONS AND OTHER TYPES OF BUSINESSES

Three major types of firms carry out the production of goods and services

in the U.S. economy: sole proprietorships, partnerships, and

corporations. In 1995 the U.S. economy included 16.4 million

proprietorships, excluding farms; 1.6 million partnerships; and about 4.3

million corporations. The corporations, however, produce far more goods

and services than the proprietorships and partnerships combined.

Proprietorships and Partnerships

Sole proprietorships are typically owned and operated by one person or

family. The owner is personally responsible for all debts incurred by the

business, but the owner gets to keep any profits the firm earns, after

paying taxes. The owner’s liability or responsibility for paying debts

incurred by the business is considered unlimited. That is, any individual

or organization that is owed money by the business can claim all of the

business owner’s assets (such as personal savings and belongings), except

those protected under bankruptcy laws.

Normally when the person who owns or operates a proprietorship retires or

dies, the business is either sold to someone else, or simply closes down

after any creditors are paid. Many small retail businesses are operated

as sole proprietorships, often by people who also work part-time or even

full-time in other jobs. Some farms are operated as sole proprietorships,

though today corporations own many of the nation’s farms.

Partnerships are like sole proprietorships except that there are two or

more owners who have agreed to divide, in some proportion, the risks

taken and the profits earned by the firm. Legally, the partners still

face unlimited liability and may have their personal property and savings

claimed to pay off the business’s debts. There are fewer partnerships

than corporations or sole proprietorships in the United States, but

historically partnerships were widely used by certain professionals, such

as lawyers, architects, doctors, and dentists. During the 1980s and

1990s, however, the number of partnerships in the U.S. economy has grown

far more slowly than the number of sole proprietorships and corporations.

Even many of the professions that once operated predominantly as

partnerships have found it important to take advantage of the special

features of corporations.

Corporations

In the United States a corporation is chartered by one of the 50 states

as a legal body. That means it is, in law, a separate entity from its

owners, who own shares of stock in the corporation. In the United States,

corporate names often end with the abbreviation Inc., which stands for

incorporated and refers to the idea that the business is a separate legal

body.

Limited Liability

The key feature of corporations is limited liability. Unlike

proprietorships and partnerships, the owners of a corporation are not

personally responsible for any debts of the business. The only thing

stockholders risk by investing in a corporation is what they have paid

for their ownership shares, or stocks. Those who are owed money by the

corporation cannot claim stockholders’ savings and other personal assets,

even if the corporation goes into bankruptcy. Instead, the corporation is

a separate legal entity, with the right to enter into contracts, to sue

or be sued, and to continue to operate as long as it is profitable, which

could be hundreds of years.

When the stockholders who own the corporation die, their stock is part of

their estate and will be inherited by new owners. The corporation can go

on doing business and usually will, unless the corporation is a small,

closely held firm that is operated by one or two major stockholders. The

largest U.S. corporations often have millions of stockholders, with no

one person owning as much as 1 percent of the business. Limited liability

and the possibility of operating for hundreds of years make corporations

an attractive business structure, especially for large-scale operations

where millions or even billions of dollars may be at risk.

When a new corporation is formed, a legal document called a prospectus is

prepared to describe what the business will do, as well as who the

directors of the corporation and its major investors will be. Those who

buy this initial stock offering become the first owners of the

corporation, and their investments provide the funds that allow the

corporation to begin doing business.

Separation of Ownership and Control

The advantages of limited liability and of an unlimited number of years

to operate have made corporations the dominant form of business for large-

scale enterprises in the United States. However, there is one major

drawback to this form of business. With sole proprietorships, the owners

of the business are usually the same people who manage and operate the

business. But in large corporations, corporate officers manage the

business on behalf of the stockholders. This separation of management and

ownership creates a potential conflict of interest. In particular,

managers may care about their salaries, fringe benefits, or the size of

their offices and support staffs, or perhaps even the overall size of the

business they are running, more than they care about the stockholders’

profits.

The top managers of a corporation are appointed or dismissed by a

corporation’s board of directors, which represents stockholders’

interests. However, in practice, the board of directors is often made up

of people who were nominated by the top managers of the company. Members

of the board of directors are elected by a majority of voting

stockholders, but most stockholders vote for the nominees recommended by

the current board members. Stockholders can also vote by proxy—a process

in which they authorize someone else, usually the current board, to

decide how to vote for them.

There are, however, two strong forces that encourage the managers of a

corporation to act in stockholders’ interests. One is competition. Direct

competition from other firms that sell in the same markets forces a

corporation’s managers to make sound business decisions if they want the

business to remain competitive and profitable. The second is the threat

that if the corporation does not use its resources efficiently, it will

be taken over by a more efficient company that wants control of those

resources. If a corporation becomes financially unsound or is taken over

by a competing company, the top managers of the firm face the prospect of

being replaced. As a result, corporate managers will often act in the

best interests of a corporation’s stockholders in order to preserve their

own jobs and incomes.

In practice, the most common way for a takeover to occur is for one

company to purchase the stock of another company, or for the two

companies to merge by legal agreement under some new management

structure. Stock purchases are more common in what are called hostile

takeovers, where the company that is being taken over is fighting to

remain independent. Mergers are more common in friendly takeovers, where

two companies mutually agree that it makes sense for the companies to

combine. In 1996 there were over $556.3 billion worth of mergers and

acquisitions in the U.S. economy. Examples of mergers include the

purchase of Lotus Development Corporation, a computer software company,

by computer manufacturer International Business Machines Corporation

(IBM) and the acquisition of Miramax Films by entertainment and media

giant Walt Disney Company.

Takeovers by other firms became commonplace in the closing decades of the

20th century, and some research indicates that these takeovers made firms

operate more efficiently and profitably. Those outcomes have been good

news for shareholders and for consumers. In the long run, takeovers can

help protect a firm’s workers, too, because their jobs will be more

secure if the firm is operating efficiently. But initially takeovers

often result in job losses, which force many workers to relocate,

retrain, or in some cases retire sooner than they had planned. Such

workforce reductions happen because if a firm was not operating

efficiently, it was probably either operating in markets where it could

not compete effectively, or it was using too many workers and other

inputs to produce the goods and services it was selling. Sometimes

corporate mergers can result in job losses because management combines

and streamlines departments within the newly merged companies. Although

this streamlining leads to greater efficiency, it often results in fewer

jobs. In many cases, some workers are likely to be laid off and face a

period of unemployment until they can find work with another firm.

How Corporations Raise Funds for Investment

By investing in new issues of a company’s stock, shareholders provide the

funds for a company to begin new or expanded operations. However, most

stock sales do not involve new issues of stock. Instead, when someone who

owns stock decides to sell some or all of their shares, that stock is

typically traded on one of the national stock exchanges, which are

specialized markets for buying and selling stocks. In those transactions,

the person who sells the stock—not the corporation whose stock is

traded—receives the funds from that sale.

An existing corporation that wants to secure funds to expand its

operations has three options. It can issue new shares of stock, using the

process described earlier. That option will reduce the share of the

business that current stockholders own, so a majority of the current

stockholders have to approve the issue of new shares of stock. New issues

are often approved because if the expansion proves to be profitable, the

current stockholders are likely to benefit from higher stock prices and

increased dividends. Dividends are corporate profits that some companies

periodically pay out to shareholders.

The second way for a corporation to secure funds is by borrowing money

from banks, from other financial institutions, or from individuals. To do

this the corporation often issues bonds, which are legal obligations to

repay the amount of money borrowed, plus interest, at a designated time.

If a corporation goes out of business, it is legally required to pay off

any bonds it has issued before any money is returned to stockholders.

That means that stocks are riskier investments than bonds. On the other

hand, all a bondholder will ever receive is the amount of money specified

in the bond. Stockholders can enjoy much larger returns, if the

corporation is profitable.

The final way for a corporation to pay for new investments is by

reinvesting some of the profits it has earned. After paying taxes,

profits are either paid out to stockholders as dividends or held as

retained earnings to use in running and expanding the business. Those

retained earnings come from the profits that belong to the stockholders,

so reinvesting some of those profits increases the value of what the

stockholders own and have risked in the business, which is known as

stockholders’ equity. On the other hand, if the corporation incurs

losses, the value of what the stockholders own in the business goes down,

so stockholders’ equity decreases.

Entrepreneurs and Profits

Entrepreneurs raise money to invest in new enterprises that produce goods

and services for consumers to buy—if consumers want these products more

than other things they can buy. Entrepreneurs often make decisions on

which businesses to pursue based on consumer demands. Making decisions to

move resources into more profitable markets, and accepting the risk of

losses if they make bad decisions—or fail to produce products that stand

the test of competition—is the key role of entrepreneurs in the U.S.

economy.

Profits are the financial incentives that lead business owners to risk

their resources making goods and services for consumers to buy. But there

are no guarantees that consumers will pay prices high enough to cover a

firm’s costs of production, so there is an inherent risk that a firm will

lose money and not make profits. Even during good years for most

businesses, about 70,000 businesses fail in the United States. In years

when business conditions are poor, the number approaches 100,000 failures

a year. And even among the largest 500 U.S. industrial corporations, a

few of these firms lose money in any given year.

Entrepreneurs invest money in firms with the expectation of making a

profit. Therefore, if the profits a company earns are not high enough,

entrepreneurs will not continue to invest in that firm. Instead, they

will invest in other companies that they hope will be more profitable. Or

if they want to reduce their risk, they can put their money into savings

accounts where banks guarantee a minimum return. They can also invest in

other kinds of financial securities (such as government or corporate

bonds) that are riskier than savings accounts, but less risky than

investments in most businesses. Generally, the riskier the investment,

the higher the return investors will require to invest their money.

Calculating Profits

The dollar value of profits earned by U.S. businesses—about $700 billion

a year in the late 1990s—is a great deal of money. However, it is

important to see how profits compare with the money that business owners

have risked in the business. Profits are also often compared to the level

of sales for individual firms, or for all firms in the U.S. economy.

Accountants calculate profits by starting with the revenue a firm

received from selling goods or services. The accountants then subtract

the firm’s expenses for all of the material, labor, and other inputs used

to produce the product. The resulting number is the dollar level of

profits. To evaluate whether that figure is high or low, it must be

compared to some measure of the size of the firm. Obviously, $1 million

would be an incredibly large amount of profits for a very small firm, and

not much profit at all for one of the largest corporations in the

country, such as telecommunications giant AT&T Corp. or automobile

manufacturer General Motors (GM).

To take into consideration the size of the firm, profits are calculated

as a percentage of several different aspects of the business, including

the firm’s level of sales, employment, and stockholders’ equity. Various

individuals will use one of these different methods to evaluate a

company’s performance, depending on what they want to know about how the

firm operates. For example, an efficiency expert might examine the firm’s

profits as a percentage of employment to determine how much profit is

generated by the average worker in that firm. On the other hand,

potential investors and a company’s chief executive would be more

interested in profit as a percentage of stockholder equity, which allows

them to gauge what kind of return to expect on their investments. A sales

executive in the same firm might be more interested in learning about the

company’s profit as a percentage of sales in order to compare its

performance to the performances of competing firms in the same industry.

Using these different accounting methods often results in different

profit percent figures for the same company. For example, suppose a firm

earned a yearly profit of $1 million, with sales of $20 million. That

represents a 5-percent rate of profit as a return on sales. But if

stockholders’ equity in the corporation is $10 million, profits as a

percent of stockholders’ equity will be 10 percent.

Return on Sales

Year after year, U.S. manufacturing firms average profits of about 5

percent of sales. Many business owners with profits at this level or

lower like to say that they earn only about what people can earn on the

interest from their savings accounts. That sounds low, especially

considering that the federal government insures many savings accounts, so

that most people with deposits at a bank run no risk of losing their

savings if the bank goes out of business. And in fact, given the risks

inherent in almost all businesses, few stockholders would be satisfied

with a return on their investment that was this low.

Although it is true that on average, U.S. manufacturing firms only make

about a 5-percent return on sales, that figure has little to do with the

risks these businesses take. To see why, consider a specific example.

Most grocery stores earn a return on sales of only 1 to 2 percent, while

some other kinds of firms typically earn more than the 5-percent average

profit on sales. But selling more or less does not really increase what

the owners of a grocery store (or most other businesses) are risking.

Each time a grocery store sells $100 worth of canned spinach, it keeps

about one or two dollars as profit, and uses the rest of the money to put

more cans of spinach on the shelves for consumers to buy. At the end of

the year, the grocery store may have sold thousands of dollars worth of

canned spinach, but it never really risked those thousands of dollars. At

any given time, it only risked what it spent for the cans that were at

the store. When some cans were sold, the store bought new cans to put on

the shelves, and it turned over its inventory of canned spinach many

times during the year.

But the total value of these sales at the end of the year says little or

nothing about the actual level of risk that the grocery store owners

accepted at any point during the year. And in fact, the grocery industry

is a relatively low-risk business, because people buy food in good times

and bad. Providing goods or services where production or consumer demand

is more variable—such as exploring for oil and uranium, or making movies

and high fashion clothing—is far riskier.

Return on Equity

What stockholders risk—the amount they stand to lose if a business incurs

losses and shuts down—is the money they have invested in the business,

their equity. These are the funds stockholders provide for the firm

whenever it offers a new issue of stock, or when the firm keeps some of

the profits it earns to use in the business as retained earnings, rather

than paying those profits out to stockholders as dividends.

Profits as a return on stockholders’ equity for U.S. corporations usually

average from 12 to 16 percent, for larger and smaller corporations alike.

That is more than people can earn on savings accounts, or on long-term

government and corporate bonds. That is not surprising, however, because

stockholders usually accept more risk by investing in companies than

people do when they put money in savings accounts or buy bonds. The

higher average yield for corporate profits is required to make up for the

fact that there are likely to be some years when returns are lower, or

perhaps even some when a company loses money.

At least part of any firm’s profits are required for it to continue to do

business. Business owners could put their funds into savings accounts and

earn a guaranteed level of return, or put them in government bonds that

carry hardly any risk of default. If a business does not earn a rate of

return in a particular market at least as high as a savings account or

government bonds, its owners will decide to get out of that market and

use the resources elsewhere—unless they expect higher levels of profits

in the future.

Over time, high profits in some businesses or industries are a signal to

other producers to put more resources into those markets. Low profits, or

losses, are a signal to move resources out of a market into something

that provides a better return for the level of risk involved. That is a

key part of how markets work and respond to changing demand and supply

conditions. Markets worked exactly that way in the U.S. economy when

people left the blacksmith business to start making automobiles at the

beginning of the 20th century. They worked the same way at the end of the

century, when many companies stopped making typewriters and started

making computers and printers.

CAPITAL, SAVINGS, AND INVESTMENT

In the United States and in other market economies, financial firms and

markets channel savings into capital investments. Financial markets, and

the economy as a whole, work much better when the value of the dollar is

stable, experiencing neither rapid inflation nor deflation. In the United

States, the Federal Reserve System functions as the central banking

institution. It has the primary responsibility to keep the right amount

of money circulating in the economy.

Investments are one of the most important ways that economies are able to

grow over time. Investments allow businesses to purchase factories,

machines, and other capital goods, which in turn increase the production

of goods and services and thus the standard of living of those who live

in the economy. That is especially true when capital goods incorporate

recently developed technologies that allow new goods and services to be

produced, or existing goods and services to be produced more efficiently

with fewer resources.

Investing in capital goods has a cost, however. For investment to take

place, some resources that could have been used to produce goods and

services for consumption today must be used, instead, to make the capital

goods. People must save and reduce their current consumption to allow

this investment to take place. In the U.S. economy, these are usually not

the same people or organizations that use those funds to buy capital

goods. Banks and other financial institutions in the economy play a key

role by providing incentives for some people to save, and then lend those

funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings

institutions pay interest to people who deposit funds with the

institution, and borrowers pay interest on their loans. Like any other

price in a market economy, supply and demand determine the interest rate.

The demand for money depends on how much money people and organizations

want to have to meet their everyday expenses, how much they want to save

to protect themselves against times when their income may fall or their

expenses may rise, and how much they want to borrow to invest. The supply

of money is largely controlled by a nation’s central bank—which in the

United States is the Federal Reserve System. The Federal Reserve

increases or decreases the money supply to try to keep the right amount

of money in the economy. Too much money leads to inflation. Too little

results in high interest rates that make it more expensive to invest and

may lead to a slowdown in the national economy, with rising levels of

unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must

build large production facilities that can cost hundreds of millions of

dollars. The firms that build these plants raise some funds with new

issues of stock, as described above. But firms also borrow huge sums of

money every year to undertake these capital investments. When they do

that, they compete with government agencies that are borrowing money to

finance construction projects and other public spending programs, and

with households that are borrowing money to finance the purchase of

housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this

borrowing to take place, banks and other lenders must have funds to lend

out. They obtain these funds from people or organizations that are

willing to deposit money in accounts at the bank, including savings

accounts. If everyone spent all of the income they earned each year,

there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses,

and government—only households are net savers. In other words, households

save more money than they borrow. Conversely, businesses and government

are net borrowers. A few businesses may save more than they invest in

business ventures. However, overall, businesses in the United States,

like businesses in virtually all countries, invest far more than they

save. Many companies borrow funds to finance their investments. And while

some local and state governments occasionally run budget surpluses,

overall the government sector is also a large net borrower in the U.S.

economy. The government borrows money by issuing various forms of bonds.

Like corporate bonds, government bonds are contractual obligations to

repay what is borrowed, plus some specified rate of interest, at a

specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against

bad times, as when wage earners or others in the household become sick,

injured, or disabled; to pay for large expenditures such as houses, cars,

and vacations; to set aside money for retirement; or to invest. Banks and

other financial institutions compete for households’ savings deposits by

paying interest to the savers. Then banks lend those funds out to

borrowers at a higher rate of interest than they pay to savers. The

difference between the interest rates charged to borrowers and paid to

savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and

firms that are creditworthy—meaning they will be able to repay the loans.

The creditworthiness of the borrower is one reason why some kinds of

loans have higher rates of interest than others do. Short-term loans made

to people or businesses with a long history of stable income and

employment, and who have assets that can be pledged as collateral that

will become the bank’s property if a loan is not repaid, will receive the

lowest interest rates. For example, well-established firms such as AT&T

often pay what is called the bank’s prime rate—the lowest available rate

for business loans—when they borrow money. New, start-up companies pay

higher rates because there is a greater risk they will default on the

loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and

other lenders charge different rates of interest. Mortgage loans are

backed by the collateral of the property the loan was used to purchase.

If someone does not pay his or her mortgage, the bank has the right to

sell the property that was pledged as collateral and to collect the

proceeds as payment for what it is owed. That means the bank’s risks are

lower, so interest rates on these loans are typically lower, too. The

money that is loaned to people who do not pay off the balances on their

credit cards every month represents a greater risk to banks, because no

collateral is provided. Because the bank does not hold any title to the

consumer’s property for these loans, it charges a higher interest rate

than it charges on mortgages. The higher rate allows the bank to collect

enough money overall so that it can cover its losses when some of these

riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of

business. The effects of bank failures on depositors and the overall

economy can be very severe, especially if many banks fail at the same

time and the deposits are not insured. In the United States, the most

famous example of this kind of financial disaster occurred during the

Great Depression of the 1930s, when a large number of banks failed. Many

other businesses also closed and many people lost both their jobs and

savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not

want to lose money or go out of business, and they try to avoid making

loans to individuals and businesses who will be unable to repay them. In

addition, a number of safeguards protect U.S. financial institutions and

their customers against failures. The Federal Deposit Insurance

Corporation (FDIC) insures most bank and savings and loan deposits up to

$100,000. Government examiners conduct regular inspections of banks and

other financial institutions to try to ensure that these firms are

operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is

the low household savings rate in this country, compared to that of many

other industrialized nations. People who live in the United States save

less of their annual income than people who live in many other

industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and

several factors are often discussed. U.S. citizens may simply choose to

enjoy more of their income in the form of current consumption than people

in nations where living standards have historically been lower. But other

considerations may also be important. There are significant differences

among nations in how savings, dividends, investment income, housing

expenditures, and retirement programs are taxed and financed. These

differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts

as much as they do other forms of income, and some countries do not tax

at least part of the income people earn on savings accounts at all. In

the United States, such favorable tax treatment does not apply to regular

savings accounts. The government does offer more limited advantages on

special retirement accounts, but such accounts have many restrictions on

how much people can deposit or withdraw before retirement without facing

tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they

pay on mortgages for the homes they live in. That encourages people to

spend more on housing than they otherwise would. As a result, some funds

that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the

Social Security system, the government program that provides some

retirement income to most older people. The money that workers pay into

the Social Security system does not go into individual savings accounts

for those workers. Instead, it is used to make Social Security payments

to current retirees. No savings are created under this system unless it

happens that the total amount being paid into the system is greater than

the current payments to retirees. Even when that has happened in the

past, the federal government often used the surplus to pay for some of

its other expenditures. Individuals are also likely to save less for

their own retirement because they expect to receive Social Security

benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with

fewer dollars available as savings to banks and other financial

institutions, interest rates are higher for both savers and borrowers

than they would otherwise be. That makes it more costly to finance

investment in factories, equipment, and other goods, which slows growth

in national output and income levels. Second, the higher U.S. interest

rates attract funds from savers and investors in other nations. As we

will see below, such foreign investments can have several effects on the

U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more

investments in capital goods, but it also creates concerns. For example,

in order for foreigners to invest in U.S. savings accounts and U.S.

government or corporate bonds, they must have dollars. As they demand

dollars for these investments, the price of the dollar in terms of other

nations’ currencies rises. When the price of the dollar is rising, people

in other countries who want to buy U.S. exports will have to pay more for

them. That means they will buy fewer goods and services produced in the

United States, which will hurt U.S. export industries. This happened in

the early 1980s, when U.S. companies such as Caterpillar, which makes

large engines and industrial equipment, saw the sales of their products

to their international customers plummet. The higher value of the dollar

also makes it cheaper for U.S. citizens to import products from other

nations. Imports will rise, leading to a larger deficit (or smaller

surplus) in the U.S. balance of trade, the amount of exports compared to

imports.

Foreign investment has other effects on the U.S. economy. Eventually the

money borrowed must be repaid. How those repayments will affect the U.S.

economy will depend on how the borrowed money is invested. If the money

borrowed from foreign individuals and companies is put into capital

projects that increase levels of output and income in the United States,

repayments can be made without any decrease in U.S. living standards.

Otherwise, U.S. living standards will decline as goods and services are

sent overseas to repay the loans. The concern is that instead of using

foreign funds for additional investments in capital goods, today these

funds are simply making it possible for U.S. consumers and government

agencies to spend more on consumption goods and social services, which

will not increase output and living standards.

In the early history of the United States, many U.S. capital projects

were financed by people in Britain, France, and other nations that were

then the wealthiest countries in the world. These loans helped the

fledgling U.S. economy to grow and were paid off without lowering the

U.S. standard of living. It is not clear that current U.S. borrowing from

foreign nations will turn out as well and will be used to invest in

capital projects, now that the United States, with the largest and

wealthiest economy in the world, faces a low national savings rate.

MONEY AND FINANCIAL MARKETS

A Money and the Value of Money

Money is anything generally accepted as final payment for goods and

services. Throughout history many things have been used around the world

as money, including gold, silver, tobacco, cattle, and rare feathers or

animal skins. In the U.S. economy today, there are three basic forms of

money: currency (dollar bills), coins, and checks drawn on deposits at

banks and other financial firms that offer checking services. Most of the

time, when households, businesses, and government agencies pay their

bills they use checks, but for smaller purchases they also use currency

or coins.

People can change the type of the money they hold by withdrawing funds

from their checking account to receive currency or coins, or by

depositing currency and coins in their checking accounts. But the money

that people have in their checking accounts is really just the balance in

that account, and most of those balances are never converted to currency

or coins. Most people deposit their paychecks and then write checks to

pay most of their bills. They only convert a small part of their pay to

currency and coins. Strange as it seems, therefore, most money in the

U.S. economy is just the dollar amount written on checks or showing in

checking account balances. Sometimes, economists also count money in

savings accounts in broader measures of the U.S. money supply, because it

is easy and inexpensive to move money from savings accounts to checking

accounts.

Most people are surprised to learn that when banks make loans, the loans

create new money in the economy. As we’ve seen, banks earn profits by

lending out some of the money that people have deposited. A bank can make

loans safely because on most days, the amount some customers are

depositing in the bank is about the same amount that other customers are

withdrawing. A bank with many customers holding a lot of deposits can

lend out a lot of money and earn interest on those loans. But of course

when that happens, the bank does not subtract the amount it has loaned

out from the accounts of the people who deposited funds in savings and

checking accounts. Instead, these depositors still have the money in

their accounts, but now the people and firms to whom the bank has loaned

money also have that money in their accounts to spend. That means the

total amount of money in the economy has increased. This process is

called fractional reserve banking, because after making loans the bank

retains only a fraction of its deposits as reserves. The bank really

could not pay all of its depositors without calling in the loans it has

made. It also means that money is created when banks make loans but

destroyed when loans are paid off.

At one time the dollar, like most other national currencies, was backed

by a specified quantity of gold or silver held by the federal government.

At that time, people could redeem their dollars for gold or silver. But

in practice paper currency is much easier to carry around than large

amounts of gold or silver. Therefore, most people have preferred to hold

paper money or checking balances, as long as paper currency and checks

are accepted as payment for goods and services and maintain their value

in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold

and guard large quantities of gold or silver. As foreign trade grew,

governments found it especially difficult to transfer gold and silver to

other countries that decided to redeem paper money acquired through

international trade. They, too, changed to using paper currencies and

writing checks against deposits in accounts. In 1971 the United States

suspended the international payment of gold for U.S. currency. This

action effectively ended the gold standard, the name for this official

link between the dollar and the price of gold. Since then, there has been

no official link between the dollar and a set price for gold, or to the

amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods

and services a dollar can purchase. That purchasing power depends

primarily on the relationship between the number of dollars people are

holding as currency and in their checking and savings accounts, and the

quantity of goods and services that are produced in the economy each

year. If the number of dollars increases much more rapidly than the

quantity of goods and services produced each year, or if people start

spending the dollars they hold more rapidly, the result is likely to be

inflation. Inflation is an increase in the average price of all goods and

services. In other words, it is a decrease in the value of what each

dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply

of money. Consequently, organizations that control how much money is

issued in an economy play a major role in how the economy performs, in

terms of prices, output and employment levels, and economic growth. In

the United States, that organization is the nation’s central bank, the

Federal Reserve System. The system’s name comes from the fact that the

Federal Reserve has the legal authority to make banks hold some of their

deposits as reserves, which means the banks cannot lend out those

deposits. These reserve funds are held in the Federal Reserve Bank. The

Federal Reserve also acts as the banker for the federal government, but

the government does not own the Federal Reserve. It is actually owned by

the nation’s banks, which by law must join the Federal Reserve System and

observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not

commercial banks. They do not accept savings deposits from or provide

loans to individuals or businesses. Instead, the Federal Reserve

functions as a central bank for other banks and for the federal

government. In that role the Federal Reserve System performs several

important functions in the national economy. First, the branches of the

Federal Reserve distribute paper currency in their regions. Dollar bills

are actually Federal Reserve notes. You can look at a dollar bill of any

denomination and see the number for the regional Federal Reserve Bank

where the bill was originally issued. But of course the dollar is a

national currency, so a bill issued by any regional Federal Reserve Bank

is good anyplace in the country. The distribution of currency occurs as

commercial banks convert some of their reserve balances at the Federal

Reserve System into currency, and then provide that currency to bank

depositors who decide to hold some of their money balances as currency

rather than deposits in checking accounts. The U.S. Treasury prints new

currency for the Federal Reserve System. The bills are introduced into

circulation when commercial banks use their reserves to buy currency from

the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that

are deposited by a bank in one part of the country, but were written by

someone who has a checking account with a bank in another part of the

country. Millions of checks are processed this way every business day.

Third, the regional Federal Reserve Banks collect and analyze data on the

economic performance of their regions, and provide that information and

their analysis of it to the national Federal Reserve System. Each of the

12 regions served by the Federal Reserve banks has its own economic

characteristics. Some of these regional economies are concerned more with

agricultural issues than others; some with different types of

manufacturing and industries; some with international trade; and some

with financial markets and firms. After reviewing the reports from all

different parts of the country, the national Federal Reserve System then

adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is

controlling the nation’s money supply and the overall availability of

credit in the economy. If the Federal Reserve System wants to put more

money in the economy, it does not ask the Treasury to print more dollar

bills. Remember, much more money is held in checking and savings accounts

than as currency, and it is through those deposit accounts that the

Federal Reserve System most directly controls the money supply. The

Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits

as reserves at the Federal Reserve System. A lower reserve requirement

allows banks to make more loans and earn more money from the interest

paid on those loans. Banks making more loans increase the money supply.

Conversely, a higher reserve requirement reduces the amount of loans

banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the

economy is by lowering the rate it charges banks when they borrow money

from the Federal Reserve System. This particular interest rate is known

as the discount rate. When the discount rate goes down, it is more likely

that banks will borrow money from the Federal Reserve System, to cover

their reserve requirements and support more loans to borrowers. Once

again, those loans will increase the nation’s money supply. Therefore, a

decrease in the discount rate can increase the money supply, while an

increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve,

so changes in the discount rate are more important as a signal of whether

the Federal Reserve wants to increase or decrease the money supply. For

example, raising the discount rate may alert banks that the Federal

Reserve might take other actions, such as increasing the reserve

requirement. That signal can lead banks to reduce the amount of loans

they are making.

The third way the Federal Reserve System can adjust the supply of money

and the availability of credit in the economy is through its open market

operations—the buying or selling of government bonds. Open market

operations are actually the tool that the Federal Reserve uses most often

to change the money supply. These open-market operations take place in

the market for government securities. The U.S. government borrows money

by issuing bonds that are regularly auctioned on the bond market in New

York. The Federal Reserve System is one of the largest purchasers of

those bonds, and the bank changes the amount of money in the economy when

it buys or sells bonds.

Government bonds are not money, because they are not generally accepted

as final payment for goods and services. (Just try paying for a hamburger

with a government savings bond.) But when the Federal Reserve System pays

for a federal government bond with a check, that check is new

money—specifically, it represents a loan to the government. This loan

creates a higher balance in the government’s own checking account after

the funds have been transferred from the privately owned Federal Reserve

Bank to the government. That new money is put into the economy as soon as

the government spends the funds. On the other hand, if the Federal

Reserve sells government bonds, it collects money that is taken out of

circulation, since the bonds that the Federal Reserve sells to banks,

firms, or households cannot be used as money until they are redeemed at a

later date.

The Wall Street Journal and other financial media regularly report on

purchases of bonds made by the Federal Reserve and other buyers at

auctions of U.S. government bonds. The Federal Reserve System itself also

publishes a record of its buying and selling in the bond market. In

practice, since the U.S. economy is growing and the money supply must

grow with it to keep prices stable, the Federal Reserve is almost always

buying bonds, not selling them. What changes over time is how fast the

Federal Reserve wants the money supply to grow, and how many dollars

worth of bonds it purchases from month to month.

To summarize the Federal Reserve System’s tools of monetary policy: It

can increase the supply of money and the availability of credit by

lowering the percentage of deposits that banks must hold as reserves at

the Federal Reserve System, by lowering the discount rate, or by

purchasing government bonds through open market operations. The Federal

Reserve System can decrease the supply of money and the availability of

credit by raising reserve ratios, raising the discount rate, or by

selling government bonds.

The Federal Reserve System increases the money supply when it wants to

encourage more spending in the economy, and especially when it is

concerned about high levels of unemployment. Increasing the money supply

usually decreases interest rates—which are the price of money paid by

those who borrow funds to those who save and lend them. Lower interest

rates encourage more investment spending by businesses, and more spending

by households for houses, automobiles, and other “big ticket” items that

are often financed by borrowing money. That additional spending increases

national levels of production, employment, and income. However, the

Federal Reserve Bank must be very careful when increasing the money

supply. If it does so when the economy is already operating close to full

employment, the additional spending will increase only prices, not output

and employment.

Effect of Monetary Policies on the U.S. Economy

The monetary policies adopted by the Federal Reserve System can have

dramatic effects on the national economy and, in particular, on financial

markets. Most directly, of course, when the Federal Reserve System

increases the money supply and expands the availability of credit, then

the interest rate, which determines the amount of money that borrowers

pay for loans, is likely to decrease. Lower interest rates, in turn, will

encourage businesses to borrow more money to invest in capital goods, and

will stimulate households to borrow more money to purchase housing,

automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money

supply. If the supply of money and credit grows much faster than the

production of goods and services in the economy, then prices will

increase, and the rate of inflation will rise. Inflation is a serious

problem for those who live on fixed incomes, since the income of those

individuals remains constant while the amount of goods and services they

can purchase with their income decreases. Inflation may also hurt banks

and other financial institutions that lend money, as well as savers. In a

period of unanticipated inflation, as the value of money decreases in

terms of what it will purchase, loans are repaid with dollars that are

worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to

protect themselves by demanding higher interest rates on loans and

savings accounts. This will be especially true on long-term loans and

savings deposits, if the higher inflation is considered likely to

continue for many years. But higher interest rates create problems for

borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then

interest rates are again likely to rise, leading to decreased spending

for capital investments and consumer durable goods (products designed for

long-term use, such as television sets, refrigerators, and personal

computers). Such decreased spending will hurt many businesses and may

lead to a recession, an economic slowdown in which the national output of

goods and services falls. When that happens, wages and salaries paid to

individual workers will fall or grow more slowly, and some workers will

be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the

Federal Reserve’s actions with monetary policy very closely. There are

regular reports in the media about policy changes made by the Federal

Reserve System, and even about statements made by Federal Reserve

officials that may indicate that the Federal Reserve is going to change

the supply of money and interest rates. The chairman of the Federal

Reserve System is widely considered to be one of the most influential

people in the world because what the Federal Reserve does so dramatically

affects the U.S. and world economies, especially financial markets.

LABOR AND LABOR MARKETS

Labor includes work done for employers and work done in a person’s own

household, but labor markets deal only with work that is done for some

form of financial compensation. Labor markets include all the means by

which workers find jobs and by which employers locate workers to staff

their businesses. A number of factors influence labor and labor markets

in the United States, including immigration, discrimination, labor

unions, unemployment, and income inequality between the rich and poor.

The official definition of the U.S. labor force includes people who are

at least 16 years old and either working, waiting to be recalled from a

layoff, or actively looking for work within the past 30 days. In 1998 the

U.S. labor force included nearly 138 million people, most of them working

in full-time or part-time jobs.

Most people in the United States receive their income as wages and

salaries paid by firms that have hired individuals to work as their

employees. Those wages and salaries are the prices they receive for the

labor services they provide to their employers. Like other prices, wages

and salaries are determined primarily by market forces.

Labor Supply and Demand

The wages and salaries that U.S. workers earn vary from occupation to

occupation, across geographic regions, and according to workers’ levels

of education, training, experience, and skill. As with goods and services

purchased by consumers, labor is traded in markets that reflect both

supply and demand. In general, higher wages and salaries are paid in

occupations where labor is more scarce—that is, in jobs where the demand

for workers is relatively high and the supply of workers with the

qualifications and ability to do that work is relatively low. The demand

for workers in particular occupations depends largely on how much the

work they do adds to a firm’s revenues. In other words, workers who

create more products or higher-priced products will be worth more to

employers than workers who make fewer or less valuable products. The

supply of workers in any occupation is affected by the amount of time and

effort required to enter that occupation compared to other things workers

might do.

Workers seeking higher wages often learn skills that will increase the

likelihood of finding a higher-paying job. The knowledge, skills, and

experience a worker has acquired are the worker’s human capital.

Education and training can clearly increase workers’ human capital and

productivity, which makes them more valuable to employers. In general,

more educated individuals make more money at their jobs. However, a

greater level of education does not always guarantee higher wages.

Certain professions that demand a high level of education, such as

teaching elementary and secondary school, are not high-paying. Such

situations arise when the number of people with the training to do that

job is relatively large compared with the number of people that employers

want to hire. Of course this situation can change over time if, for

example, fewer young people choose to train for the profession.

Supply and demand factors change in labor markets, just as they do in

markets for goods and services. As a result, occupations that paid high

wages and salaries in the past sometimes become outdated, while entirely

new occupations are created as a result of technological change or

changes in the goods and services consumers demand. For example,

blacksmiths were once among the most skilled workers in the United

States; today, computer programmers and software developers are in great

demand.

The process of creative destruction carries over from product markets to

labor markets because the demand for particular goods and services

creates a demand for the labor to produce them. Conversely, when the

demand for particular goods or services decreases, the demand for labor

to produce them will also fall. Similarly, when new technologies create

new products or new ways of producing existing products, some workers

will have new job opportunities, but other workers might have to retrain,

relocate, or take new jobs.

Factors Affecting Labor Markets

Changes in society and in the makeup of the population also affect labor

markets. For example, starting in the 1960s it became more common for

married women to work outside the home. Unprecedented numbers of

women—many with little previous job experience and training—entered the

labor markets for the first time during the 1970s. As a result, wages for

entry-level jobs were pushed down and did not rise as rapidly as they had

in the past. This decline in entry-level wages was further fueled by huge

numbers of teens who were also entering the labor market for the first

time. These young people were the children of the baby boom of 1946 to

1964, a period in which the birth rate increased dramatically in the

United States. So, two changes—one affecting women’s roles in the labor

market, the other in the makeup of the age of the workforce—combined to

affect the labor market.

The baby boomers’ effects have continued to reverberate through the U.S.

economy. For example, starting salaries for people with college degrees

became depressed when large numbers of baby boomers started graduating

from college. And as workers born during the boom have aged, the work

force in the United States has grown progressively older, with the

percentage of workers under the age of 25 falling from 20.3 percent in

1980 to 14.3 percent in 1997.

By the 1990s, the women and baby boomers who first entered the job market

in the 1970s had acquired more experience and training. Therefore, the

aging of the labor force was not affecting entry-level jobs as it once

did, and starting salaries for college graduates were rising rapidly

again. There will be, however, other kinds of labor market and public

policy issues to face when the baby boomers begin to retire in the early

decades of the 21st century.

Immigration

Labor markets in the United States have also been significantly affected

by the immigration of families and workers from other nations. Most

families and workers in the United States can trace their heritage to

immigrants. In fact, before the 20th century, while the United States was

trying to settle its frontiers, it allowed essentially unlimited

immigration. see Immigration: A Nation of Immigrants. In these periods

the U.S. economy had more land and other natural resources than it was

able to use, because labor was so scarce. Immigration served as one of

the main remedies for this shortage of labor.

Generally, immigration raises national output and income levels. These

changes occur because immigration increases the number of workers in the

economy, which allows employers to produce more goods and services.

Capital resources in the economy may also become more valuable as

immigration increases. The number of workers available to work with

machines and tools increases, as does the number of consumers who want to

buy goods and services. However, wages for jobs that are filled by large

numbers of immigrants may decrease. This wage decline stems from greater

competition for these jobs and from the fact that many immigrants are

willing to work for lower wages than other U.S. workers.

Immigration into the United States is now regulated by a system of quotas

that limits the number of immigrants who can legally enter the country

each year. In 1964 Congress changed immigration policies to give

preference to those with families already in the United States, to

refugees facing political persecution, and to individuals with other

humanitarian concerns. Before that time, more weight had been placed on

immigrants’ labor-market skills. Although this change in policy helped

reunite families, it also increased the supply of unskilled labor in the

nation, especially in the states of California, Florida, and New York. In

1990 Congress modified the immigration legislation to set a separate

annual quota for immigrants with job skills needed in the United States.

But people with family members who are already U.S. citizens remain the

largest category of immigrants, and U.S. immigration law still puts less

focus on job skills than do immigration laws in many other market

economies, including Canada and many of the nations of Western Europe.

Discrimination

Women and many minorities have long faced discrimination in U.S. labor

markets. Employed women earn less, on average, than men with similar

levels of education. In part this wage disparity reflects different

educational choices that women and men have made. In the past, women have

been less likely to study engineering, sciences, and other technical

fields that generally pay more. In part, the wage differences result from

women leaving the job market for a period of years to raise children.

Another reason for the disparity in wages between men and women is that

there is still a considerable degree of occupational segregation between

males and females—for example, nurses are much more likely to be females

and dentists males. But even after allowing for those factors, studies

have generally found that, on average, women earn roughly 10 percent less

than men even in comparable jobs, with equal levels of education,

training, and experience.

Analysis of wage discrimination against black Americans leads to similar

conclusions. Specifically, after controlling for differences in age,

education, hours worked, experience, occupation, and region of the

country, wages for black men are roughly 10 percent lower than for white

men, though occupational segregation appears to be less common by race

than by gender. Issues other than wage discrimination are also important

to note for black workers. In particular, unemployment rates for black

workers are about twice as high as they are for white workers. Partly

because of that, a much lower percentage of the U.S. black population is

employed than the white population.

Hispanic workers generally receive wages about 5 percent lower than white

workers, after adjusting for differences in education, training,

experience, and other characteristics that affect workers’ productivity.

Some studies suggest that differences in the ability to speak English are

particularly important in understanding wage differences for Hispanic

workers.

The differences between the earnings of white males and earnings of

females and minorities slowly decreased in the closing decades of the

20th century. Some laws and regulations prohibiting discrimination seem

to have helped in this process. A large part of those gains occurred

shortly after the adoption of the 1964 Civil Rights Act, which among

other things, outlawed discrimination by employers and unions. Many

economists worry that the discrimination that remains may be more

difficult to identify and eliminate through legislation.

Discrimination in competitive labor markets is economically inefficient

as well as unfair. When workers are not paid based on the value of what

they add to employers’ production and profit levels, society loses

opportunities to use labor resources in their most valuable ways. As a

result, fewer goods and services are produced. If employers discriminate

against certain groups of workers, they will pay for that behavior in

competitive markets by earning lower profits. Similarly, if workers

refuse to work with (or for) coworkers of a different gender, race, or

ethnic background, they will have to accept lower wages in competitive

markets because their discrimination makes it more costly for employers

to run their businesses. And if customers refuse to be served by workers

of a certain gender, race, or ethnicity in certain kinds of jobs, they

will have to pay higher prices in competitive markets because their

discrimination raises the costs of providing these goods and services.

Those who are discriminated against receive lower wages and often

experience other forms of economic hardship, such as more frequent and

longer periods of unemployment. Beyond that, the lower wage rates and

restricted career opportunities they face will naturally affect their

decisions about how much education and training to acquire and what kinds

of careers to pursue. For that reason, some of the costs of

discrimination are paid over very long periods of time, sometimes for a

worker’s entire life.

It is clear that there is still discrimination in the U.S. economy. What

is not always so clear is how much that discrimination costs the economy

as a whole, and that it costs not only those who are discriminated

against, but also those who practice discrimination.

Unions

Many U.S. workers belong to unions or to professional associations (such

as the National Education Association for teachers) that act like unions.

These unions and associations represent groups of workers in collective

bargaining with employers to agree on contracts. During this bargaining,

workers and employers establish wages and fringe benefits, such as health

care and pension benefits, for different types of jobs. They also set

grievance procedures to resolve labor disputes during the life of the

contract and often address many other issues, such as procedures for job

transfers and promotions of workers.

Many studies indicate that wages for union workers in the United States

are 10 to 15 percent higher than for nonunion workers in similar jobs and

that fringe benefits for union workers also tend to be higher. That

compensation difference is an important consideration both for workers

thinking about joining unions, and for employers who are concerned about

paying higher wages and benefits than their competitors. In some cases,

it appears that the higher wages and benefits are paid because union

workers are more productive than nonunion workers are. But in other cases

unions have been found to decrease productivity, sometimes by limiting

the kinds of work that certain employees can do, or by requiring more

workers in some jobs than employers would otherwise hire. Economists have

not reached definite conclusions on some of these issues, but it is

evident that there are many other broad effects of unions on the economy.

Unions and collective bargaining in the United States are markedly

different from such organizations and procedures in other industrialized

nations. U.S. unions generally practice what is often described as

business unionism, which focuses mainly on the direct economic interests

of their members. In contrast, unions in Europe and South America focus

more on influencing national policy agendas and political parties.

The different focus by U.S. unions partly reflects the special history of

unions in the United States, where the first sustained successes were

achieved by craft unions representing skilled workers such as carpenters,

printers, and plumbers. These skilled workers had more bargaining power

and were more difficult for employers to replace or do without than

workers with less training. Unions representing these skilled workers

were also able to provide special services to employers that allowed both

the unions and employers to operate more efficiently. For example, craft

unions in large cities often ran apprenticeship programs to train young

workers in these occupations. And many craft unions operated hiring halls

that employers could call to find trained workers on short notice or for

short periods of time.

Most of these craft unions were members of the American Federation of

Labor (AFL), founded in 1886. The strong bargaining position of these

skilled workers, and the fact that these workers typically earned much

higher wages than most other workers, led the AFL unions to focus on

wages and other financial benefits for their members. Samuel Gompers, the

president of the AFL for nearly all of its first 38 years, once

summarized his philosophy of unions by saying, “What do we want? More.

When do we want it? Now.”

By contrast, industrial unions—which represent all of the workers at a

firm or work site, regardless of their function or trade—were generally

not successful in the United States before Congress passed the National

Labor Relations Act of 1935. This law, also known as the Wagner Act after

its sponsor, Senator Robert F. Wagner of New York, changed the way that

unions are recognized as bargaining agents for workers by employers, and

made it easier for unions representing all workers to win that

recognition. The Wagner Act largely put an end to the violent strikes

that often occurred when unions were trying to be recognized as the

bargaining agent for employees at some firm or work site. The act

established clear procedures for calling and holding elections in which

the workers decide whether they want to be represented by a union, and if

so by which union. The Wagner Act also established a government agency

known as the National Labor Relations Board (NLRB) to hear charges of

unfair labor practices. Either employees or employers may file charges of

unfair labor practices with the NLRB.

After the Wagner Act was passed, the number of workers who belonged to

unions increased rapidly. This trend continued through World War II (1939-

1945), when unions successfully negotiated more fringe benefits for their

members. These fringe benefits were partly a result of wage and price

controls established during the war, which made large wage increases

impossible. In the 1950s union strength continued to grow, and the

national association of industrial unions, known as the Congress of

Industrial Organization (CIO) merged with the AFL.

Since the late 1970s, total union membership has fallen. The percentage

of the U.S. labor force that belongs to unions has decreased dramatically

in the last half of the 20th century, from more than 25 percent in the

mid-1950s to 14 percent in 1997. A number of reasons explain the decline

in union representation of the U.S. labor force. First, unions are

traditionally strong in manufacturing industries, but since the 1950s

manufacturing has accounted for a smaller percentage of overall

employment in the U.S. economy. Employment has grown more rapidly in the

service sector, particularly in professional services and white-collar

jobs. Unions have not had as much success in acquiring new members in the

service sector, with the exception of government employees.

Union membership has also declined as the government established laws and

regulations that mandate for all workers many of the benefits and

guarantees that unions had achieved for their members. These mandates

include minimum wage, workplace safety, higher pay rates for overtime,

and oversight of the management of pension funds if employers fund or

partially fund pensions.

Third, many U.S. firms have become more aggressive in opposing the

recognition of unions as bargaining agents for their employees, and in

dealing with confrontations involving existing unions. For example, it is

increasingly common for firms to hire permanent replacement workers if

strikes occur at a firm or work site.

Finally, workers with college degrees held a larger percentage of jobs in

the U.S. economy in the late 1990s than in earlier decades. These workers

are more likely to be in jobs with some level of managerial

responsibilities, and less likely to think of themselves as potential

union members.

Unions, however, continue to play many valuable roles in representing

their members on economic issues. Equally or perhaps more importantly,

unions provide workers with a stronger voice in how work is done and how

workers are treated. This is particularly true in jobs where it is

difficult to identify clearly how much an individual worker contributes

to total output in the production process. During the 1990s, many U.S.

manufacturing firms adopted team production methods, in which small

groups of workers function as a team. Any member of the team can suggest

ideas for different ways of doing jobs. But management is likely to

consider more carefully those that are recommended by the union or have

union support. Workers may also be more willing to present ideas for job

improvements to union representatives than to managers. In some cases,

workers feel that the union would consider how the changes can be made

without reducing jobs, wages, or other benefits.

Unemployment

A persistent problem for the U.S. economy and some of its workers is

unemployment—not being able to find a job despite actively looking for

work for at least 30 consecutive days. There are three major kinds of

unemployment: frictional, cyclical, and structural. Each type of

unemployment has different causes and consequences, and so public

policies designed to reduce each type of unemployment must be different,

too.

Frictional unemployment occurs as a result of labor mobility, when

workers change jobs or wait to begin a new job. Labor mobility is, in

general, a good thing for workers and the economy overall. It allows

workers to look for the best available job for which they are qualified

and lets employers find the best-qualified people for their job openings.

Because this searching and matching by employees and employers takes

time, on any given day in a market economy there will be some workers who

are looking for a new job, or waiting to begin a job. Even when

economists describe the economy as being at full employment there will be

some frictional unemployment (as much as 5 to 6 percent of the labor

force in some years). This kind of unemployment is generally not a major

economic problem.

Cyclical unemployment occurs when the economy goes into a recession. The

basic causes of cyclical unemployment are decreases in the levels of

consumption, investment, or government spending in the economy, or a

decrease in the demand for goods and services exported to other

countries. As national spending and production levels fall, some

employers begin to lay off workers. Cyclical unemployment varies greatly

according to the health of the economy. Some of the highest unemployment

rates for the last decades of the 20th century took place during the

recession of 1982 to 1983, when unemployment levels reached almost 10

percent. The highest U.S. unemployment rate of the 20th century occurred

in 1933, when the Great Depression left almost 25 percent of the labor

force without work.

Sometimes the government can use monetary or fiscal policies to increase

spending by businesses and households, for instance by cutting taxes. Or

the government can increase its own spending to fight this kind of

unemployment. . Perhaps the most famous example of this kind of tax cut

in the United States was the one designed in 1963 and passed in 1964 by

the administrations of U.S. president John F. Kennedy and his successor,

Lyndon B. Johnson.

Structural unemployment occurs when people who are looking for jobs do

not have the education or skills to fill the jobs that are currently

available. Most policies designed to reduce structural unemployment

provide training programs for these workers, or subsidize education and

training programs available from colleges and universities, technical

schools, or businesses. In some cases, the government provides support

for retraining when increased competition from imported goods and

services puts U.S. workers out of work or when factories are shut down

because production is moved to another state or country.

Unemployment rates also vary sharply by occupation and educational

levels. As a group, workers with college degrees experience far lower

unemployment rates than workers with less education. In 1998 the

unemployment rate for U.S. workers who had not graduated from high school

was 7.1 percent; for high school graduates, the rate was 4.0 percent; for

those with some college the rate was 3.0 percent; and for college

graduates the unemployment rate was only 1.8 percent.

Income Inequality

Another issue involving the operation of labor markets in the U.S.

economy has been the growing difference between the earnings of high-

income and low-income workers at the end of the 20th century. From 1977

to 1997, families who make up the top 20 percent of income groups have

seen their money income rise from 40.9 percent of the national income to

47.2 percent. Over the same period, families in the lowest 20 percent of

income groups have experienced a decline from 5.5 percent of the national

income to 4.2 percent. This trend is the result of several factors.

Wages for skilled workers, those with more education and training, have

increased quickly because the supply of these workers in the U.S. has not

risen as quickly as demand for these workers. In addition, wages for

unskilled labor in the United States have been held down more than in

other nations as a result of U.S. immigration policies. The United States

has admitted a larger number of unskilled workers than other

industrialized nations. Other countries often consider job market factors

more heavily in determining who will be allowed to immigrate. As a

result, the supply of unskilled workers in the United States has

increased faster than in other countries, pushing wages in low-paying

jobs lower.

Finally, government assistance programs for low-income families tend to

be more extensive and generous in other industrialized market economies

than they are in the United States. That is perhaps one of the reasons

that workers in those countries are less willing to accept jobs that pay

lower wages, and why unemployment rates in those countries are

substantially higher than they are in the United States. The exact

relationship between those factors has not been determined, however.

It is clear that it has become increasingly difficult for U.S. workers

who have not at least completed high school to achieve a high or moderate

level of income. In 1996 the average annual income for graduates of four-

year colleges was $63,127 for males and $41,339 for females, while the

average annual income for those who did not graduate from high school was

only $25,283 for males and $17,313 for females.

GOVERNMENT AND THE ECONOMY

Although the market system in the United States relies on private

ownership and decentralized decision-making by households and privately

owned businesses, the government does perform important economic

functions. The government passes and enforces laws that protect the

property rights of individuals and businesses. It restricts economic

activities that are considered unfair or socially unacceptable.

In addition, government programs regulate safety in products and in the

workplace, provide national defense, and provide public assistance to

some members of society coping with economic hardship. There are some

products that must be provided to households and firms by the government

because they cannot be produced profitably by private firms. For example,

the government funds the construction of interstate highways, and

operates vaccination programs to maintain public health. Local

governments operate public elementary and secondary schools to ensure

that as many children as possible will receive an education, even when

their parents are unable to afford private schools.

Other kinds of goods and services (such as health care and higher

education) are produced and consumed in private markets, but the

government attempts to increase the amount of these products available in

the economy. For yet other goods and services, the government acts to

decrease the amount produced and consumed; these include alcohol,

tobacco, and products that create high levels of pollution. These special

cases where markets fail to produce the right amount of certain goods and

services mean that the government has a large and important role to play

in adjusting some production patterns in the U.S. economy. But economists

and other analysts have also found special reasons why government

policies and programs often fail, too.

At the most basic level, the government makes it possible for markets to

function more efficiently by clearly defining and enforcing people’s

property or ownership rights to resources and by providing a stable

currency and a central banking system (the Federal Reserve System in the

U.S. economy). Even these basic functions require a wide range of

government programs and employees. For example, the government maintains

offices for recording deeds to property, courts to interpret contracts

and resolve disputes over property rights, and police and other law

enforcement agencies to prevent or punish theft and fraud. The Treasury

Department issues currency and coins and handles the government’s

revenues and expenditures. And as we have seen, the Federal Reserve

System controls the nation’s supply of money and availability of credit.

To perform these basic functions, the government must be able to shift

resources from private to public uses. It does this mainly through taxes,

but also with user fees for some services (such as admission fees to

national parks), and by borrowing money when it issues government bonds.

In the U.S. economy, private markets are generally used to allocate basic

products such as food, housing, and clothing. Most economists—and most

Americans—widely accept that competitive markets perform these functions

most efficiently. One role of government is to maintain competition in

these markets so that they will continue to operate efficiently. In other

areas, however, markets are not allowed to operate because other

considerations have been deemed more important than economic efficiency.

In these cases, the government has declared certain practices illegal.

For example, in the United States people are not free to buy and sell

votes in political elections. Instead, the political system is based on

the democratic rule of “one person, one vote.” It is also illegal to buy

and sell many kinds of drugs. After the Civil War (1861-1865) the

Constitution was amended to make slavery illegal, resulting in a major

change in the structure of U.S. society and the economy.

In other cases, the government allows private markets to operate, but

regulates them. For example, the government makes laws and regulations

concerning product safety. Some of these laws and regulations prohibit

the use of highly flammable material in the manufacture of children’s

clothing. Other regulations call for government inspection of food

products, and still others require extensive government review and

approval of potential prescription drugs.

In still other situations, the government determines that private markets

result in too much production and consumption of some goods, such as

alcohol, tobacco, and products that contribute to environmental

pollution. The government is also concerned when markets provide too

little of other products, such as vaccinations that prevent contagious

diseases. The government can use its spending and taxing authority to

change the level of production and consumption of these products, for

example, by subsidizing vaccinations.

Even the staunchest supporters of private markets have recognized a role

for the government to provide a safety net of support for U.S. citizens.

This support includes providing income, housing, food, and medicine for

those who cannot provide a basic standard of living for themselves or

their families.

Because the federal government has become such a large part of the U.S.

economy over the past century, it sometimes tries to reduce levels of

unemployment or inflation by changing its overall level of spending and

taxes. This is done with an eye to the monetary policies carried out by

the Federal Reserve System, which also have an effect on the national

rates of inflation, unemployment, and economic growth. The Federal

Reserve System itself is chartered by federal legislation, and the

president of the United States appoints board members of the Federal

Reserve, with the approval of the U.S. Senate. However, the private banks

that belong to the system own the Federal Reserve, and its policy and

operational decisions are made independently of Congress and the

president.

Correcting Market Failures

The government attempts to adjust the production and consumption of

particular goods and services where private markets fail to produce

efficient levels of output for those products. The two major examples of

these market failures are what economists call public goods and external

benefits or costs.

Providing Public Goods

Private markets do not provide some essential goods and services, such as

national defense. Because national defense is so important to the

nation’s existence, the government steps in and entirely funds and

administers this product.

Public goods differ from private goods in two key respects. First, a

public good can be used by one person without reducing the amount

available for others to use. This is known as shared consumption. An

example of a public good that has this characteristic is a spraying or

fogging program to kill mosquitoes. The spraying reduces the number of

mosquitoes for all of the people who live in an area, not just for one

person or family. The opposite occurs in the consumption of private

goods. When one person consumes a private good, other people cannot use

the product. This is known as rival consumption. A good example of rival

consumption is a hamburger. If someone else eats the sandwich, you

cannot.

The second key characteristic of public goods is called the nonexclusion

principle: It is not possible to prevent people from using a public good,

regardless of whether they have paid for it. For example, a visitor to a

town who does not pay taxes in that community will still benefit from the

town’s mosquito-spraying program. With private goods, like a hamburger,

when you pay for the hamburger, you get to eat it or decide who does.

Someone who does not pay does not get the hamburger.

Because many people can benefit from the same pubic goods and share in

their consumption, and because those who do not pay for these goods still

get to use them, it is usually impossible to produce these goods in

private markets. Or at least it is impossible to produce enough in

private markets to reach the efficient level of output. That happens

because some people will try to consume the goods without paying for

them, and get a free ride from those who do pay. As a result, the

government must usually take over the decision about how much of these

products to produce. In some cases, the government actually produces the

good; in other cases it pays private firms to make these products.

The classic example of a public good is national defense. It is not a

rival consumption product, since protecting one person from an invading

army or missile attack does not reduce the amount of protection provided

to others in the country. The nonexclusion principle also applies to

national defense. It is not possible to protect only the people who pay

for national defense while letting bombs or bullets hit those who do not

pay. Instead, the government imposes broad-based taxes to pay for

national defense and other public goods.

Adjusting for External Costs or Benefits

There are some private markets in which goods and services are produced,

but too much or too little is produced. Whether too much or too little is

produced depends on whether the problem is one of external costs or

external benefits. In either case, the government can try to correct

these market failures, to get the right amount of the good or service

produced.

External costs occur when not all of the costs involved in the production

or consumption of a product are paid by the producers and consumers of

that product. Instead, some of the costs shift to others. One example is

drunken driving. The consumption of too much alcohol can result in

traffic accidents that hurt or kill people who are neither producers nor

consumers of alcoholic products. Another example is pollution. If a

factory dumps some of its wastes in a river, then people and businesses

downstream will have to pay to clean up the water or they may become ill

from using the water.

When people other than producers and consumers pay some of the costs of

producing or consuming a product, those external costs have no effect on

the product’s market price or production level. As a result, too much of

the product is produced considering the overall social costs. To correct

this situation, the government may tax or fine the producers or consumers

of such products to force them to cover these external costs. If that can

be done correctly, less of the product will be produced and consumed.

An external benefit occurs when people other than producers and consumers

enjoy some of the benefits of the production and consumption of the

product. One example of this situation is vaccinations against contagious

diseases. The company that sells the vaccine and the individuals who

receive the vaccine are better off, but so are other people who are less

likely to be infected by those who have received the vaccine. Many people

also argue that education provides external benefits to the nation as a

whole, in the form of lower unemployment, poverty, and crime rates, and

by providing more equality of opportunity to all families.

When people other than the producers and consumers receive some of the

benefits of producing or consuming a product, those external benefits are

not reflected in the market price and production cost of the product.

Because producers do not receive higher sales or profits based on these

external benefits, their production and price levels will be too

low–based only on those who buy and consume their product. To correct

this, the government may subsidize producers or consumers of these

products and thus encourage more production.

Maintaining Competition

Competitive markets are efficient ways to allocate goods and services

while maintaining freedom of choice for consumers, workers, and

entrepreneurs. If markets are not competitive, however, much of that

freedom and efficiency can be lost. One threat to competition in the

market is a firm with monopoly power. Monopoly power occurs when one

producer, or a small group of producers, controls a large part of the

production of some product. If there are no competitors in the market, a

monopoly can artificially drive up the price for its products, which

means that consumers will pay more for these products and buy less of

them. One of the most famous cases of monopoly power in U.S. history was

the Standard Oil Company, owned by U.S. industrialist John D.

Rockefeller. Rockefeller bought out most of his business rivals and by

1878 controlled 90 percent of the petroleum refineries in the United

States.

Largely in reaction to the business practices of Standard Oil and other

trusts or monopolistic firms, the United States passed laws limiting

monopolies. Since 1890, when the Sherman Antitrust Act was passed, the

federal government has attempted to prevent firms from acquiring monopoly

power or from working together to set prices and limit competition in

other ways. A number of later antitrust laws were passed to extend the

government’s power to promote and maintain competition in the U.S.

economy. Some states have passed their own versions of some of these

laws.

The government does allow what economists call natural monopolies.

However, the government then regulates those businesses to protect

consumers from high prices and poor service, and often limits the profits

these firms can earn. The classic examples of natural monopolies are

local services provided by public utilities. Economies of scale make it

inefficient to have even two companies distributing electricity, gas,

water, or local telephone service to consumers. It would be very

expensive to have even two sets of electric and telephone wires, and two

sets of water, gas, and sewer pipes going to every house. That is why

firms that provide these services are called natural monopolies.

There have been some famous antitrust cases in which large companies were

broken up into smaller firms. One such example is the breakup of American

Telephone and Telegraph (AT&T) in 1982, which led to the formation of a

number of long-distance and regional telephone companies. Other examples

include a ruling in 1911 by the Supreme Court of the United States, which

broke the Standard Oil Trust into a number of smaller oil companies and

ordered a similar breakup of the American Tobacco Company.

Some government policies intentionally reduce competition, at least for

some period of time. For example, patents on new products and copyrights

on books and movies give one producer the exclusive right to sell or

license the distribution of a product for 17 or more years. These

exclusive rights provide the incentive for firms and individuals to spend

the time and money required to develop new products. They know that no

one else will copy and sell their product when it is introduced into the

marketplace, so it pays to devote more resources to developing these new

products.

The benefits of certain other government policies that reduce competition

are not always this clear, however. More controversial examples include

policies that restrict the number of taxicabs in a large city or that

limit the number of companies providing cable television services in a

community. It is much less expensive for cable companies to install and

operate a cable television system than it is for large utilities, such as

the electric and telephone companies, to install the infrastructure they

need to provide services. Therefore, it is often more feasible to have

two or more cable companies in reasonably large cities. There are also

more substitutes for cable television, such as satellite dish systems and

broadcast television. But despite these differences, many cities auction

off cable television rights to a single company because the city receives

more revenue that way. Such a policy results in local monopolies for

cable television, even in areas where more competition might well be

possible and more efficient.

Establishing government policies that efficiently regulate markets is

difficult to do. Policies must often balance the benefits of having more

firms competing in an industry against the possible gains from allowing a

smaller number of firms to compete when those firms can achieve economies

of scale. The government must try to weigh the benefits of such

regulations against the advantages offered by more competitive, less

regulated markets.

Promoting Full Employment and Price Stability

In addition to the monetary policies of the Federal Reserve System, the

federal government can also use its taxing and spending policies, or

fiscal policies, to counteract inflation or the cyclical unemployment

that results from too much or too little total spending in the economy.

Specifically, if inflation is too high because consumers, businesses, and

the government are trying to buy more goods and services than it is

possible to produce at that time, the government can reduce total

spending in the economy by reducing its own spending. Or the government

can raise taxes on households and businesses to reduce the amount of

money the private sector spends. Either of these fiscal policies will

help reduce inflation. Conversely, if inflation is low but unemployment

rates are too high, the government can increase its spending or reduce

taxes on households and businesses. These policies increase total

spending in the economy, encouraging more production and employment.

Some government spending and tax policies work in ways that automatically

stabilize the economy. For example, if the economy is moving into a

recession, with falling prices and higher unemployment, income taxes paid

by individuals and businesses will automatically fall, while spending for

unemployment compensation and other kinds of assistance programs to low-

income families will automatically rise. Just the opposite happens as the

economy recovers and unemployment falls—income taxes rise and government

spending for unemployment benefits falls. In both cases, tax programs and

government-spending programs change automatically and help offset changes

in nongovernment employment and spending.

In some cases, the federal government uses discretionary fiscal policies

in addition to automatic stabilization policies. Discretionary fiscal

policies encompass those changes in government spending and taxation that

are made as a result of deliberations by the legislative and executive

branches of government. Like the automatic stabilization policies,

discretionary fiscal policy can reduce unemployment by increasing

government spending or reducing taxes to encourage the creation of new

jobs. Conversely, it can reduce inflation by decreasing government

spending and raising taxes. .

In general, the federal government tries to consider the condition of the

national economy in its annual budgeting deliberations. However,

discretionary spending is difficult to put into practice unless the

nation is in a particularly severe episode of unemployment or inflation.

In such periods, the severity of the situation builds more consensus

about what should be done, and makes it more likely that the problem will

still be there to deal with by the time the changes in government

spending or tax programs take effect. But in general, it takes time for

discretionary fiscal policy to work effectively, because the economic

problem to be addressed must first be recognized, then agreement must be

reached about how to change spending and tax levels. After that, it takes

more time for the changes in spending or taxes to have an effect on the

economy.

When there is only moderate inflation or unemployment, it becomes harder

to reach agreement about the need for the government to change spending

or taxes. Part of the problem is this: In order to increase or decrease

the overall level of government spending or taxes, specific expenditures

or taxes have to be increased or decreased, meaning that specific

programs and voters are directly affected. Choosing which programs and

voters to help or hurt often becomes a highly controversial political

issue.

Because discretionary fiscal policies affect the government’s annual

deficit or surplus, as well as the national debt, they can often be

controversial and politically sensitive. For these reasons, at the close

of the 20th century, which experienced years with normal levels of

unemployment and inflation, there was more reliance on monetary policies,

rather than on discretionary fiscal policies to try to stabilize the

national economy. There have been, however, some famous episodes of

changing federal spending and tax policies to reduce unemployment and

fight inflation in the U.S. economy during the past 40 years. In the

early 1980s, the administration of U.S. president Ronald Reagan cut

taxes. Other notable tax cuts occurred during the administrations of U.S.

presidents John Kennedy and Lyndon Johnson in 1963 and 1964.

Limitations of Government Programs

Government economic programs are not always successful in correcting

market failures. Just as markets fail to produce the right amount of

certain kinds of goods and services, the government will often spend too

much on some programs and too little on others for a number of reasons.

One is simply that the government is expected to deal with some of the

most difficult problems facing the economy, taking over where markets

fail because consumers or producers are not providing clear signals about

what they want. This lack of clear signals also makes it difficult for

the government to determine a policy that will correct the problem.

Political influences, rather than purely economic factors, often play a

major role in inefficient government policies. Elected officials

generally try to respond to the wishes of the voting public when making

decisions that affect the economy. However, many citizens choose not to

vote at all, so it is not clear how good the political signals are that

elected officials have to work with. In addition, most voters are not

well informed on complicated matters of economic policy.

For example, the federal government’s budget director David Stockman and

other officials in the administration of President Reagan proposed cuts

in income tax rates. Congress adopted the cuts in 1981 and 1984 as a way

to reduce unemployment and make the economy grow so much that tax

revenues would actually end up rising, not falling. Most economists and

many politicians did not believe that would happen, but the tax cuts were

politically popular.

In fact, the tax cuts resulted in very large budget deficits because the

government did not collect enough taxes to cover its expenditures. The

government had to borrow money, and the national debt grew very rapidly

for many years. As the government borrowed large sums of money, the

increased demand caused interest rates to rise. The higher interest rates

made it more expensive for U.S. firms to invest in capital goods, and

increased the demand for dollars on foreign exchange markets as

foreigners bought U.S. bonds paying higher interest rates. That caused

the value of the dollar to rise, compared with other nations’ currencies,

and as a result U.S. exports became more expensive for foreigners to buy.

When that happened in the mid-1980s, most U.S. companies that exported

goods and services faced very difficult times.

In addition, whenever resources are allocated through the political

process, the problem of special interest groups looms large. Many

policies, such as tariffs or quotas on imported goods, create very large

benefits for a small group of people and firms, while the costs are

spread out across a large number of people. That gives those who receive

the benefits strong reasons to lobby for the policy, while those who each

pay a small part of the cost are unlikely to oppose it actively. This

situation can occur even if the overall costs of the program greatly

exceed its overall benefits.

For instance, the United States limits sugar imports. The resulting

higher U.S. price for sugar greatly benefits farmers who grow sugarcane

and sugar beets in the United States. U.S. corn farmers also benefit

because the higher price for sugar increases demand for corn-based

sweeteners that substitute for sugar. Companies in the United States that

refine sugar and corn sweeteners also benefit. But candy and beverage

companies that use sweeteners pay higher prices, which they pass on to

millions of consumers who buy their products. However, these higher

prices are spread across so many consumers that the increased cost for

any one is very small. It therefore does not pay a consumer to spend much

time, money, or effort to oppose the import barriers.

For sugar growers and refiners, of course, the higher price of sugar and

the greater quantity of sugar they can produce and sell makes the import

barriers something they value greatly. It is clearly in their interest to

hire lobbyists and write letters to elected officials supporting these

programs. When these officials hear from the people who benefit from the

policies, but not from those who bear the costs, they may well decide to

vote for the import restrictions. This can happen despite the fact that

many studies indicate the total costs to consumers and the U.S. economy

for these programs are much higher than the benefits received by sugar

producers.

Special interest groups and issues are facts of life in the political

arena. One striking way to see that is to drive around the U.S. national

capital, Washington D.C., or a state capital and notice the number of

lobbying groups that have large offices near the capitol building. Or

simply look at the list of trade and professional associations in the

yellow pages for those cities. These lobbying groups are important and

useful to the political process in many ways. They provide information on

issues and legislation affecting their interests. But these special

interest groups also favor legislation that often benefits their members

at the expense of the overall public welfare.

E The Scope of Government in the U.S. Economy

The size of the government sector in the U.S. economy increased

dramatically during the 20th century. Federal revenues totaled less than

5 percent of total GDP in the early 1930s. In 1995 they made up 22

percent. State, county, and local government revenues represent an

additional 15 percent of GDP.

Although overall government revenues and spending are somewhat lower in

the United States than they are in many other industrialized market

economies, it is still important to consider why the size of government

has increased so rapidly during the 20th century. The general answer is

that the citizens of the United States have elected representatives who

have voted to increase government spending on a variety of programs and

to approve the taxes required to pay for these programs.

Actually, government spending has increased since the 1930s for a number

of specific reasons. First, the different branches of government began to

provide services that improved the economic security of individuals and

families. These services include Social Security and Medicare for the

elderly, as well as health care, food stamps, and subsidized housing

programs for low-income families. In addition, new technology increased

the cost of some government services; for example, sophisticated new

weapons boosted the cost of national defense. As the economy grew, so did

demand for the government to provide more and better transportation

services, such as super highways and modern airports. As the population

increased and became more prosperous, demand grew for government-financed

universities, museums, parks, and arts programs. In other words, as

incomes rose in the United States, people became more willing to be taxed

to support more of the kinds of programs that government agencies

provide.

Social changes have also contributed to the growing role of government.

As the structure of U.S. families changed, the government has

increasingly taken over services that were once provided mainly by

families. For instance, in past times, families provided housing and

health care for their elderly. Today, extended families with several

generations living together are rare, partly because workers move more

often than they did in the past to take new jobs. Also the elderly live

longer today than they once did, and often require much more

sophisticated and expensive forms of medical care. Furthermore, once the

government began to provide more services, people began to look to the

government for more support, forming special interest groups to push

their demands.

Some people and groups in the United States favor further expansion of

government programs, while others favor sharp reductions in the current

size and scope of government. Reliance on a market system implies a

limited role for government and identifies fairly specific kinds of

things for the government to do in the economy. Private households and

businesses are expected to make most economic decisions. It is also true

that if taxes and other government revenues take too large a share of

personal income, incentives to work, save, and invest are diminished,

which hurts the overall performance of the economy. But these general

principles do not establish precise guidelines on how large or small a

role the government should play in a market economy. Judging the

effectiveness of any current or proposed government program requires a

careful analysis of the additional benefits and costs of the program. And

ultimately, of course, the size of government is something that U.S.

citizens decide through democratic elections.

IX IMPACT OF THE WORLD ECONOMY Today, virtually every country

in the world is affected by what happens in other countries. Some of

these effects are a result of political events, such as the overthrow of

one government in favor of another. But a great deal of the

interdependence among the nations is economic in nature, based on the

production and trading of goods and services.

One of the most rapidly growing and changing sectors of the U.S. economy

involves trade with other nations. In recent decades, the level of goods

and services imported from other countries by U.S. consumers, businesses,

and government agencies has increased dramatically. But so, too, has the

level of U.S. goods and services sold as exports to consumers,

businesses, and government agencies in other nations. This international

trade and the policies that encourage or restrict the growth of imports

and exports have wide-ranging effects on the U.S. economy.

As the nation with the world’s largest economy, the United States plays a

key role on the international political and economic stages. The United

States is also the largest trading nation in the world, exporting and

importing more goods and services than any other country.. Some people

worry that extensive levels of international trade may have hurt the U.S.

economy, and U.S. workers in particular. But while some firms and workers

have been hurt by international competition, in general economists view

international trade like any other kind of voluntary trade: Both parties

can gain, and usually do. International trade increases the total level

of production and consumption in the world, lowers the costs of

production and prices that consumers pay, and increases standards of

living. How does that happen?

All over the world, people specialize in producing particular goods and

services, then trade with others to get all of the other goods and

services they can afford to buy and consume. It is far more efficient for

some people to be lawyers and other people doctors, butchers, bakers, and

teachers than it is for each person to try to make or do all of the

things he or she consumes.

In earlier centuries, the majority of trade took place between

individuals living in the same town or city. Later, as transportation and

communications networks improved, individuals began to trade more

frequently with people in other places. The industrial revolution that

began in the 18th century greatly increased the volume of goods that

could be shipped to other cities and regions, and eventually to other

nations. As people became more prosperous, they also traveled more to

other countries and began to demand the new products they encountered

during their travels.

The basic motivation and benefits of international trade are actually no

different from those that lead to trade within a nation. But

international trade differs from trade within a nation in two major ways.

First, international trade involves at least two national currencies,

which must usually be exchanged before goods and services can be imported

or exported. Second, nations sometimes impose barriers on international

trade that they do not impose on trade that occurs entirely inside their

own country.

A U.S. Imports and Exports

U.S. exports are goods and services made in the United States that are

sold to people or businesses in other countries. Goods and services from

other countries that U.S. citizens or firms purchase are imports for the

United States. Like almost all of the other nations of the world, the

United States has seen a rapid increase in both its imports and exports

over the last several decades. In 1959 the combined value of U.S. imports

and exports amounted to less than 9 percent of the country’s gross

domestic product (GDP); by 1997 that figure had risen to 25 percent.

Clearly, the international trade sector has grown much more rapidly than

the overall economy.

Most of this trade occurs between industrialized, developed nations and

involves similar kinds of products as both imports and exports. While it

is true that the U.S. imports some things that are only found or grown in

other parts of the world, most trade involves products that could be made

in the United States or any other industrialized market economies. In

fact, some products that are now imported, such as clothing and textiles,

were once manufactured extensively in the United States. However,

economists note that just because things were or could be made in a

country does not mean that they should be made there.

Just as individuals can increase their standard of living by specializing

in the production of the things they do best, nations also specialize in

the products they can make most efficiently. The kinds of goods and

services that the United States can produce most competitively for export

are determined by its resources. The United States has a great deal of

fertile land, is the most technologically advanced nation in the world,

and has a highly educated and skilled labor force. That explains why U.S.

companies produce and export many agricultural products as well as

sophisticated machines, such as commercial jets and medical diagnostic

equipment.

Many other nations have lower labor costs than the United States, which

allows them to export goods that require a lot of labor, such as shoes,

clothing, and textiles. But even in trading with other industrialized

countries—whose workers are similarly well educated, trained, and highly

paid—the United States finds it advantageous to export some high-tech

products or professional services and to import others. For example, the

United States both imports and exports commercial airplanes, automobiles,

and various kinds of computer products. These trading patterns arise

because within these categories of goods, production is further

specialized into particular kinds of airplanes, automobiles, and computer

products. For example, automobile manufacturers in one nation may focus

production primarily on trucks and utility vehicles, while the automobile

industries in other countries may focus on sport cars or compact

vehicles.

Greater specialization allows producers to take full advantage of

economies of scale. Manufacturers can build large factories geared toward

production of specialized inventories, rather than spending extra

resources on factory equipment needed to produce a wide variety of goods.

Also, by selling more of their products to a greater number of consumers

in global markets, manufacturers can produce enough to make

specialization profitable.

The United States enjoyed a special advantage in the availability of

factories, machinery, and other capital goods after World War II ended in

1945. During the following decade or two, many of the other industrial

nations were recovering from the devastation of the war. But that

situation has largely disappeared, and the quality of the U.S. labor

force and the level of technological innovation in U.S. industry have

become more important in determining trade patterns and other

characteristics of the U.S. economy. A skilled labor force and the

ability of businesses to develop or adapt new technologies are the key to

high standards of living in modern global economies, particularly in

highly industrialized nations. Workers with low levels of education and

training will find it increasingly difficult to earn high wages and

salaries in any part of the world, including the United States.

B Barriers to Trade Despite the mutual advantages of global

trade, governments often adopt policies that reduce or eliminate

international trade in some markets. Historically, the most important

trade barriers have been tariffs (taxes on imports) and quotas (limits on

the number of products that can be imported into a country). In recent

decades, however, many countries have used product safety standards or

legal standards controlling the production or distribution of goods and

services to make it difficult for foreign businesses to sell in their

markets. For example, Russia recently used health standards to limit

imports of frozen chicken from the United States, and the United States

has frequently charged Japan with using legal restrictions and allowing

exclusive trade agreements among Japanese companies. These exclusive

agreements make it very difficult for U.S. banks and other firms to

operate or sell products in Japan.

While there are special reasons for limiting imports or exports of

certain kinds of products—such as products that are vital to a nation’s

national defense—economists generally view trade barriers as hurting both

importing and exporting nations. Although the trade barriers protect

workers and firms in industries competing with foreign firms, the costs

of this protection to consumers and other businesses are typically much

higher than the benefits to the protected workers and firms. And in the

long run it usually becomes prohibitively expensive to continue this kind

of protection. Instead it often makes more sense to end the trade barrier

and help workers in industries that are hurt by the increased imports to

relocate or retrain for jobs with firms that are competitive. In the

United States, trade adjustment assistance payments were provided to

steelworkers and autoworkers in the late 1970s, instead of imposing trade

barriers on imported cars. Since then, these direct cash payments have

been largely phased out in favor of retraining programs.

During recessions, when national unemployment rates are high or rising,

workers and firms facing competition from foreign companies usually want

the government to adopt trade barriers to protect their industries. But

again, historical experience with such policies shows that they do not

work. Perhaps the most famous example of these policies occurred during

the Great Depression of the 1930s. The United States raised its tariffs

and other trade barriers in legislation such as the Smoot-Hawley Act of

1930. Other nations imposed similar kinds of trade barriers, and the

overall result was to make the Great Depression even worse by reducing

world trade.

C World Trade Organization (WTO) and Its Predecessors

As World War II drew to a close, leaders in the United States and other

Western nations began working to promote freer trade for the post-war

world. They set up the International Monetary Fund (IMF) in 1944 to

stabilize exchange rates across member nations. The Marshall Plan,

developed by U.S. general and economist George Marshall, promoted free

trade. It gave U.S. aid to European nations rebuilding after the war,

provided those nations reduced tariffs and other trade barriers.

In 1947 the United States and many of its allies signed the General

Agreement on Tariffs and Trade (GATT), which was especially successful in

reducing tariffs over the next five decades. In 1995 the member nations

of the GATT founded the World Trade Organization (WTO), which set even

greater obligations on member countries to follow the rules established

under GATT. It also established procedures and organizations to deal with

disputes among member nations about the trading policies adopted by

individual nations.

In 1992 the United States also signed the North American Free Trade

Agreement (NAFTA) with its closest neighbors and major trading partners,

Canada and Mexico. The provisions of this agreement took effect in 1994.

Since then, studies by economists have found that NAFTA has benefited all

three nations, although greater competition has resulted in some

factories closing. As a percentage of national income, the benefits from

NAFTA have been greater in Canada and Mexico than in the United States,

because international trade represents a larger part of those economies.

While the United States is the largest trading nation in the world, it

has a very large and prosperous domestic economy; therefore international

trade is a much smaller percentage of the U.S. economy than it is in many

countries with much smaller domestic economies.

D Exchange Rates and the Balance of Payments

Currencies from different nations are traded in the foreign exchange

market, where the price of the U.S. dollar, for instance, rises and falls

against other currencies with changes in supply and demand. When firms in

the United States want to buy goods and services made in France, or when

U.S. tourists visit France, they have to trade dollars for French francs.

That creates a demand for French francs and a supply of dollars in the

foreign exchange market. When people or firms in France want to buy goods

and services made in the United States they supply French francs to the

foreign exchange market and create a demand for U.S. dollars.

Changes in people’s preferences for goods and services from other

countries result in changes in the supply and demand for different

national currencies. Other factors also affect the supply and demand for

a national currency. These include the prices of goods and services in a

country, the country’s national inflation rate, its interest rates, and

its investment opportunities. If people in other countries want to make

investments in the United States, they will demand more dollars. When the

demand for dollars increases faster than the supply of dollars on the

exchange markets, the price of the dollar will rise against other

national currencies. The dollar will fall, or depreciate, against other

currencies when the supply of dollars on the exchange market increases

faster than the demand.

All international transactions made by U.S. citizens, firms, and the

government are recorded in the U.S. annual balance of payments account.

This account has two basic sections. The first is the current account,

which records transactions involving the purchase (imports) and sale

(exports) of goods and services, interest payments paid to and received

from people and firms in other nations, and net transfers (gifts and aid)

paid to other nations. The second section is the capital account, which

records investments in the United States made by people and firms from

other countries, and investments that U.S. citizens and firms make in

other nations.

These two accounts must balance. When the United States runs a deficit on

its current account, often because it imports more that it exports, that

deficit must be offset by a surplus on its capital account. If foreign

investments in the United States do not create a large enough surplus to

cover the deficit on the current account, the U.S. government must

transfer currency and other financial reserves to the governments of the

countries that have the current account surplus. In recent decades, the

United States has usually had annual deficits in its current account,

with most of that deficit offset by a surplus of foreign investments in

the U.S. economy.

Economists offer divergent views on the persistent surpluses in the U.S.

capital account. Some analysts view these surpluses as evidence that the

United States must borrow from foreigners to pay for importing more than

it exports. Other analysts attribute the surpluses to a strong desire by

foreigners to invest their funds in the U.S. economy. Both

interpretations have some validity. But either way, it is clear that

foreign investors have a claim on future production and income generated

in the U.S. economy. Whether that situation is good or bad depends how

the foreign funds are used. If they are used mainly to finance current

consumption, they will prove detrimental to the long-term health of the

U.S. economy. On the other hand, their effect will be positive if they

are used primarily to fund investments that increase future levels of

U.S. output and income.

X CURRENT TRENDS AND ISSUES

In the early decades of the 21st century, many different social, economic

and technological changes in the United States and around the world will

affect the U.S. economy. The population of the United States will become

older and more racially and ethnically diverse. The world population is

expected to continue to grow at a rapid rate, while the U.S. population

will likely grow much more slowly. World trade will almost certainly

continue to expand rapidly if current trade policies and rates of

economic growth are maintained, which in turn will make competition in

the production of many goods and services increasingly global in scope.

Technological progress is likely to continue at least at current rates,

and perhaps faster. How will all of this affect U.S. consumers,

businesses, and government?

Over the next century, average standards of living in the United States

will almost certainly rise, so that on average, people living at the end

of the century are likely to be better off in material terms than people

are today. During the past century, the primary reasons for the increase

in living standards in the United States were technological progress,

business investments in capital goods, and people’s investments in

greater education and training (which were often subsidized by government

programs). There is no evident reason why these same factors will not

continue to be the most important reasons underlying changes in the

standard of living in the United States and other industrialized

economies. A comparatively small number of economists and scientists from

other fields argue that limited supplies of energy or of other natural

resources will eventually slow or stop economic growth. Most, however,

expect those limits to be offset by discoveries of new deposits or new

types of resources, by other technological breakthroughs, and by greater

substitution of other products for the increasingly scarce resources.

Although the U.S. economy will likely remain the world’s largest national

economy for many decades, it is far less certain that U.S. households

will continue to enjoy the highest average standard of living among

industrialized nations. A number of other nations have rapidly caught up

to U.S. levels of income and per capita output over the last five decades

of the 20th century. They did this partly by adopting technologies and

business practices that were first developed in the United States, or by

developing their own technological and managerial innovations. But in

large part, these nations have caught up with the United States because

of their higher rates of savings and investment, and in some cases,

because of their stronger systems for elementary and secondary education

and for training of workers.

Most U.S. workers and families will still be better off as the U.S.

economy grows, even if some other economies are growing faster and

becoming somewhat more prosperous, as measured per capita. Certainly

families in Britain today are far better off materially than they were

150 to 200 years ago, when Britain was the largest and wealthiest economy

in the world, despite the fact that many other nations have since

surpassed the British economy in size and affluence.

A more important problem for the U.S. economy in the next few decades is

the unequal distribution of gains from growth in the economy. In recent

decades, the wealth created by economic growth has not been as evenly

distributed as was the wealth created in earlier periods. Incomes for

highly educated and trained workers have risen faster than average, while

incomes for workers with low levels of education and training have not

increased and have even fallen for some groups of workers, after

adjusting for inflation. Other industrialized market economies have also

experienced rising disparity between high-income and low-income families,

but wages of low-income workers have not actually fallen in real terms in

those countries as they have in the United States.

In most industrialized nations, the demand for highly educated and

trained workers has risen sharply in recent decades. That happened in

part because many kinds of jobs now require higher skill levels, but

other factors were also important. New production methods require workers

to frequently and rapidly change what they do on the job. They also

increase the need for quality products and customer service and the

ability of employees to work in teams. Increased levels of competition,

including competition from foreign producers, have put a higher premium

on producing high quality products.

Several other factors help explain why the relative position of low-

income workers has fallen more in the United States than in other

industrialized Western nations. The growth of college graduates has

slowed in the United States but not in other nations. United States

immigration policies have not been as closely tied to job-market

requirements as immigration policies in many other nations have been.

Also, government assistance programs for low-income families are usually

not as generous in the United States as they are in other industrialized

nations.

Changes in the make-up of the U.S. population are likely to cause income

disparity to grow, at least through the first half of the 21st century.

The U.S. population is growing most rapidly among the groups that are

most likely to have low incomes and experience some form of

discrimination. Children in these groups are less likely to attend

college or to receive other educational opportunities that might help

them acquire higher-paying jobs.

The U.S. population will also be aging during this period. As people born

during the baby boom of 1946 to 1964 reach retirement age, the percentage

of the population that is retired will increase sharply, while the

percentage that is working will fall. The demand for medical care and

long-term care facilities will increase, and the number of people drawing

Social Security benefits will rise sharply. That will increase pressure

on government budgets. Eventually, taxes to pay for these services will

have to be increased, or the level of these services provided by the

government will have to be cut back. Neither of those approaches will be

politically popular.

A few economists have called for radical changes in the Social Security

system to deal with these problems. One suggestion has been to allow

workers to save and invest in private retirement accounts rather than pay

into Social Security. Thus far, those approaches have not been considered

politically feasible or equitable. Current retirees strongly oppose

changing the system, as do people who fear that they will lose future

benefits from a program they have paid taxes to support all their working

lives. Others worry that private accounts will not provide adequate

retirement income for low-income workers, or that the government will

still be called on to support those who make bad investment choices in

their private retirement accounts.

Political and economic events that occur in other parts of the world are

felt sooner and more strongly in the United States than ever before, as a

result of rising levels of international trade and the unique U.S.

position as an economic, military, and political superpower. The 1991

breakup of the Union of Soviet Socialist Republics (USSR)—perhaps the

most dramatic international event to unfold since World War II—has

presented new opportunities for economic trade and cooperation. But it

also has posed new challenges in dealing with the turbulent political and

economic situations that exist in many of the independent nations that

emerged from the breakup . Some fledgling democracies in Africa are

similarly volatile.

Many U.S. firms are eager to sell their products to consumers and firms

in these nations, and U.S. banks and other financial institutions are

eager to lend funds to support investments in these countries, if they

can be reasonably sure that these loans will be repaid. But there are

economic risks to doing business in these countries, including inflation,

low income levels, high crime rates, and frequent government and company

defaults on loans. Also, political upheavals sometimes bring to power

leaders who oppose market reforms.

The greater political and economic unification of nations in the European

Union (EU) offers different kinds of issues. There is much less risk of

inflation, crime, and political upheaval to contend with in this area. On

the other hand, there is more competition to face from well-established

and technologically sophisticated firms, and more concern that the EU

will put trade barriers on products produced in the United States and in

other countries that are not members of the Union. Clearly, the United

States will be concerned with maintaining its trading position with those

nations. It will also look to the EU to act as an ally in settling

international policies in political and economic arenas, such as a peace

initiative in the Middle East and treaties on international trade and

environmental issues.

The United States has other major economic and political interests in the

Middle East, Asia, and around the world. China is likely to become an

even larger trading partner and an increasingly important political power

in the world. Other Asian nations, including Japan, Korea, Indonesia, and

the Philippines, are also important trading partners, and in some cases

strong political and national security allies, too. The same can be said

for Australia and for Canada, which has long been the largest single

trading partner for the United States. Mexico and the other nations of

Central and South America are, similarly, natural trading partners for

the United States, and likely to play an even larger role over the next

century in both economic and political affairs.

It may once have been possible for the United States to practice an

isolationist policy by developing an economy largely cut off from foreign

trade and international relations, but that possibility is no longer

feasible, nor is it advisable. Economic and technological developments

have made the world’s nations increasingly interdependent.

Greater world trade and cooperation offer an enormous range of mutually

beneficial activities. Trading with other countries inevitably increases

opportunities for travel and cultural exchange, as well as business

opportunities. In a very broad sense, nations that buy and sell goods and

services with each other also have a greater stake in other forms of

peaceful cooperation, and in seeing other countries prosper and grow.

On the other hand, global interdependence also raises major

problems—political, economic, and environmental—that require

international solutions. Many of these problems, such as pollution,

global warming, and assistance for developing nations, have been

controversial even when solutions were discussed only at the national

level. Often, controversy increases with the number of nations that must

agree on a solution, but some problems require global remedies. Such

problems will challenge the productive capacity of the U.S. economy and

the wisdom of U.S. citizens and their political leaders.

No nation has ever had the rich supply of resources to face the future

that the U.S. economy has as it enters the 21st century. Despite that, or

perhaps because of it, U.S. consumers, businesses, and political leaders

are still trying to do more than earlier generations of citizens.

XI CHIEF GOODS AND SERVICES OF THE U.S. ECONOMY

The U.S. economy, the largest in the world, produces many different goods

and services. This can be seen more easily by dividing economic

activities into four sectors that produce different kinds of goods and

services. The first sector provides goods that come directly from natural

resources: agriculture, forestry, fishing, and mining. The second sector

includes manufacturing and the generation of electricity. The third

sector, made up of commerce and services, is now the largest part of the

U.S. economy. It encompasses financial services, retail and wholesale

sales, government services, transportation, entertainment, tourism, and

other businesses that provide a wide variety of services to individuals

and businesses. The fourth major economic sector deals with the

recording, processing, and transmission of information, and includes the

communications industry.

A Natural Resource Sector

The United States, more than most countries, enjoys a wide array of

natural resources. Agricultural output in the United States has

historically been among the highest in the world. Rich fishing grounds

and coastal habitats provide abundant seafood. Companies harvest the

nation’s large reserves of timber to use in wood products and housing.

Major mineral resources—including iron ore, lead, and copper, as well as

energy resources such as coal, crude oil, and natural gas—are abundant in

the United States.

A1 Agriculture

The United States contains some of the best cropland in the world.

Cultivated farmland constitutes 19 percent of the land area of the

country and makes the United States the world’s richest agricultural

nation. In part because of the nation’s favorable climate, soil, and

water conditions, farmers produce huge quantities of agricultural

commodities and a variety of crops and livestock.

The United States is the largest producer of corn, soybeans, and sorghum,

and it ranks second in the production of wheat, oats, citrus fruits, and

tobacco. The United States is also a major producer of sugar cane,

potatoes, peanuts, and beet sugar. It ranks fourth in the world in cattle

production and second in hogs. The total annual value of farm output

increased from $55 billion in 1970 to $202 billion in 1996. Farmers in

the United States not only produce enough food to feed the nation’s

population, they also export more farm products than any other nation.

Despite this vast output, the U.S. economy is so large and diversified

that agriculture accounted for only 2 percent of annual GDP and employed

only 3 percent of the workforce in 1998.

During the 20th century, many Americans moved from rural to urban areas

of the United States, resulting in large population decreases in farming

regions. Even though the number of farms has been declining since the

1930s, overall production has increased because of more efficient

operations. Bigger farms, operated as large businesses, have increasingly

replaced small family farms. The owners of larger farms make greater use

of modern machinery and other equipment. By the 1990s, farm operations

were highly mechanized. By applying mechanization, technology, efficient

business practices, and scientific advances in agricultural methods,

larger farms produce great quantities of agricultural output using small

amounts of labor and land.

In 1999 there were 2,194,070 farms in the United States, down from a high

of 6.8 million in 1935. As smaller farms have been consolidated into

larger units, the average farm size in the United States increased from

about 63 hectares (about 155 acres) to 175 hectares (432 acres) by 1999.

Cattle production is widespread throughout the United States. Texas leads

in the production of range cattle, which are allowed to graze freely.

Iowa and Illinois are important for nonrange feeder cattle, which are

cattle that eat feed grain provided by cattle farmers. The Dairy Belt

continues to be concentrated in southern Wisconsin but is also prominent

in the rural landscapes of most northeastern states and fairly common in

other states, too. Hog production tends to be concentrated in Iowa,

Illinois, and surrounding states, where hogs are fattened for market.

Chicken production is widespread, but southern states, including Texas,

Arkansas, and Alabama, dominate.

Corn and soybean production is concentrated heavily in Iowa and Illinois

and is also important in surrounding states, including Missouri, Indiana,

Nebraska, and the southern regions of Minnesota and Wisconsin. Wheat is

another important U.S. crop. Kansas usually leads all states in yearly

wheat production. North Dakota, Montana, Oklahoma, Washington, Idaho,

South Dakota, Colorado, Texas, Minnesota, and Nebraska also are major

wheat producers.

For more than a century and a half, cotton was the predominant cash crop

in the South. Today, however, it is no longer important in some of the

traditional cotton-growing areas east of the Mississippi River. While

some cotton is still produced in the Old South, it has become more

important in the Mississippi Valley, the Panhandle of Texas, and the

Central Valley of California. Cotton is shipped to mills in the eastern

United States and is exported to cotton textile plants in Japan, South

Korea, Indonesia, and Taiwan.

Vegetables are grown widely in the United States. Outside major U.S.

cities, small farms and gardens, known as truck farms, grow vegetables

and some varieties of fruits for urban markets. California is the leading

vegetable producing state; much of its cropland is irrigated.

Most fruits grown in the United States fall in the categories of

midlatitude and citrus fruits. Midlatitude fruits, such as apples, pears,

and plums, grow in northern states including Washington, Michigan,

Pennsylvania, and New York. Citrus fruits—lemons, oranges, and

grapefruits—thrive in Florida, southern Texas, and southern California.

Nuts grow on irrigated land in the Central Valley of California and in

parts of southern California.

Production of specialty crops and livestock has increased in recent

years, particularly along the East and West coasts and in the Southeast.

Ranches in New York and Texas have introduced exotic game, such as emu,

fallow deer, and nilgai and black buck antelope. Deer and antelope meat,

known as venison, is served mainly in restaurants. Specialty vegetable

and fruit operations produce dwarf apples, brown and green cotton,

canola, and jasmine rice. Farmers raise more than 60 specialty crops in

the United States for Asian-American markets, including bean sprouts,

snow peas, and Chinese cabbage.

A2 Forestry

In the 1990s, less than 1 percent of the country’s workforce was involved

in the lumber industry, and forestry accounted for less than 0.5 percent

of the nation’s gross domestic product (GDP). Nevertheless, forests

represent a crucial resource for U.S. industry. Forest resources are used

in producing housing, fuel, foodstuffs, and manufactured goods. The

United States leads the world in lumber production and is second in the

production of wood for pulp and paper manufacture. These high production

levels, however, do not satisfy all of the U.S. demand for forest

products. The United States is the world’s largest importer of lumber,

most of which comes from Canada.

When European settlers first arrived in North America, half of the land

on the continent was covered with forests. The forests of the eastern and

northern portions of the country were fairly continuous. Beginning with

the early colonists, the natural vegetation was altered drastically as

farmers cleared land for crops and pastures, and cut trees for firewood

and lumber. In the north and east, lumbermen quickly cut all of the

valuable trees before moving on to other locations. Only 10 percent of

the original virgin timber remains. Almost two thirds of the forests that

remain have been classified as commercial resources.

Forests still cover 23 percent of the United States. The trees in the

nation’s forests contain an estimated 7.1 billion cu m (249.3 billion cu

ft) of wood suitable for lumber. Private individuals and businesses,

including farmers, lumber companies, paper mills, and other wood-using

industries, own about 73 percent of the commercial forestland. Federal,

state, and local governments own the remaining 27 percent.

Softwoods (wood harvested from cone-bearing trees) make up about three-

fourths of forestry production and hardwoods (wood harvested from broad-

leafed trees) about one-fourth. Nearly half the timber output is used for

making lumber boards, and about one-third is converted to pulpwood, which

is subsequently used to manufacture paper. Most of the remaining output

goes into plywood and veneer. Douglas fir and southern yellow pine are

the primary softwoods used in making lumber, and oak is the most

important hardwood.

About half of the nation’s lumber and all of its fir plywood come from

the forests of the Pacific states, an area dominated by softwoods. In

addition to the Douglas fir forests in Washington and Oregon, this area

includes the famous California redwoods and the Sitka spruce along the

coast of Alaska. Forests in the mountain states of the West cover a

relatively small area, yet they account for more than 10 percent of the

nation’s lumber production. Ponderosa pine is the most important species

cut from the forests of this area.

Forests in the South supply about one-third of the lumber, nearly three-

fifths of the pulpwood, and almost all the turpentine, pitch, resin, and

wood tar produced in the United States. Longleaf, shortleaf, loblolly,

and slash pine are the most important commercial trees of the southern

coastal plain. Commercially valuable hardwood trees, such as gum, ash,

pecan, and oak, grow in the lowlands along the rivers of the South.

The Appalachian Highland and parts of the Great Lakes area have excellent

hardwood forests. Hickory, maple, oak, and other hardwoods removed from

these forests provide fine woods for the manufacture of furniture and

other products.

In the 1990s the forest products industry was undergoing a

transformation. New environmental requirements, designed to protect

wildlife habitat and water resources, were changing forest practices,

particularly in the West. The amount of timber cut on federal land

declined by 50 percent from 1989 to 1993.

A3 Fishing

The U.S. waters off the coast of North America provide a rich marine

harvest, which is about evenly split in commercial value between fish and

shellfish. Humans consume approximately 80 percent of the catch as food.

The remaining 20 percent goes into the manufacturing of products such as

fish oil, fertilizers, and animal food.

In 1997 the United States had a commercial fish catch of 5.4 million

metric tons. The value of the catch was an estimated $3.1 billion in

1998. In most years, the United States ranks fifth among the nations of

the world in weight of total catch, behind China, Peru, Chile, and Japan.

Marine species dominate U.S. commercial catches, with freshwater fish

representing only a small portion of the total catch. Shellfish account

for only one-sixth of the weight of the total catch but nearly one-half

of the value; finfish represent the remaining share of weight and value.

Alaskan pollock and menhaden, a species used in the manufacture of oil

and fertilizer, are the largest catches by tonnage. The most valuable

seafood harvests are crabs, salmon, and shrimp, each representing about

one-sixth of the total value. Other important species include lobsters,

clams, flounders, scallops, Pacific cod, and oysters.

Alaska leads all states in both volume and value of the catch; important

species caught off Alaska’s coast include pollock and salmon. Other

leading fishing states, ranked by value, are Louisiana, Massachusetts,

Texas, Maine, California, Florida, Washington, and Virginia. Important

species caught in the New England region include lobsters, scallops,

clams, oysters, and cod; in the Chesapeake Bay, crabs; and in the Gulf of

Mexico, menhaden and shrimp.

Much of the annual U.S. tonnage of commercial freshwater fish comes from

aquatic farms. The most important species raised on farms are catfish,

trout, salmon, oysters, and crawfish. The total annual output of private

catfish and trout farms in the mid-1990s was 235,800 metric tons, valued

at more than $380 million. In the 1970s catfish farming became important

in states along the lower Mississippi River. Mississippi leads all states

in the production of catfish on farms.

A4 Mining

As a country of continental proportions, the United States has within its

borders substantial mineral deposits. America leads the world in the

production of phosphate, an important ingredient in fertilizers, and

ranks second in gold, silver, copper, lead, natural gas, and coal.

Petroleum production is third in the world, after Russia and Saudi

Arabia.

Mining contributes 1.5 percent of annual GDP and employs 0.5 percent of

all U.S. workers. Although mining accounts for only a small share of the

nation’s economic output, it was historically essential to U.S.

industrial development and remains important today. Coal and iron ore are

the basis for the steel industry, which fabricates components for

manufactured items such as automobiles, appliances, machinery, and other

basic products. Petroleum is refined into gasoline, heating oil, and the

petrochemicals used to make plastics, paint, pharmaceuticals, and

synthetic fibers.

The nation’s three chief mineral products are fuels. In order of value,

they are natural gas, petroleum, and coal. In 1996 the United States

produced 23 percent of the world’s natural gas, 21 percent of its coal,

and 13 percent of its crude oil. From 1990 to 1995, as the inflation-

adjusted prices for these products declined, the extraction of these

fossil fuels declined, increasing U.S. dependence on foreign sources of

oil and natural gas.

The United States contains huge fields of natural gas and oil. These

fields are scattered across the country, with concentrations in the

midcontinent fields of Texas and Oklahoma, the Gulf Coast region of Texas

and Louisiana, and the North Slope of Alaska. Texas and Louisiana account

for almost 60 percent of the country’s natural gas production. Today, oil

and natural gas are pumped to the surface, then sent by pipeline to

refineries located in all parts of the nation. Offshore deposits account

for 13 percent of total production. Coal production, important for

industry and for the generation of electric power, comes primarily from

Wyoming (29 percent of U.S. production in 1997), West Virginia (18

percent), and Kentucky (16 percent).

Important metals mined in the United States include gold, copper, iron

ore, zinc, magnesium, lead, and silver. Iron ore is found mainly in

Minnesota, and to a lesser degree in northern Michigan. The ore consists

of low-grade taconite; U.S. deposits of high-grade ores, such as

hematite, magnetite, and limonite, have been consumed. Leading industrial

minerals include materials used in construction—mainly clays, lime, salt,

phosphate rock, boron, and potassium salts. The United States also

produces large percentages of the world’s output for a number of

important minerals. In 1997 the United States produced 42 percent of the

world’s molybdenum, 34 percent of its phosphate rock, 22 percent of its

elemental sulfur, 17 percent of its copper, and 16 percent of its lead.

Major deposits of many of these minerals are found in the western states.

B Manufacturing and Energy Sector B1 Manufacturing

The United States leads all nations in the value of its yearly

manufacturing output. Manufacturing employs about one-sixth of the

nation’s workers and accounts for 17 percent of annual GDP. In 1996 the

total value added by manufacturing was $1.8 trillion. Value added is the

price of finished goods minus the cost of the materials used to make

them. Although manufacturing remains a key component of the U.S. economy,

it has declined in relative importance since the late 1960s. From 1970 to

1995 the number of employees in manufacturing declined slightly from 20.7

million to 20.5 million, while the total U.S. labor force grew by more

than 46.2 million people.

One of the most important changes in the pattern of U.S. industry in

recent decades has been the growth of manufacturing in regions outside

the Northeast and North Central regions. The nation’s industrial core

first developed in the Northeast. This area still has the greatest number

of industrial firms, but its share of these firms is smaller than in the

past. In 1947 about 75 percent of the nation’s manufacturing employees

lived in the 21 Northeast and Midwest states that extend from New England

to Kansas. By the early 1990s, however, only about one-half of

manufacturing employees resided in the same region. Since 1947, the

South’s share of the nation’s manufacturing workers increased from 19 to

32 percent, and the West’s share grew from 7 to 18 percent.

In the North, manufacturing is centered in the Middle Atlantic and East

North Central states, which accounted for 38 percent of the value added

by all manufacturing in the United States in 1996. Located in this area

are five of the top seven manufacturing statesa—New York, Ohio, Illinois,

Pennsylvania, and Michigan—which together were responsible for

approximately 27 percent of the value added by manufacturing in all

states. Important products in this region include motor vehicles,

fabricated metal products, and industrial equipment. New York, New

Jersey, and Pennsylvania specialize in the production of machinery and

chemicals. This area bore the brunt of the decline in manufacturing’s

value of national output, losing a total of 800,000 jobs from the early

1980s to the early 1990s.

In the South the greatest gains in manufacturing have been in Texas. The

most phenomenal growth in the West has been in California, which in the

late 1990s was the leading manufacturing state, accounting for more than

one-tenth of the annual value added by U.S. manufacturing. California

dominates the Pacific region, which specializes in the production of

transportation equipment, food products, and electrical and electronic

equipment.

B1a International Manufacturing

United States industry has become much more international in recent

years. Most major industries are multinational, which means that they not

only market products in foreign countries but maintain production

facilities and administrative headquarters in other nations. In the late

1990s, giant U.S. corporations began a wave of international

partnerships, with U.S. companies sometimes merging with foreign

companies.

Beginning in the early 1980s, U.S. companies increasingly produced

component parts and even finished goods in foreign countries. The

practice of a company sending work to outside factories to reduce

production costs is called outsourcing. Foreign outsourcing sends

production to countries where labor costs are lower than in the United

States. One of the first methods of foreign outsourcing was the

maquiladora (Spanish for “mill”) in Mexican border towns. Manufacturers

built twin plants, one on the Mexican side and one on the United States

side. Companies in the United States sent partially manufactured products

into Mexico where labor-intensive plants finished the product and sent it

back to the United States for sale. Outsourcing to Mexico became more

widespread after the North American Free Trade Agreement went into effect

in 1994. Firms in the United States also outsource to many other nations,

including South Korea, Indonesia, Malaysia, Jamaica, and the Philippines.

In the 1990s, few products were made entirely within the United States.

Although a product may be fabricated in the United States, some component

parts may have been produced in foreign countries. Despite outsourcing

and the international operations of multinational firms, the United

States is still a major producer of thousands of industrial items and has

a comparative advantage over most foreign countries in several industrial

categories.

B1b Principal Products

Ranked by value added by manufacturing, in 1996 the leading categories of

U.S. manufactured goods were chemicals, industrial machinery, electronic

equipment, processed foods, and transportation equipment. The chemical

industry accounted for about 11.1 percent of the overall annual value

added by manufacturing. Texas and Louisiana are leaders in chemical

manufacturing. The petroleum and natural gas produced and refined in both

states are basic raw materials used in manufacturing many chemical

products.

Industrial machinery accounted for 10.7 percent of the yearly value added

by manufacture. Industrial machinery includes engines, farm equipment,

various kinds of construction machinery, computers, and refrigeration

equipment. California led all states in the annual value added by

industrial machinery, followed by Illinois, Ohio, and Michigan.

Factories in the United States build millions of computers, and the

United States occupies second place in the world in the production of

electronic components (semiconductors, microprocessors, and computer

equipment). Electronic equipment accounted for 10.5 percent of the yearly

value added by manufacturing, and it was one of the fastest growing

manufacturing sectors during the 1990s; production of electronics and

electric equipment increased by 77 percent from 1987 to 1994. High-

technology research and production facilities have developed in the

Silicon Valley of California, south of San Francisco; the area

surrounding Boston; the Research Triangle of Raleigh, Chapel Hill, and

Durham in North Carolina; and the area around Austin, Texas. In addition,

the United States has world leadership in the development and production

of computer software. Leading software producers are located in areas

around Seattle, Washington; Boston, Massachusetts; and San Francisco,

California.

Food processing accounted for about 10.2 percent of the overall annual

value added by manufacturing. Food processing is an important industry in

several states noted for the production of food crops and livestock, or

both. California has a large fruit- and vegetable-processing industry.

Meat-packing is important to agriculture in Illinois and dairy processing

is a large industry in Wisconsin.

Transportation equipment includes passenger cars, trucks, airplanes,

space vehicles, ships and boats, and railroad equipment. This category

accounted for 10.1 percent of the yearly value added by manufacturing.

Michigan, with its huge automobile industry, is a leading producer of

transportation equipment.

The manufacture of fabricated metal and primary metal is concentrated in

the nation’s industrial core region. Iron ore from the Lake Superior

district, plus that imported from Canada and other countries, and

Appalachian coal are the basis for a large iron and steel industry.

Pennsylvania, Ohio, Indiana, Illinois, and Michigan are leading states in

the value of primary metal output. The fabricated metal industry, which

includes the manufacture of cans and other containers, hardware, and

metal forgings and stampings, is important in the same states. The

primary metals industry of these states provides the basic raw materials,

especially steel, that are used in making metal products.

Printing and publishing is a widespread industry, with newspapers

published throughout the country. New York, with its book-publishing

industry, is the leading state, but California, Illinois, and

Pennsylvania also have sizable printing and publishing industries.

The manufacture of paper products is important in several states,

particularly those with large timber resources, especially softwood trees

used to make most paper. The manufacture of paper and paperboard

contributes significantly to the economies of Wisconsin, Alabama,

Georgia, Washington, New York, Maine, and Pennsylvania.

Other major U.S. manufactures include textiles, clothing, precision

instruments, lumber, furniture, tobacco products, leather goods, and

stone, clay, and glass items.

B2 Energy Production

The energy to power the nation's economy—to provide fuels for its

vehicles and furnaces and electricity for its machinery and appliances—is

derived primarily from petroleum, natural gas, and coal. Measured in

terms of heat-producing capacity (British thermal units, or Btu),

petroleum provides 39 percent of the total energy consumed in the United

States. It supplies nearly all of the energy used to power the nation’s

transportation system and heats millions of houses and factories.

Natural gas is the source of 24 percent of the energy consumed. Many

industrial plants use natural gas for heat and power, and several million

households burn it for heating and cooking. Coal provides 22 percent of

the energy consumed. Its major uses are in the generation of electricity,

which uses more than three-fourths of all the coal consumed, and in the

manufacture of steel.

Waterpower generates 4 to 5 percent of the nation’s energy, and nuclear

power supplies about 10 percent. Both are employed mainly to produce

electricity for residential and industrial use. Nuclear energy has been

viewed as an important alternative to expensive petroleum and natural

gas, but its development has proceeded somewhat more slowly than

originally anticipated. People are reluctant to live near nuclear plants

for fear of a radiation-releasing accident. Another obstacle to the

expansion of nuclear power use is that it is very expensive to dispose of

radioactive material used to power the plants. These nuclear fuel

materials remain radioactive for thousands of years and pose health risks

if they are not properly contained.

Some 33 percent of the energy consumed in the United States is used in

the generation of electricity. In 1999 the nation’s generating plants had

a total installed capacity of 728,259 megawatts and produced 3.62

trillion kilowatt-hours of electricity. Coal is the most common fuel used

by electric power plants, and 57 percent of the nation’s yearly

electricity is generated in coal-fired plants. The states producing the

most coal-generated electricity are Ohio, Texas, Indiana, Pennsylvania,

Illinois, West Virginia, Kentucky, and Georgia.

Natural gas accounts for 9 percent of the electricity produced, and

refined petroleum for 2 percent. The states producing the most

electricity from natural gas are Texas and California. Refined petroleum

is especially important in Florida, New York, and Massachusetts. The

leading producers of hydroelectricity are Washington, Oregon, New York,

and California. Illinois, Pennsylvania, South Carolina, and California

have the largest nuclear power industries.

Petroleum is a key resource for an American lifestyle based on extensive

use of private automobiles and trucks for commerce and businesses. Since

1947, when the United States became a net importer of oil, annual

domestic production has not been enough to meet the demands of the highly

mobile American society.

In 1970 domestic crude-oil production reached a record high of 3.5

billion barrels, but this had to be supplemented by imports amounting to

12 percent of the nation’s overall crude oil supply. Most Americans were

unaware of the dependence of the country on foreign petroleum until an

oil embargo imposed by some Middle Eastern nations in 1973 and 1974 led

to government price ceilings for gasoline and other energy products,

which in turn led to shortages. In 1973 the nation imported about one-

fourth of its total supply of crude oil. Imports continued to rise until

1977, when about half of the crude and refined oil supply was imported.

Imports then declined for a time, largely because energy-conservation

measures were introduced and because other domestic energy sources such

as coal were used increasingly. As of 1997, however, 47 percent of the

crude oil needs of the United States were met by net imports. Energy

Supply, World.

The United States consumes 25 percent of the world’s energy, far more

than any other country, despite having less than 5 percent of the world’s

population. The United States also produces a disproportionate share of

the world’s total output of goods and services, which is the main reason

the nation consumes so much energy. In addition, the U.S. population is

spread over a larger area than are the populations in many other

industrialized nations, such as Japan and the countries of Western

Europe. This lower population density in the United States results in a

greater consumption of energy for transportation, as truck, trains, and

planes are needed to move goods and people to the far-flung American

citizenry.

As a result of the nation’s high energy consumption, the United States

accounts for nearly 20 percent of the global emissions of greenhouse

gases. These gases—carbon dioxide, methane, and oxides of nitrogen—result

from the burning of fossil fuels, and they can have a harmful effect on

the environment. C Service and Commerce Sector

By far the largest sector of the economy in terms of output and

employment is the service and commerce sector. This sector grew rapidly

during the last part of the 20th century, creating many new jobs and more

than offsetting the slight loss of jobs in manufacturing industries. In

1998 commerce and service industries generated 72 percent of the GDP and

employed 75 percent of the U.S. workforce. Most of these jobs are

classified as white collar, and many require advanced education. They

include many high-paying jobs in financing, banking, education, and

health services, as well as lower-paying positions that require little

educational background, such as retail store clerks, janitors, and fast-

food restaurant workers.

C1 Service Industries The service sector is extremely diverse.

It includes an assortment of private businesses and government agencies

that provide a wide spectrum of services to the U.S. public. Services

industries can be very different from each other, ranging from health-

care providers to vacation resorts to automobile repair shops. Although

it would be almost impossible to list every kind of service industry

operating in the United States, many of these businesses fall into one of

several large service categories.

C1a Banking and Financial Services

In 1995 the U.S. financial market had a total of 628,500 institutions,

which employed 7.0 million people. These institutions included

investment, commercial, and savings banks; credit unions; mortgage banks;

insurance companies; mutual funds; real estate agencies; and various

holdings and trusts.

Banks play a central role in any economy since they act as intermediaries

in the flow of money. They collect deposits and distribute them as loans,

allowing depositors to save for future consumption and allowing borrowers

to invest. In 1998 the United States had 10,481 insured banks and savings

institutions with a total of 84,123 banking offices. Because of mergers

and closures, the number of banks steadily declined in the 1980s and

1990s while the number of bank offices increased. Combined assets of

insured banks and savings institutions totaled $5.44 trillion in 1998.

Banking in the 1990s was a highly competitive business, as banks offered

a variety of services to attract customers and sought to stem the flow of

investors to brokerage houses and insurance firms. Large banks in the

United States, in terms of assets, include Chase Manhattan Corporation,

Citibank, Morgan Guaranty Trust, and Bankers Trust, all headquartered in

New York City; Bank of America, headquartered in San Francisco; and

NationsBank, headquartered in Charlotte, North Carolina.

In 1998 the United States had 1,687 savings and loan associations (SLAs),

with combined assets of $1.1 trillion. SLAs are similar to banks, in that

they accept deposits from customers, but SLAs focus primarily on the

housing and building industries by making loans to home buyers. The

industry was substantially restructured in the late 1980s and early 1990s

after some prominent SLAs became insolvent largely because of falling

real estate prices in some parts of the country.

In addition, a host of other professions offer financial services to

individuals and corporations. Insurance companies provide insurance as

well as a variety of other services, including deposit accounts, pension

management, mutual funds, and other investments. Stockbrokers, investment

experts, pension managers, and personal financial consultants advise

consumers on investing money. In addition, corporate finance managers,

accountants, and tax consultants make recommendations on financial

planning to businesses and individuals.

C1b Travel and Tourism

One of the largest service industries in the United States is travel and

tourism. In 1997, individual U.S. citizens took 1.3 billion trips within

the United States to destinations that were at least 100 miles

(equivalent to 160 km) from home. In increasing numbers, domestic and

foreign travelers are visiting theme parks, natural wonders, and points

of interest in major cities, and the convention business is booming. New

York City is a popular destination, and tourism is a mainstay of the

economies of California, Florida, and Hawaii.

In recent decades, visitors from overseas have become an increasingly

important part of the U.S. tourism business. In 1970 about 2.3 million

overseas visitors came to the United States, spending $889 million. By

1997 the number of overseas visitors—chiefly from western Europe, Japan,

Latin America, and the Caribbean—was 48 million. Millions of visitors

from Canada and Mexico also cross the border every year. Estimated annual

expenditures in the United States by Canadian travelers totaled $6

billion, and spending by Mexicans was $5 billion.

America’s historic sites and national parks draw many visitors. In 1998,

287 million visits were made to the more than 350 areas administered by

the National Park Service. Millions of people each year visit the

national monuments, buildings, and museums in the Washington, D.C., area.

More than 14 million visits are made annually to Golden Gate National

Recreation Area in the San Francisco region. More than 19 million people

per year travel on the Blue Ridge Parkway in North Carolina and Virginia,

and about 6 million visit the Natchez Trace Parkway in Mississippi,

Alabama, and Tennessee. Located within a day’s drive from most parts of

the eastern United States, Great Smoky Mountains National Park is the

most popular national park in the United States, receiving nearly 10

million visitors annually.

C1c Transportation

Transportation-related businesses are an important part of the service

industry. Trucks, railroads, and ships transport goods to markets across

the country. Commercial airlines, railroads, bus companies, and taxis

move tourists and commuters to their destinations. The U.S. Postal

Service and a number of private carriers deliver goods as well as mail to

consumers. The U.S. transportation network spreads into all sections of

the country, but the web of railroads and highways is much denser in the

eastern half of the United States, where it serves the nation’s largest

urban, industrial, and population concentrations.

As of 1996 the 10 largest railroad companies in the United States

operated 72 percent of tracks. Takeovers and mergers among the major

private railroad companies were common during the 1980s and 1990s. Amtrak

(the National Railroad Passenger Corporation), a federally subsidized

organization, operates almost all the intercity passenger trains in the

United States. It carried 20.2 million passengers in 1997. Although rail

passenger travel has declined in importance during the 20th century, some

U.S. cities still maintain extensive subways or commuter railways,

including New York City, Washington, D.C., Chicago, and the San Francisco-

Oakland area of California.

During the early decades of the 20th century, motor vehicle transport

developed as a serious competitor of the railroads, both for passengers

and freight. Federal aid to states for highway construction began with

the passage of the Federal-Aid Road Act of 1916.

The federal aid program was greatly expanded in 1956 when the government

began an ambitious expansion of the Interstate Highway System, a 74,165-

km (46,084-mi) network of limited-access highways that connects the

nation’s principal cities. This carefully designed system enables

motorists to drive across the country without encountering an

intersection or traffic signal. It carries about 20 percent of U.S. motor-

vehicle traffic, though it accounts for just over 1 percent of U.S. roads

and streets. The system is designed for safe, efficient driving, with

gentle curves, easy grades and long sight distances. Entering and exiting

the highway system is permitted only at planned interchanges.

Air transport began to compete with other modes of transport in the

United States after World War I (1914-1918). The first commercial flights

in the United States were made in 1918 and carried small amounts of mail.

Passenger service began to gain importance in the late 1920s, but air

transport did not become a leading mode of travel until the advent of

commercial jet craft after World War II. By the 1990s a growing number of

Americans flew for personal and business travel, in part because of the

need to cover long distances and in part because they like to get to

their destinations quickly. In 1997 airlines in the United States carried

598.1 million passengers, the vast majority of whom were domestic

travelers.

By the end of the 20th century, large and small airports across the

nation formed a network providing air transportation to individual

travelers. The nation had 5,129 public and 13,263 private airports in

1996. The largest airports in the United States by passenger arrivals and

departures are William B. Hartsfield International Airport near Atlanta,

Georgia; Chicago-O’Hare International Airport in Illinois; Dallas-Fort

Worth Airport in Texas; and Los Angeles International Airport in

California.

The United States has a relatively small commercial shipping fleet. In

1998 only 473 vessels of 1,000 gross tons and larger were registered in

the United States. Only 56 percent were in use; most of the remainder

formed part of a government-owned military reserve fleet. However, many

American ship owners register their vessels in foreign countries such as

Liberia and Panama, where crew wages, taxes, and operating costs are

lower.

In terms of the number of ships docking, New Orleans, Louisiana, is the

busiest port in the nation; each year it handles more than 6,000 vessels.

Other leading ports include Los Angeles-Long Beach, California; Houston,

Texas; New York, New York; San Francisco-Oakland, California; Miami,

Florida; and Philadelphia, Pennsylvania. Crude petroleum accounts for 22

percent of the waterborne tonnage of the United States. Petroleum

products make up 18 percent. Coal accounts for 14 percent, and farm

products for 14 percent.

The inland waterway network of the United States has three main

components—the Mississippi River system, the Great Lakes, and the coastal

waterways. Some 66 percent of the annual water freight traffic is on the

Mississippi River and its tributaries, 17 percent is on the Great Lakes,

and most of the remainder is on the coastal waterways. A major

thoroughfare of the coastal waterways is the Intracoastal Waterway, a

navigable, toll-free shipping route extending for about 1,740 km (about

1,080 mi) along the Atlantic Coast and for about 1,770 km (about 1,100

mi) along the Gulf of Mexico coast. About 45 percent of the total annual

traffic on all coastal waterways travels on the Gulf Intracoastal

Waterway, about 30 percent is on the Atlantic Intracoastal Waterway, and

about 25 percent is on Pacific Coast waterways.

Most goods in the United States travel by railroad and truck, which

compete vigorously for freight transport. In 1996, 38 percent of all

United States freight moved by rail and about 27 percent traveled by

truck. However, other modes of transportation more easily handle special

freight items. An additional 20 percent of all freight, by volume, moved

through pipelines, mainly oil and natural gas pipelines originating in

Texas and Louisiana with destinations in the Midwest and Northeast.

Another 16 percent, mainly bulk commodities like coal, grain, and

industrial limestone, moved by barge on inland waters.

C1d Government

Federal, state, and local governments provide a sizeable portion of

services delivered in the nation. In 1996, government workers made up 4

percent of all workers and together produced 12 percent of GDP.

Government services include items as such Social Security benefits,

national defense, education, public welfare programs, law enforcement,

and the maintenance of transportation systems, libraries, hospitals, and

public parks.

The government sector in the U.S. economy has increased dramatically in

size during the 20th century. Federal revenues grew from less than 5

percent of total GDP in the early 1930s to more than 20 percent by the

late 1990s. Much of this growth took place during two time periods. In

the 1930s, following the economic downturn of the Great Depression, U.S.

president Franklin D. Roosevelt instituted sweeping social programs

designed to provide basic financial security to individuals and families.

Many of these programs, such as unemployment insurance and Social

Security payments to retirees, have remained in place since then. During

the 1960s, U.S. president Lyndon B. Johnson instituted a series of

programs designed to fight poverty, promote education, and provide basic

medical coverage for less-affluent Americans. In addition, during the

last half of the 20th century, government expenditures increased for

medical care and national defense as a result of technological advances.

The cost of transportation construction also rose as the growing

population demanded more and better highway systems.

C1e Entertainment

Another leading industry is the entertainment business. Motion picture

production has been centered in Hollywood, California, since the early

decades of the 20th century, when the budding motion picture industry

discovered that the warm climate and sunny skies of southern California

provided ideal conditions for film production. Other entertainment

industries include theater, which tends to be located in larger urban

areas, particularly New York City, and television, with major networks

operating out of the New York City area. .

C2 Commerce The 1990s have been years of unrivaled prosperity

in the United States, with per capita GDP reaching $30,450 by 1998. This

high quality of life results partly from a rapid expansion of commerce in

the years following World War II.

C2a Domestic Trade

Convenience is the key to consumer markets in the United States, whether

it is fast food, movie theaters, clothing, or any of hundreds of

different types of consumer goods. Products are being delivered to

citizens in a more efficient manner, as industries and business firms

have decentralized to more closely fit the distribution of population.

Malls have sprung up in suburban areas, making the downtown department

store obsolete in many smaller cities. Manufacturers also market their

goods directly to customers in factory outlet malls. Prices are often

lower in these outlets than in regular retail stores. Customers often

travel hundreds of miles to shop at larger factory outlet malls. At the

other end of the spectrum, mail order catalogs and Internet sites have

made it possible for many consumers to purchase products directly from

companies by mail or using personal computers.

Wholesalers and retailers carry on most domestic commerce, or trade, in

the United States. Wholesalers buy goods from producers and sell them

mainly to retail business firms. Retailers sell goods to the final

consumer. Wholesale and retail trade together account for 16 percent of

annual GDP of the United States and employ 21 percent of the labor force.

Wholesale establishments conducted aggregate annual sales of $3.2

trillion in 1992. The leading type of wholesale business is the

distribution of groceries and related products, which accounts for 16

percent of all wholesale activity. Next in rank are motor-vehicle parts

and supplies; petroleum and petroleum products; professional and

commercial equipment, and machinery, equipment, and supplies. Wholesalers

tend to be located in large urban centers that enable them to distribute

goods over wide sections of the nation. The New York City metropolitan

area is the country’s leading wholesale center. It serves as the national

distribution center for a variety of goods and as the main regional

center for the eastern United States. Other leading wholesale centers

include Los Angeles, the main center for the western part of the United

States; Chicago; San Francisco; Philadelphia; Houston; Dallas; and

Atlanta.

In the mid-1990s retail establishments in the United States had aggregate

annual sales of $2.2 trillion. Automotive dealers, with 23 percent of the

total yearly retail trade, and food stores, with 18 percent, are the

leading retailers. The volume of retail sales is directly related to the

number of consumers in an area. The four leading states in annual retail

sales—California, Texas, Florida, and New York—are also the four most

populous states.

C2b Foreign Trade

The United States is the world’s leading trading nation, with total

merchandise exports amounting to $683 billion, and imports to $944.6

billion. Despite its massive size, large population, and economic

prosperity, the United States economy can provide a higher quality of

life for consumers and more opportunity for businesses by trading with

other nations. Foreign, or international, trade enables the United States

to specialize in producing those goods that it is best suited to make

given its available resources. It then imports products that other

nations can make more efficiently, lowering prices of these goods for

U.S. consumers.

Nonagricultural products usually account for 90 percent of the yearly

value of exports, and agricultural products account for about 10 percent.

Machinery and transportation equipment make up the leading categories of

exports, amounting together to one-third of the value of all exports.

Other leading exports include electrical equipment, chemicals, precision

instruments, and food products. Beginning in the mid-1970s, the nation’s

imports of petroleum from the Middle East and manufactured goods from

Canada and Asia (especially Japan) created a trade imbalance.

D Information and Technology Sector

By the end of the 20th century, many technological innovations had been

introduced in the United States. Communications satellites orbited the

earth, computers performed day-to-day functions in many businesses, and

the Internet provided instant information on most aspects of U.S. life

via computer. Developments in communications and technology have

transformed many aspects of daily life in the United States, from

improvements in kitchen appliances to advances in medical treatment to

television broadcasts that are transmitted live via satellite from around

the world.

An increasing number of job opportunities are opening in fields related

to the research and application of new technology. Entirely new

industries have emerged, such as companies that build the equipment used

in space explorations. In addition, technology has opened new

opportunities for investment and employment in established industries,

such as those that manufacture medicines and machines used in the

detection and treatment of diseases and individuals who market and sell

products via the Internet.

D1 Communications

The communications systems in the United States are among the most

developed in the world. Television, radio, newspapers, and other

publications, provide most of the country’s news and entertainment. On

average there are two radios and one television set for every person in

the United States. Although the economic output of the communications

industry is relatively small, the industry has enormous importance to the

political, social, and intellectual activity of the nation. Most

communication media in the United States are privately owned and operate

independently of government control.

The Federal Communications Commission must license all radio and

television broadcasting stations in the United States. In 1997, 1,285

television broadcasters were in operation. All states had television

stations, and more than 40 percent of the stations were concentrated in

nine states: Texas, California, Florida, New York, Pennsylvania, Ohio,

Illinois, Michigan, and North Carolina. A rapidly growing number of U.S.

households (estimated at 64 million in 1997) subscribed to cable

television. An estimated 98.3 percent of U.S. households had at least one

television set. Telephone communication changed as cellular phones

allowed people to communicate via telephone while away from their homes

and businesses or while traveling. There were 69 million cellular phones

in use in 1998.

There were 1,489 daily newspapers published in the United States in 1998,

8 fewer than the year before. Daily newspapers had a circulation of

approximately 60.1 million copies in 1998. The top daily newspapers in

the United States according to circulation were the Wall Street Journal

(published in New York City), USA Today (published in Arlington,

Virginia), the New York Times, and the Los Angeles Times, each with a

circulation in excess of 1 million. Other leading newspapers included the

Washington Post, the New York Daily News, the Chicago Tribune, the

Detroit Free Press, the San Francisco Chronicle, the Chicago Sun-Times,

the Dallas Morning News, the Boston Globe, and the Philadelphia Inquirer.

Nearly 21,300 periodicals were published in 1997. These ranged from

specialized journals reaching only a small number of professionals to

major newsmagazines such as Time, with a circulation of 4.1 million a

week, and Newsweek, with a circulation of 3.2 million a week. Other mass

publications with vast audiences included the weekly TV Guide, reaching

13.2 million readers, and the monthly Reader’s Digest, with a circulation

of 15.1 million copies.

D2 Technology

One of the most far-reaching technological advances of the late 20th

century took place in the field of computer science. Computers developed

from large, cumbersome, and expensive machines to relatively small and

affordable devices. The development of the personal computer (PC) in the

1970s made it possible for many individuals to own computers and allowed

even small businesses to use computer technology in their operations. The

U.S. Bureau of the Census estimates that jobs in the computer industry

are growing at the fastest rate of any employment area, with job openings

for computer specialists expected to double from 1996 to 2006.

The Internet began in the 1960s as a small network of academic and

government computers primarily involved in research for the U.S.

military. Originally limited to researchers at a handful of universities

and government facilities, the Internet quickly became a worldwide

network providing users with information on a range of subjects and

allowing them to purchase goods directly from companies via computer. By

1999, 84 million U.S. citizens had access to the Internet at home or

work. More and more Americans were paying bills, shopping, ordering

airline tickets, and purchasing stocks via computer over the Internet.

This article was written by Michael Watts, with the exception of the

Chief Goods and Services of the U.S. Economy section, which he reviewed.