: U.S. Economy

: U.S. Economy

United States (Economy)


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 knowndespite 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 countrys 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.


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 rolesthey 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

cooperativesorganizations formed by producers or consumers who band together

to share resourcesas 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 thingsthings you can touchthat 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 peoples 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 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 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 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 nations 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 individuals

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 MacDonalds, Harland Sanders of

Kentucky Fried Chicken (KFC), and Dave Thomas of Wendys 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 productionnatural resources, labor, capital, and

entrepreneurshipare 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 systemeven one as large and wealthy as

the U.S. economyis 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


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

because even though it is not possible to satisfy everyones 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 nations 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 Internetthe worldwide computer-based

network of information systemsto 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


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


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 priceor in

other words, if the quantity demanded is greater than the quantity

suppliedthe 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


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


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


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 peoples 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 fallingas it has in

many small towns where farm populations are shrinkingdemand 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 decades 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.


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


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 firms

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 nations

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


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 governments

guarantee of $1.5 billion in loans to the Chrysler Corporation, the nations

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.


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 owners 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 owners

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 nations 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 businesss 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.


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


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

corporations 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 proxya 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

corporations 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

corporations 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


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 firms 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 companys 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 stocknot the corporation whose stock is tradedreceives 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


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 buyif 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 decisionsor fail to produce products that stand the test of

competitionis 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 firms 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. businessesabout $700 billion a

year in the late 1990sis 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 firms 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 firms

level of sales, employment, and stockholders equity. Various individuals

will use one of these different methods to evaluate a companys performance,

depending on what they want to know about how the firm operates. For example,

an efficiency expert might examine the firms 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 companys 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 companys profit as a percentage of sales in order to

compare its performance to the performances of competing firms in the same


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

variablesuch as exploring for oil and uranium, or making movies and high

fashion clothingis far riskier.

Return on Equity

What stockholders riskthe amount they stand to lose if a business incurs

losses and shuts downis 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 firms 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

elsewhereunless 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



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

nations central bankwhich 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


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. economyhouseholds, businesses, and

governmentonly 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 creditworthymeaning 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 banks 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 banks

prime ratethe lowest available rate for business loanswhen 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 banks 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 consumers 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


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.


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 weve 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 nations central bank, the Federal Reserve System. The

systems 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 nations 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


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 nations 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 nations 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

operationsthe 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 moneyspecifically,

it represents a loan to the government. This loan creates a higher balance in

the governments 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 Systems 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 rateswhich 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 Reserves 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 includes work done for employers and work done in a persons 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 scarcethat 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 firms

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 workers 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


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


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 womenmany with little

previous job experience and trainingentered 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 changesone affecting

womens roles in the labor market, the other in the makeup of the age of the

workforcecombined 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


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



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


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.


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 femalesfor

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


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 workers 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.


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 unionswhich represent all of the workers at a firm

or work site, regardless of their function or tradewere 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.


A persistent problem for the U.S. economy and some of its workers is

unemploymentnot 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


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


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.


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 peoples 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 governments revenues and expenditures. And as we have seen, the Federal

Reserve System controls the nations 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 economistsand most

Americanswidely 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 childrens 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


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


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 nations

existence, the government steps in and entirely funds and administers this


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 towns

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


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

products 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 lowbased 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


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


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 governments 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


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 fallsincome 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 governments 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 governments 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


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


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 worlds 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


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 countrys 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


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

countrieswhose workers are similarly well educated, trained, and highly

paidthe 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


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 productssuch as products that are vital to a nations national

defenseeconomists 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


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 peoples 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 countrys

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.


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 peoples 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


Although the U.S. economy will likely remain the worlds 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


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 IIhas 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


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 worlds 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

problemspolitical, economic, and environmentalthat 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.


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 nations large reserves of

timber to use in wood products and housing. Major mineral resourcesincluding

iron ore, lead, and copper, as well as energy resources such as coal, crude

oil, and natural gasare 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 worlds richest agricultural nation. In part because of the

nations 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 nations 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,


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


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 fruitslemons, oranges, and grapefruitsthrive 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 countrys workforce was involved in

the lumber industry, and forestry accounted for less than 0.5 percent of the

nations 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

worlds 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

nations 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 nations 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 nations lumber production.

Ponderosa pine is the most important species cut from the forests of this


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


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


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 Alaskas 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 nations

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 nations 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 worlds 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 countrys 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 constructionmainly clays, lime, salt, phosphate rock, boron, and

potassium salts. The United States also produces large percentages of the

worlds output for a number of important minerals. In 1997 the United States

produced 42 percent of the worlds 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


The United States leads all nations in the value of its yearly manufacturing

output. Manufacturing employs about one-sixth of the nations 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 nations 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 nations 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 Souths share of the nations manufacturing workers

increased from 19 to 32 percent, and the Wests share grew from 7 to 18


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 statesaNew York, Ohio, Illinois, Pennsylvania,

and Michiganwhich 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 manufacturings 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,


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


The manufacture of fabricated metal and primary metal is concentrated in the

nations 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 economyto provide fuels for its vehicles

and furnaces and electricity for its machinery and appliancesis 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 nations 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 nations 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 nations 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 nations 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 nations 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 worlds energy, far more than

any other country, despite having less than 5 percent of the worlds

population. The United States also produces a disproportionate share of the

worlds 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 nations high energy consumption, the United States

accounts for nearly 20 percent of the global emissions of greenhouse gases.

These gasescarbon dioxide, methane, and oxides of nitrogenresult 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


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


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 visitorschiefly from western Europe, Japan, Latin

America, and the Caribbeanwas 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.

Americas 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 days 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 nations 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 nations

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-

OHare 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

componentsthe 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


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 countrys 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

salesCalifornia, Texas, Florida, and New Yorkare also the four most

populous states.

C2b Foreign Trade

The United States is the worlds 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 nations 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 countrys 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 Readers 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.

(C) 2009