Ñòàòüÿ: 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
Those levels of production, consumption, and spending make the U.S. economy
by far the largest economy the world has ever known—despite the fact that
some other nations have far more people, land, or other resources. Through
most of the 20th century, U.S. citizens also enjoyed the highest material
standards of living in the world. Some nations have higher per capita (per
person) incomes than the United States. However, these comparisons are based
on international exchange rates, which set the value of a country’s currency
based on a narrow range of goods and services traded between nations. Most
economists agree that the United States has a higher per capita income based
on the total value of goods and services that households consume. American
prosperity has attracted worldwide attention and imitation. There are several
key reasons why the U.S. economy has been so successful and other reasons
why, in the 21st century, it is possible that some other industrialized
nations will surpass the U.S. standard of living. To understand those
historical and possible future events, it is important first to understand
what an economic system is and how that system affects the way people make
decisions about buying, selling, spending, saving, investing, working, and
taking time for leisure activities.
Capital, savings, and investment are taken up in the fourth section, which
explains how the long-term growth of any economy depends upon the
relationship between investments in capital goods (inventories and the
facilities and equipment used to make products) and the level of saving in
that economy. The next section explains the role money and financial markets
play in the economy. Labor markets, the topic of section six, are also
extremely important in the U.S. economy, because most people earn their
incomes by working for wages and salaries. By the same token, for most firms,
labor is the most costly input used in producing the things the firms sell.
The role of government in the U.S. economy is the subject of section seven.
The government performs a number of economic roles that private markets
cannot provide. It also offers some public services that elected officials
believe will be in the best interests of the public. The relationship between
the U.S. economy and the world economy is discussed in section eight. Section
nine looks at current trends and issues that the U.S economy faces at the
start of the 21st century. The final section provides an overview of the
kinds of goods and services produced in the United States.
U.S. ECONOMIC SYSTEM
An economic system refers to the laws and institutions in a nation that
determine who owns economic resources, how people buy and sell those
resources, and how the production process makes use of resources in providing
goods and services. The U.S. economy is made up of individual people,
business and labor organizations, and social institutions. People have many
different economic roles—they function as consumers, workers, savers, and
investors. In the United States, people also vote on public policies and for
the political leaders who set policies that have major economic effects. Some
of the most important organizations in the U.S. economy are businesses that
produce and distribute goods and services to consumers. Labor unions, which
represent some workers in collective bargaining with employers, are another
important kind of economic organization. So, too, are
cooperatives—organizations formed by producers or consumers who band together
to share resources—as well as a wide range of nonprofit organizations,
including many charities and educational organizations, that provide services
to families or groups with special problems or interests.
For the most part, the United States has a market economy in which individual
producers and consumers determine the kinds of goods and services produced
and the prices of those products. The most basic economic institution in
market economies is the system of markets in which goods and services are
bought and sold. That is where consumers buy most of the food, clothing, and
shelter they use, and any number of things that they simply want to have or
that they enjoy doing. Private businesses make and sell most of those goods
and services. These markets work by bringing together buyers and sellers who
establish market prices and output levels for thousands of different goods
A guiding principle of the U.S. economy, dating back to the colonial period,
has been that individuals own the goods and services they make for themselves
or purchase to consume. Individuals and private businesses also control the
factors of production. They own buildings and equipment, and are free to hire
workers, and acquire things that businesses use to produce goods and
services. Individuals also own the businesses that are established in the
United States. In other economic systems, some or all of the factors of
production are owned communally or by the government.
For the most part, U.S. producers decide which goods and services to make and
offer to sell, and what prices to charge for those products. Goods are
tangible things—things you can touch—that satisfy wants. Examples of goods
are cars, clothing, food, houses, and toys. Services are activities that
people do for themselves or for other people to satisfy their wants. Examples
of services are cutting hair, polishing shoes, teaching school, and providing
police or fire protection.
Producers decide which goods and services to make and sell, and how much to
ask for those products. At the same time, consumers decide what they will
purchase and how much money they are willing to pay for different goods and
services. The interaction between competing producers, who attempt to make
the highest possible profit, and consumers, who try to pay as little as
possible to acquire what they want, ultimately determines the price of goods
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, which come directly from the land, air, and sea, can
satisfy people’s wants directly (for example, beautiful mountain scenery or a
clear lake used for fishing and swimming), or they can be used to produce
goods and services that satisfy wants (such as a forest used to make lumber
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
Entrepreneurship is an ability some people have to accept risks and combine
factors of production in order to produce goods and services. Entrepreneurs
organize the various components necessary to operate a business. They raise
the necessary financial backing, acquire a physical site for the business,
assemble a team of workers, and manage the overall operation of the
enterprise. They accept the risk of losing the money they spend on the
business in the hope that eventually they will earn a profit. If the business
is successful, they receive all or some share of the profits. If the business
fails, they bear some or all of the losses.
Many people mistakenly believe that anyone who manages a large company is an
entrepreneur. However, many managers at large companies simply carry out
decisions made by higher-ranking executives. These managers are not
entrepreneurs because they do not have final control over the company and
they do not make decisions that involve risking the companies resources. On
the other hand, many of the nation’s entrepreneurs run small businesses,
including restaurants, convenience stores, and farms. These individuals are
true entrepreneurs, because entrepreneurship involves not merely the
organization and management of a business, but also an individual’s
willingness to accept risks in order to make a profit.
Throughout its history, the United States has had many notable entrepreneurs,
including 18th-century statesman, inventor, and publisher Benjamin Franklin,
and early-20th-century figures such as inventor Thomas Edison and automobile
producer Henry Ford. More recently, internationally recognized leaders have
emerged in a number of fields: Bill Gates of Microsoft Corporation and Steve
Jobs of Apple Computer in the computer industry; Sam Walton of Wal-Mart in
retail sales; Herb Kelleher and Rollin King of Southwest Airlines in the
commercial airline business; Ray Kroc of MacDonald’s, Harland Sanders of
Kentucky Fried Chicken (KFC), and Dave Thomas of Wendy’s in fast food; and in
motion pictures, Michael Eisner of the Walt Disney Company as well as a
number of entrepreneurs at smaller independent production studios that
developed during the 1980s and 1990s.
Acquiring the Factors of Production
All four factors of production—natural resources, labor, capital, and
entrepreneurship—are traded in markets where businesses buy these inputs or
productive resources from individuals. These are called factor markets.
Unlike a grocery market, which is a specific physical store where consumers
purchase goods, the markets mentioned above comprise a wide range of
locations, businesses, and individuals involved in the exchange of the goods
and services needed to run a business.
Businesses turn to the factor markets to acquire the means to make goods and
services, which they then try to sell to consumers in product or output
markets. For example, an agricultural firm that grows and sells wheat can buy
or rent land from landowners. The firm may shop for this natural resource by
consulting real estate agents and farmers throughout the Midwest. This same
firm may also hire many kinds of workers. It may find some of its newly hired
workers by recruiting recent graduates of high schools, colleges, or
technical schools. But its market for labor may also include older workers
who have decided to move to a new area, or to find a new job and employer
where they currently live.
Firms often buy new factories and machines from other firms that specialize
in making these kinds of capital goods. That kind of investment often
requires millions of dollars, which is usually financed by loans from banks
or other financial institutions.
Entrepreneurship is perhaps the most difficult resource for a firm to
acquire, but there are many examples of even the largest and most well-
established firms seeking out new presidents and chief executive officers to
lead their companies. Small firms that are just beginning to do business
often succeed or fail based on the entrepreneurial skills of the people
running the business, who in many cases have little or no previous experience
Markets and the Problem of Scarcity
A basic principle in every economic system—even one as large and wealthy as
the U.S. economy—is that few, if any, individuals ever satisfy all of their
wants for goods and services. That means that when people buy goods and
services in different markets, they will not be able to buy all of the things
they would like to have. In fact, if everyone did have all of the things they
wanted, there would be no reason for anyone to worry about economic problems.
But no nation has ever been able to provide all of the goods and services
that its citizens wanted, and that is true of the U.S. economy as much as any
Scarcity is also the reason why making good economic choices is so important,
because even though it is not possible to satisfy everyone’s wants, all
people are able to satisfy some of their wants. Similarly, every nation is
able to provide some of the things its citizens want. So the basic problem
facing any nation’s economy is how to make sure that the resources available
to the people in the nation are used to satisfy as many as possible of the
wants people care about most.
The U.S. economy, with its system of private ownership, has an extensive set
of markets for final products and for the factors of production. The economy
has been particularly successful in providing material goods and services to
most of its citizens. That is even more striking when results in the U.S.
economy are compared with those of other nations and economic systems.
Nevertheless, most U.S. consumers say they would like to be able to buy and
use more goods and services than they have today. And some U.S. citizens are
calling for significant changes in how the economic system works, or at least
in how the purchasing power and the goods and services in the system are
divided up among different individuals and families.
Not surprisingly, low-income families would like to receive more income, and
often favor higher taxes on upper-income households. But many upper-income
families complain that government already taxes them too much, and some argue
that government is taking over too many things in the economy that were, in
the past, left up to individuals, families, and private firms or charities.
These debates take place because of the problem of scarcity. For individuals
and governments, resources that satisfy a particular want cannot be used to
satisfy other wants. Therefore, deciding to satisfy one want means paying the
cost of not satisfying another. Such choices take place every time the
government decides how to spend its tax revenues.
What Are Markets?
Goods and services are traded in markets. Usually a market is a physical place
where buyers and sellers meet to make exchanges, once they have agreed on a
price for the product. One kind of marketplace is a grocery store, where people
go to buy food and household products. However, many markets are not
confined to specific locations. In a broader sense, markets include all the
places and sources where goods and services are exchanged. For example, the
labor market does not exist in a specific physical building, as does a grocery
market. Instead, the term labor market describes a multitude of
individuals offering their labor for sale as well as all the businesses
searching for employees.
Traders do not always have to meet in person to buy and sell. Markets can
operate via technology, such as a telephone line or a computer site. For
example, stocks and other financial securities have long been traded
electronically or by telephone. It is becoming increasingly common in the
United States for many other kinds of goods and services to be sold this way.
For instance, many people today use the Internet—the worldwide computer-based
network of information systems—to buy airline tickets, make hotel
reservations, and rent a car for their vacation. Other people buy and sell
items ranging from books, clothing, and airline tickets to baseball cards and
other rare collectibles over the Internet. Although these Internet buyers and
sellers may never meet face to face the way buyers and sellers do in more
traditional markets, these markets share certain basic features.
How a Single Market Works
Buyers hope to buy at low prices and will purchase more units of a product at
lower prices than they do at higher prices. Sellers are just the opposite.
They hope to sell at high prices, and typically they will be willing to
produce and sell more units of a product at higher prices than at lower
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 price—or in
other words, if the quantity demanded is greater than the quantity
supplied—the price for the computer increases. When producers try to sell
more of their computers at a price higher than consumers are willing to buy,
the quantity supplied exceeds the quantity demanded and the price falls.
The price stops rising or falling at the price where the amount consumers are
willing and able to buy is just equal to the amount sellers are willing and
able to produce and sell. This is called the market clearing price. Market
clearing prices for many goods and services change frequently, for reasons
that will be discussed below. But some market prices are stable for long
periods of time, such as the prices of candy bars and sodas sold in vending
machines, and the prices of pizzas and hamburgers. Most buyers of these
products have come to know the general price they will have to pay for these
items. Sellers know what prices they can charge, given what consumers will
pay and considering the competition they face from other sellers of
identical, or very similar, products.
A System of Markets for All Goods and Services
How markets determine price is simple enough to understand for a single good
or service in a single location. But consider what happens when there are
markets for nearly all of the goods and services produced and consumed in an
economy, across the entire country. In that context, this reasonably simple
process of setting market prices allows an economic system as large and
complex as the U.S. economy to operate with great efficiency and a high
degree of freedom for consumers and producers.
Efficiency here means producing what consumers want to buy, at prices that
are as low as they can be for producers to stay in business. And it turns out
this efficiency is directly linked to the freedom that buyers and sellers
have in a market economy. No central authority has to decide how many shirts
or cars or sandwiches to produce each day, or where to produce them, or what
price to charge for them. Instead, consumers spend their money for the
products that give them the most satisfaction, and they try to find the best
deal they can in terms of price, quality, convenience, assurances that
defective products will be replaced or repaired, or other considerations.
What consumers are willing and able to buy tells producers what they should
produce, if they hope to make a profit. Usually consumers have many options
to choose from, because more than one producer offers the same or reasonably
similar products (such as two or more kinds of cars, colas, and carpets).
Producers then compete energetically for the dollars that consumers spend.
Competition among producers determines the best ways to produce a good or
service. For example, in the early 1900s automobiles were made largely by
hand, one at a time. But once Henry Ford discovered how to lower the cost of
producing cars by using assembly lines, other car makers had to adopt the
same production methods or be driven out of business (as many were).
Competition also determines what features and quality standards go into
products. And competition holds down the costs of production because
producers know that consumers compare their prices to the prices charged by
other firms and for other products they might buy. In markets where a large
number of producers compete, inefficient producers will be driven out of the
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,
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 people’s closets, too.
If people expect the price of something to go up in the future, they start to
buy more of the product now, which increases demand. If they believe the
price is going to fall in the future, they wait to buy and hope they were
right. Sometimes these choices involve very serious decisions and large
amounts of money. For example, people who buy stocks on the stock market are
hoping that prices will rise, while at least some of the people selling those
stocks expect the prices to fall. But not all economic decisions are this
serious. For example, in the 1970s there was a brief episode when toilet
paper disappeared from the shelves of grocery stores, because people were
afraid that there were going to be shortages and rising prices. It turns out
that some of these unfounded fears were based on remarks made by a comedian
on a late-night talk show.
The final factor that affects the demand for most goods and services is the
number of consumers in the market for a product. In cities where population
is rising rapidly, the demand for houses, food, clothing, and entertainment
increases dramatically. In areas where population is falling—as it has in
many small towns where farm populations are shrinking—demand for these goods
and services falls.
Changes in Supply
The supply of most products is also affected by a number of factors. Most
important is the cost of producing products. If the price of natural
resources, labor, capital, or entrepreneurship rises, sellers will make less
profit and will not be as motivated to produce as many units as they were
before the cost of production increased. On the other hand, when production
costs fall, the amount producers are willing and able to sell increases.
Technological change also affects supply. A new invention or discovery can
allow producers to make something that could not be made before. It could
also mean that producers can make more of a product using the same or fewer
inputs. The most dramatic example of technological change in the U.S. economy
over the past few decades has been in the computer industry. In the 1990s,
small computers that people carry to and from work each day were more
powerful and many times less expensive than computers that filled entire
rooms just 20 to 30 years earlier.
Opportunities to make profits by producing different goods and services also
affect the supply of any individual product. Because many producers are
willing to move their resources to completely different markets, profits in
one part of the economy can affect the supply of almost any other product.
For example, if someone running a barbershop decided to sign a contract to
provide and operate the machines that clean runways at a large airport, this
would decrease the supply of haircutting services and increase the supply of
runway sweeping services.
When suppliers believe the price of the good or service they provide is going
to rise in the future, they often wait to sell their product, reducing the
current supply of the product. On the other hand, if they believe that the
price is going to fall in the future, they try to sell more today, increasing
the current supply. We see this behavior by large and small sellers. Examples
include individuals who are thinking about selling a house or car, corn and
wheat farmers deciding whether to sell or store their crops, and corporations
selling manufactured products or reserves of natural resources.
Finally, the number of sellers in a market can also affect the level of
supply. Generally, markets with a larger number of sellers are more
competitive and have a greater supply of the product to be sold than markets
with fewer sellers. But in some cases, the technology of producing a product
makes it more efficient to produce large quantities at just a few production
sites, or perhaps even at just one. For example, it would not make sense to
have two or more water and sewage companies running pipes to every house and
business in a city. And automobiles can be produced at a much lower cost in
large plants than in small ones, because large plants can take greater
advantage of assembly-line production methods.
All these different factors can lead to changes in what consumers demand and
what producers supply. As a result, on any given day prices for some things
will be rising and those for others will be falling. This creates
opportunities for some individuals and firms, and problems for others. For
example, firms producing goods for which the demand and the price are falling
may have to lay off workers or even go out of business. But for the economy
as a whole, allowing prices to rise and fall quickly in response to changes
in any of the market forces that affect supply and demand offers important
advantages. It provides an extremely flexible and decentralized system for
getting goods and services produced and delivered to households while
responding to a vast number of unpredictable changes.
Taking advantage of new opportunities while curtailing production of things that
are no longer in demand or no longer competitive was described as the process
of creative destruction by 20th century Austrian-American economist
Joseph Schumpeter. For example, Schumpeter discussed how the United States,
Britain, and other market economies helped many new businesses to grow by
building systems of canals (such as the Erie Canal) during the mid-19th
century. But then the canal systems were replaced or “destroyed” by the
railroads, which in turn saw their role diminished with the rise of national
systems of highways and airports. The same thing happened in the communications
industry in the United States. The Pony Express, which carried mail between
Missouri and California in the early 1860s, went out of business with the
completion of telegraph lines to California. In the 20th century, the telegraph
was replaced by the telephone. Time and time again, one decade’s innovation is
partially replaced or even destroyed by the next round of technological change.
In the modern world, prices change not only as a result of things that happen
in one country, but increasingly because of changes that happen in other
countries, too. International change affects production patterns, wages, and
jobs in the U.S. economy. Sometimes these changes are triggered by something
as simple as weather conditions someplace else in the world that affect the
production of grain, coffee, sugar, or other crops. Sometimes it reflects
political or financial upheavals in Europe, Asia, or other parts of the
world. There have been several examples of such events in the U.S. economy in
the 1990s. Higher coffee prices occurred after poor harvests of coffee beans
in South America, and U.S. banks lost large sums of money following financial
and political crises in places such as Indonesia and Russia.
The ability to respond quickly to an increasingly volatile economic and
political environment is, in many ways, one of the greatest strengths of the
U.S. economic system. But these changes can result in hardships for some
people or even some large segments of the economy. For example, importing
clothing produced in other nations has benefited U.S. consumers by keeping
clothing prices lower. In addition, it has been profitable for the firms that
import and sell this clothing. However, it has also reduced the number of
jobs available in clothing manufacturing for U.S. workers.
Many people think the most important general issue facing the U.S. economy
today is how to balance the benefits of quickly adapting to changing economic
conditions against the costs of abandoning the old ways. It is vital for the
economy to adapt quickly to changing conditions and to focus on producing
goods and services that will meet the most recent demands of the market
place. However, when businesses close because their products no longer meet
the demands of the market, it is important to make retraining or new jobs
available to workers who lost their means of making a living.
PRODUCTION OF GOODS AND SERVICES
Before goods and services can be distributed to households and consumed, they
must be produced by someone, or by some business or organization. In the
United States and other market economies, privately owned firms produce most
goods and services using a variety of techniques. One of the most important
is specialization, in which different firms make different kinds of products
and individual workers perform specific jobs within a company.
Successful firms earn profits for their owners, who accept the risk of losing
money if the products the firms try to sell are not purchased by consumers at
prices high enough to cover the costs of production. In the modern economy,
most firms and workers have found that to be competitive with other firms and
workers they must become very good at producing certain kinds of goods and
Most businesses in the United States also operate under one of three
different legal forms: corporations, partnerships, or sole proprietorships.
Each of these forms has certain advantages and disadvantages. Because of
that, these three types of business organizations often operate in different
kinds of markets. For example, most firms with large amounts of money
invested in factories and equipment are organized as corporations.
Specialization and the Division of Labor
In earlier centuries, especially in frontier areas, families in the United
States were much more self-sufficient, producing for themselves most of the
goods and services they consumed. But as the U.S. population and economy
grew, it became easier for people to buy more and more things in the
marketplace. Once that happened, people faced a choice they still face today:
In terms of time, money, and other things that they could do, is it less
expensive to make something themselves or to let someone else produce it and
buy it from them?
Over the years, most people and businesses realized that they could make
better use of their time and resources by concentrating on one particular
kind of work, rather than trying to produce for themselves all the items they
want to consume. Most people now work in jobs where they do one kind of work;
they are carpenters, bankers, cooks, mechanics, and so forth. Likewise, most
businesses produce only certain kinds of goods or services, such as cars,
tacos, or gardening services. This feature of production is known as
specialization. A high degree of specialization is a key part of the economic
system in the United States and all other industrialized economies. When
businesses specialize, they focus on providing a particular product or type
of product. For instance, some large companies produce only automobiles and
trucks, or even special parts of cars and trucks, such as tires.
At almost all businesses, when goods and services are produced, labor is
divided among workers, with different employees responsible for completing
different tasks. This is known as division of labor. For example, the
individual parts of cars and televisions are made by many different workers
and then put together in an assembly line. Other well-known examples of this
specialization and division of labor are seen in the production of computers
and electrical appliances. But even kitchens in large restaurants have
different chefs for different items, and professional workers such as doctors
and dentists have also become more specialized during the past century.
Advantages of Specialization
By specializing in what they produce, workers become more expert at a
particular part of the production process. As a result, they become more
efficient in these jobs, which lowers the costs of production. Specialization
also makes it possible to develop tools and machines that help workers do
highly specialized tasks. Carpenters use many tools that plumbers and
painters do not. Commercial bakeries have much larger ovens and mixers than
those used by people who only bake bread and pies once a year. And unlike a
household kitchen, a commercial bakery has machines to slice and package
bread. All of these tools and machines help workers and businesses produce
more efficiently, and lower the cost of producing goods and services.
The advantages of specialization have led to the creation of many very large
production facilities in the United States and other industrialized nations.
This trend is especially prevalent in the manufacturing sector. For example,
many automobile factories produce thousands of cars each day, and some
shipyards employ more than 10,000 workers. One open-pit mine in the western
United States has dug a crater so large that it can be seen from space.
When the market for a product is very large, and a company can sell enough goods
or services in that market to support a very large production facility, it will
often choose to produce on a large scale to take advantage of specialization
and division of labor. As long as producing more in larger facilities lowers
the average costs of production, the producer enjoys what are known as
economies of scale.
But bigger is not always better, and eventually almost all producers encounter
diseconomies of scale in which larger plants or production sites become less
efficient and more costly to operate. Usually that happens because monitoring
and managing increasingly larger production facilities becomes more difficult.
That is why most large manufacturers have more than one factory to make their
products, instead of one massive facility where they make everything they
produce. In recent years, many steel companies have found it more efficient to
build and operate smaller steel mills than they once operated.
Specialization and International Trade
Over the past few decades, international trade has led to greater
specialization and competition among producers in the United States and
throughout the world. By selling worldwide, companies in the United States
and in other countries can reach many more customers. Specialization is
ultimately limited by the size of the market for a good or service. In other
words, larger markets always allow for greater levels of specialization. For
example, in small towns with few customers to serve, there is often only one
clothing store that carries a small selection of many different kinds of
clothing. In large cities with a million or more potential customers, there
are much larger clothing stores with many more choices of items and styles,
and even some stores that sell only hats, gloves, or some other particular
kind of clothing.
International trade is a dramatic way of expanding the size of a firm’s
market. In markets where transportation costs are low compared with the
selling price of a product, it has become possible for producers to compete
globally to take full advantage of highly specialized production. But
international trade also means that businesses must compete more efficiently
against firms from all around the world. That competition also makes them try
to take advantage of greater specialization and the division of labor.
In many cases, products are produced and sold by firms from two or more
countries that have large production and employment levels in the same
industry. Often, however, these firms still specialize in the kinds of
products they produce. For example, though many small cars and small pickup
trucks are made in Japan and sent to the United States, large pickups and
four-wheel drive sport utility vehicles are often exported from the United
States to Japan and other nations. Similarly, the United States exports large
commercial passenger jets to most countries, but imports many small jets from
Canada, Brazil, and other nations. While this may seem strange at first
glance, it allows greater specialization in production for particular kinds
Transportation costs can also help to explain the pattern of international
production and trade. It often makes sense to produce goods close to the
markets where they will be sold, or close to where the resources used in the
production process are found or made. In recent years, the availability of a
skilled and hard-working labor force has become more important to producers
in many different industries, so new factories are often located in areas
with large numbers of well-trained workers and good schools that provide a
future supply of well-educated workers.
Production Patterns: Past, Present, and Future
Several dramatic changes in production patterns occurred in the United States
during the 20th century. First, most employment shifted from farming in rural
areas to industrial jobs in cities and suburbs. Then, during the second half
of the century, production and employment patterns changed again as a result
of technological advances, increased levels of world trade, and a rapid
increase in the demand for services.
Technological changes in the transportation, communications, and computer
industries created entirely new kinds of jobs and businesses, and altered the
kinds of skills workers were expected to have in many others. World trade led
to increased specialization and competition, as businesses adapted to meet
the demands of international competition.
Perhaps the greatest change in the U.S. economy came with the nation’s
growing prosperity in the years following World War II (1939-1945). This
prosperity resulted in a population with more money to spend on services and
leisure activities. More people began dining out at restaurants, taking
vacations to far-off locations, and going to movies and other forms of
entertainment. As family incomes increased, a wealthier population became
more willing to pay others for services.
As a result of these developments, the closing decades of the 20th century
saw a dramatic increase in service industries in the United States. In 1940
about 33 percent of U.S. employees worked in manufacturing, and about 49
percent worked in service-producing industries. By the late 1990s, only 26
percent worked in goods-producing industries, and 74 percent worked in
service-producing industries. This change was driven by powerful market
forces, including technological change and increased levels of world trade,
competition, and income.
Some observers worried that this growth of employment in service-producing
industries would result in declining living standards for most U.S. workers,
but in fact most of this growth has occurred in industries where job skill
requirements and wages have risen or at least remained high. That is less
surprising when you consider that this employment includes business and
repair services, entertainment and recreation occupations, and professional
and related services (including health care, education, and legal services).
United States consumers and families are, on average, financially better off
today than they were 50 or 100 years ago, and they have more leisure time,
which is one of the reasons why the demand for services has increased so
During the 20th century, businesses and their workers had to adjust to many
changes in the kinds of goods and services people demanded. These changes
naturally led to changes in where jobs were available, and in what kinds of
education, training, and skills employees were expected to have. As the base
of employment in the United States has changed from predominantly agriculture
to manufacturing to services, individuals, firms, and communities have faced
often-difficult adjustments. Many workers lost jobs in traditional
occupations and had to seek employment in jobs that required completely
different sets of skills. Standards of living declined in some communities
whose economies centered on farming or around large factories that shut down.
In recent decades, populations have decreased in some states where
agriculture provides a significant number of jobs. While high-technology
industries in places such as California's Silicon Valley were booming and
attracting larger populations, some textile and clothing factories in
Southern and Midwest states were closing their doors.
Public Policies to “Protect” Firms and Workers
Historically in the United States, the government has rarely stepped in to
protect individual businesses from changing levels of demand or competition.
There have been some notable exceptions, including the federal government’s
guarantee of $1.5 billion in loans to the Chrysler Corporation, the nation’s
third-largest automobile manufacturer, when it faced bankruptcy in 1980.
Although direct financial assistance to corporations has been rare, the
government has provided subsidies or partial protection from international
competition to a large number of industries. Economic analysis of these
programs rarely finds such subsidies and protection to be a good idea for the
nation as a whole, though naturally the companies and workers who receive the
support are better off. But usually these programs result in higher prices
for consumers, higher taxes, and they hurt other U.S. businesses and workers.
For example, in the 1980s the U.S. government negotiated limits on Japanese
car imports, and the price of new Japanese cars sold in the United States
increased by an average of $2,000. The price of new U.S. cars also rose on
average by about $1,000. Although the import limits did save some jobs in the
U.S. automobile industry, the total cost of saving the jobs was several times
higher than what workers earned from these jobs. When fewer dollars are sent
to Japan to buy new automobiles, the Japanese companies and consumers also
have fewer dollars to spend on U.S. exports to Japan, such as grain, music
cassettes and CDs, and commercial passenger jets. So the protection from
Japanese car imports hurt firms and workers in U.S. export industries. Still
other U.S. firms and workers were hurt because some U.S. consumers spent more
for cars and had less to spend on other goods and services.
It is simply not possible to subsidize and protect everyone in the U.S.
economy from changes in consumer demands and technology, or from
international trade and competition. And while most people agree that the
government should subsidize the production of certain types of goods required
for national defense, such as electronic navigation and surveillance systems,
economists warn against the futility of trying to protect large numbers of
firms and workers from change and competition. Typically such support cannot
be sustained over the long run, when the cost of protection and subsidies
begins to mount up, except in cases where producers and workers represent a
strong special interest group with enough political clout to maintain their
special protection or subsidies.
When the special protection or support is removed, the adjustments that
producers and workers often have to make then can be much more severe than
they would have been when the government programs were first adopted. That
has happened when price support programs for milk and other agricultural
products were phased out, and when policies that subsidized U.S. oil
production and limited imports of oil were dropped in the 1970s, during the
worldwide oil shortage.
For these reasons, if public assistance is provided to a particular industry,
economists are likely to favor only temporary payments to cover some of the
costs of relocation and retraining of workers. That policy limits the cost of
such assistance and leaves workers and firms free to move their resources
into whatever opportunities they believe will work best for them.
Most producers in the United States and other market economies must face
competition every day. If they are successful, they stand to earn large
returns. But they also risk the possibility of failure and large losses. The
lure of profits and the risk of losses are both part of what makes production
in a market economy efficient and responsive to consumer demands.
CORPORATIONS AND OTHER TYPES OF BUSINESSES
Three major types of firms carry out the production of goods and services in
the U.S. economy: sole proprietorships, partnerships, and corporations. In
1995 the U.S. economy included 16.4 million proprietorships, excluding farms;
1.6 million partnerships; and about 4.3 million corporations. The
corporations, however, produce far more goods and services than the
proprietorships and partnerships combined.
Proprietorships and Partnerships
Sole proprietorships are typically owned and operated by one person or
family. The owner is personally responsible for all debts incurred by the
business, but the owner gets to keep any profits the firm earns, after paying
taxes. The owner’s liability or responsibility for paying debts incurred by
the business is considered unlimited. That is, any individual or organization
that is owed money by the business can claim all of the business owner’s
assets (such as personal savings and belongings), except those protected
under bankruptcy laws.
Normally when the person who owns or operates a proprietorship retires or
dies, the business is either sold to someone else, or simply closes down
after any creditors are paid. Many small retail businesses are operated as
sole proprietorships, often by people who also work part-time or even full-
time in other jobs. Some farms are operated as sole proprietorships, though
today corporations own many of the nation’s farms.
Partnerships are like sole proprietorships except that there are two or more
owners who have agreed to divide, in some proportion, the risks taken and the
profits earned by the firm. Legally, the partners still face unlimited
liability and may have their personal property and savings claimed to pay off
the business’s debts. There are fewer partnerships than corporations or sole
proprietorships in the United States, but historically partnerships were
widely used by certain professionals, such as lawyers, architects, doctors,
and dentists. During the 1980s and 1990s, however, the number of partnerships
in the U.S. economy has grown far more slowly than the number of sole
proprietorships and corporations. Even many of the professions that once
operated predominantly as partnerships have found it important to take
advantage of the special features of corporations.
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.
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
corporation’s board of directors, which represents stockholders’ interests.
However, in practice, the board of directors is often made up of people who
were nominated by the top managers of the company. Members of the board of
directors are elected by a majority of voting stockholders, but most
stockholders vote for the nominees recommended by the current board members.
Stockholders can also vote by proxy—a process in which they authorize someone
else, usually the current board, to decide how to vote for them.
There are, however, two strong forces that encourage the managers of a
corporation to act in stockholders’ interests. One is competition. Direct
competition from other firms that sell in the same markets forces a
corporation’s managers to make sound business decisions if they want the
business to remain competitive and profitable. The second is the threat that
if the corporation does not use its resources efficiently, it will be taken
over by a more efficient company that wants control of those resources. If a
corporation becomes financially unsound or is taken over by a competing
company, the top managers of the firm face the prospect of being replaced. As
a result, corporate managers will often act in the best interests of a
corporation’s stockholders in order to preserve their own jobs and incomes.
In practice, the most common way for a takeover to occur is for one company to
purchase the stock of another company, or for the two companies to merge by
legal agreement under some new management structure. Stock purchases are more
common in what are called hostile takeovers, where the company that is
being taken over is fighting to remain independent. Mergers are more common in
friendly takeovers, where two companies mutually agree that it makes sense
for the companies to combine. In 1996 there were over $556.3 billion worth of
mergers and acquisitions in the U.S. economy. Examples of mergers include the
purchase of Lotus Development Corporation, a computer software company, by
computer manufacturer International Business Machines Corporation (IBM) and the
acquisition of Miramax Films by entertainment and media giant Walt Disney
Takeovers by other firms became commonplace in the closing decades of the
20th century, and some research indicates that these takeovers made firms
operate more efficiently and profitably. Those outcomes have been good news
for shareholders and for consumers. In the long run, takeovers can help
protect a firm’s workers, too, because their jobs will be more secure if the
firm is operating efficiently. But initially takeovers often result in job
losses, which force many workers to relocate, retrain, or in some cases
retire sooner than they had planned. Such workforce reductions happen because
if a firm was not operating efficiently, it was probably either operating in
markets where it could not compete effectively, or it was using too many
workers and other inputs to produce the goods and services it was selling.
Sometimes corporate mergers can result in job losses because management
combines and streamlines departments within the newly merged companies.
Although this streamlining leads to greater efficiency, it often results in
fewer jobs. In many cases, some workers are likely to be laid off and face a
period of unemployment until they can find work with another firm.
How Corporations Raise Funds for Investment
By investing in new issues of a company’s stock, shareholders provide the
funds for a company to begin new or expanded operations. However, most stock
sales do not involve new issues of stock. Instead, when someone who owns
stock decides to sell some or all of their shares, that stock is typically
traded on one of the national stock exchanges, which are specialized markets
for buying and selling stocks. In those transactions, the person who sells
the stock—not the corporation whose stock is traded—receives the funds from
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 buy—if consumers want these products more than
other things they can buy. Entrepreneurs often make decisions on which
businesses to pursue based on consumer demands. Making decisions to move
resources into more profitable markets, and accepting the risk of losses if
they make bad decisions—or fail to produce products that stand the test of
competition—is the key role of entrepreneurs in the U.S. economy.
Profits are the financial incentives that lead business owners to risk their
resources making goods and services for consumers to buy. But there are no
guarantees that consumers will pay prices high enough to cover a firm’s costs
of production, so there is an inherent risk that a firm will lose money and
not make profits. Even during good years for most businesses, about 70,000
businesses fail in the United States. In years when business conditions are
poor, the number approaches 100,000 failures a year. And even among the
largest 500 U.S. industrial corporations, a few of these firms lose money in
any given year.
Entrepreneurs invest money in firms with the expectation of making a profit.
Therefore, if the profits a company earns are not high enough, entrepreneurs
will not continue to invest in that firm. Instead, they will invest in other
companies that they hope will be more profitable. Or if they want to reduce
their risk, they can put their money into savings accounts where banks
guarantee a minimum return. They can also invest in other kinds of financial
securities (such as government or corporate bonds) that are riskier than
savings accounts, but less risky than investments in most businesses.
Generally, the riskier the investment, the higher the return investors will
require to invest their money.
The dollar value of profits earned by U.S. businesses—about $700 billion a
year in the late 1990s—is a great deal of money. However, it is important to
see how profits compare with the money that business owners have risked in
the business. Profits are also often compared to the level of sales for
individual firms, or for all firms in the U.S. economy.
Accountants calculate profits by starting with the revenue a firm received from
selling goods or services. The accountants then subtract the firm’s expenses
for all of the material, labor, and other inputs used to produce the product.
The resulting number is the dollar level of profits. To evaluate whether that
figure is high or low, it must be compared to some measure of the size of the
firm. Obviously, $1 million would be an incredibly large amount of profits for
a very small firm, and not much profit at all for one of the largest
corporations in the country, such as telecommunications giant AT&T Corp. or
automobile manufacturer General Motors (GM).
To take into consideration the size of the firm, profits are calculated as a
percentage of several different aspects of the business, including the firm’s
level of sales, employment, and stockholders’ equity. Various individuals
will use one of these different methods to evaluate a company’s performance,
depending on what they want to know about how the firm operates. For example,
an efficiency expert might examine the firm’s profits as a percentage of
employment to determine how much profit is generated by the average worker in
that firm. On the other hand, potential investors and a company’s chief
executive would be more interested in profit as a percentage of stockholder
equity, which allows them to gauge what kind of return to expect on their
investments. A sales executive in the same firm might be more interested in
learning about the company’s profit as a percentage of sales in order to
compare its performance to the performances of competing firms in the same
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
Although it is true that on average, U.S. manufacturing firms only make about
a 5-percent return on sales, that figure has little to do with the risks
these businesses take. To see why, consider a specific example.
Most grocery stores earn a return on sales of only 1 to 2 percent, while some
other kinds of firms typically earn more than the 5-percent average profit on
sales. But selling more or less does not really increase what the owners of a
grocery store (or most other businesses) are risking. Each time a grocery
store sells $100 worth of canned spinach, it keeps about one or two dollars
as profit, and uses the rest of the money to put more cans of spinach on the
shelves for consumers to buy. At the end of the year, the grocery store may
have sold thousands of dollars worth of canned spinach, but it never really
risked those thousands of dollars. At any given time, it only risked what it
spent for the cans that were at the store. When some cans were sold, the
store bought new cans to put on the shelves, and it turned over its inventory
of canned spinach many times during the year.
But the total value of these sales at the end of the year says little or
nothing about the actual level of risk that the grocery store owners accepted
at any point during the year. And in fact, the grocery industry is a
relatively low-risk business, because people buy food in good times and bad.
Providing goods or services where production or consumer demand is more
variable—such as exploring for oil and uranium, or making movies and high
fashion clothing—is far riskier.
Return on Equity
What stockholders risk—the amount they stand to lose if a business incurs
losses and shuts down—is the money they have invested in the business, their
equity. These are the funds stockholders provide for the firm whenever it
offers a new issue of stock, or when the firm keeps some of the profits it
earns to use in the business as retained earnings, rather than paying those
profits out to stockholders as dividends.
Profits as a return on stockholders’ equity for U.S. corporations usually
average from 12 to 16 percent, for larger and smaller corporations alike.
That is more than people can earn on savings accounts, or on long-term
government and corporate bonds. That is not surprising, however, because
stockholders usually accept more risk by investing in companies than people
do when they put money in savings accounts or buy bonds. The higher average
yield for corporate profits is required to make up for the fact that there
are likely to be some years when returns are lower, or perhaps even some when
a company loses money.
At least part of any firm’s profits are required for it to continue to do
business. Business owners could put their funds into savings accounts and
earn a guaranteed level of return, or put them in government bonds that carry
hardly any risk of default. If a business does not earn a rate of return in a
particular market at least as high as a savings account or government bonds,
its owners will decide to get out of that market and use the resources
elsewhere—unless they expect higher levels of profits in the future.
Over time, high profits in some businesses or industries are a signal to
other producers to put more resources into those markets. Low profits, or
losses, are a signal to move resources out of a market into something that
provides a better return for the level of risk involved. That is a key part
of how markets work and respond to changing demand and supply conditions.
Markets worked exactly that way in the U.S. economy when people left the
blacksmith business to start making automobiles at the beginning of the 20th
century. They worked the same way at the end of the century, when many
companies stopped making typewriters and started making computers and
CAPITAL, SAVINGS, AND INVESTMENT
In the United States and in other market economies, financial firms and
markets channel savings into capital investments. Financial markets, and the
economy as a whole, work much better when the value of the dollar is stable,
experiencing neither rapid inflation nor deflation. In the United States, the
Federal Reserve System functions as the central banking institution. It has
the primary responsibility to keep the right amount of money circulating in
Investments are one of the most important ways that economies are able to
grow over time. Investments allow businesses to purchase factories, machines,
and other capital goods, which in turn increase the production of goods and
services and thus the standard of living of those who live in the economy.
That is especially true when capital goods incorporate recently developed
technologies that allow new goods and services to be produced, or existing
goods and services to be produced more efficiently with fewer resources.
Investing in capital goods has a cost, however. For investment to take place,
some resources that could have been used to produce goods and services for
consumption today must be used, instead, to make the capital goods. People
must save and reduce their current consumption to allow this investment to
take place. In the U.S. economy, these are usually not the same people or
organizations that use those funds to buy capital goods. Banks and other
financial institutions in the economy play a key role by providing incentives
for some people to save, and then lend those funds to firms and other people
who are investing in capital goods.
Interest rates are the price someone pays to borrow money. Savings
institutions pay interest to people who deposit funds with the institution,
and borrowers pay interest on their loans. Like any other price in a market
economy, supply and demand determine the interest rate. The demand for money
depends on how much money people and organizations want to have to meet their
everyday expenses, how much they want to save to protect themselves against
times when their income may fall or their expenses may rise, and how much
they want to borrow to invest. The supply of money is largely controlled by a
nation’s central bank—which in the United States is the Federal Reserve
System. The Federal Reserve increases or decreases the money supply to try to
keep the right amount of money in the economy. Too much money leads to
inflation. Too little results in high interest rates that make it more
expensive to invest and may lead to a slowdown in the national economy, with
rising levels of unemployment.
Providing Funds for Investments in Capital
To take advantage of specialization and economies of scale, firms must build
large production facilities that can cost hundreds of millions of dollars.
The firms that build these plants raise some funds with new issues of stock,
as described above. But firms also borrow huge sums of money every year to
undertake these capital investments. When they do that, they compete with
government agencies that are borrowing money to finance construction projects
and other public spending programs, and with households that are borrowing
money to finance the purchase of housing, automobiles, and other goods and
Savings play an important role in the lending process. For any of this
borrowing to take place, banks and other lenders must have funds to lend out.
They obtain these funds from people or organizations that are willing to
deposit money in accounts at the bank, including savings accounts. If
everyone spent all of the income they earned each year, there would be no
funds available for banks to lend out.
Among the three major sectors of the U.S. economy—households, businesses, and
government—only households are net savers. In other words, households save
more money than they borrow. Conversely, businesses and government are net
borrowers. A few businesses may save more than they invest in business
ventures. However, overall, businesses in the United States, like businesses
in virtually all countries, invest far more than they save. Many companies
borrow funds to finance their investments. And while some local and state
governments occasionally run budget surpluses, overall the government sector
is also a large net borrower in the U.S. economy. The government borrows
money by issuing various forms of bonds. Like corporate bonds, government
bonds are contractual obligations to repay what is borrowed, plus some
specified rate of interest, at a specified time.
Matching Borrowers and Lenders in Financial Markets
Households save money for several reasons: to provide a cushion against bad
times, as when wage earners or others in the household become sick, injured,
or disabled; to pay for large expenditures such as houses, cars, and
vacations; to set aside money for retirement; or to invest. Banks and other
financial institutions compete for households’ savings deposits by paying
interest to the savers. Then banks lend those funds out to borrowers at a
higher rate of interest than they pay to savers. The difference between the
interest rates charged to borrowers and paid to savers is the main way that
banks earn profits.
Of course banks must also be careful to lend the money to people and firms that
are creditworthy—meaning they will be able to repay the loans. The
creditworthiness of the borrower is one reason why some kinds of loans have
higher rates of interest than others do. Short-term loans made to people or
businesses with a long history of stable income and employment, and who have
assets that can be pledged as collateral that will become the bank’s property
if a loan is not repaid, will receive the lowest interest rates. For example,
well-established firms such as AT&T often pay what is called the bank’s
prime rate—the lowest available rate for business loans—when they borrow
money. New, start-up companies pay higher rates because there is a greater risk
they will default on the loan or even go out of business.
Other kinds of loans also have greater risks of default, so banks and other
lenders charge different rates of interest. Mortgage loans are backed by the
collateral of the property the loan was used to purchase. If someone does not
pay his or her mortgage, the bank has the right to sell the property that was
pledged as collateral and to collect the proceeds as payment for what it is
owed. That means the bank’s risks are lower, so interest rates on these loans
are typically lower, too. The money that is loaned to people who do not pay
off the balances on their credit cards every month represents a greater risk
to banks, because no collateral is provided. Because the bank does not hold
any title to the consumer’s property for these loans, it charges a higher
interest rate than it charges on mortgages. The higher rate allows the bank
to collect enough money overall so that it can cover its losses when some of
these riskier loans are not repaid.
If a bank makes too many loans that are not repaid, it will go out of
business. The effects of bank failures on depositors and the overall economy
can be very severe, especially if many banks fail at the same time and the
deposits are not insured. In the United States, the most famous example of
this kind of financial disaster occurred during the Great Depression of the
1930s, when a large number of banks failed. Many other businesses also closed
and many people lost both their jobs and savings.
Bank failures are fairly rare events in the U.S. economy. Banks do not want
to lose money or go out of business, and they try to avoid making loans to
individuals and businesses who will be unable to repay them. In addition, a
number of safeguards protect U.S. financial institutions and their customers
against failures. The Federal Deposit Insurance Corporation (FDIC) insures
most bank and savings and loan deposits up to $100,000. Government examiners
conduct regular inspections of banks and other financial institutions to try
to ensure that these firms are operating safely and responsibly.
U.S. Household Savings Rate
A broader issue for the U.S. economy at the end of the 20th century is the
low household savings rate in this country, compared to that of many other
industrialized nations. People who live in the United States save less of
their annual income than people who live in many other industrialized market
economies, including Japan, Germany, and Italy.
There is considerable debate about why the U.S. savings rate is low, and
several factors are often discussed. U.S. citizens may simply choose to enjoy
more of their income in the form of current consumption than people in
nations where living standards have historically been lower. But other
considerations may also be important. There are significant differences among
nations in how savings, dividends, investment income, housing expenditures,
and retirement programs are taxed and financed. These differences may lead to
different decisions about saving.
For example, many other nations do not tax interest on savings accounts as
much as they do other forms of income, and some countries do not tax at least
part of the income people earn on savings accounts at all. In the United
States, such favorable tax treatment does not apply to regular savings
accounts. The government does offer more limited advantages on special
retirement accounts, but such accounts have many restrictions on how much
people can deposit or withdraw before retirement without facing tax
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
In the early history of the United States, many U.S. capital projects were
financed by people in Britain, France, and other nations that were then the
wealthiest countries in the world. These loans helped the fledgling U.S.
economy to grow and were paid off without lowering the U.S. standard of
living. It is not clear that current U.S. borrowing from foreign nations will
turn out as well and will be used to invest in capital projects, now that the
United States, with the largest and wealthiest economy in the world, faces a
low national savings rate.
MONEY AND FINANCIAL MARKETS
A Money and the Value of Money
Money is anything generally accepted as final payment for goods and services.
Throughout history many things have been used around the world as money,
including gold, silver, tobacco, cattle, and rare feathers or animal skins.
In the U.S. economy today, there are three basic forms of money: currency
(dollar bills), coins, and checks drawn on deposits at banks and other
financial firms that offer checking services. Most of the time, when
households, businesses, and government agencies pay their bills they use
checks, but for smaller purchases they also use currency or coins.
People can change the type of the money they hold by withdrawing funds from
their checking account to receive currency or coins, or by depositing
currency and coins in their checking accounts. But the money that people have
in their checking accounts is really just the balance in that account, and
most of those balances are never converted to currency or coins. Most people
deposit their paychecks and then write checks to pay most of their bills.
They only convert a small part of their pay to currency and coins. Strange as
it seems, therefore, most money in the U.S. economy is just the dollar amount
written on checks or showing in checking account balances. Sometimes,
economists also count money in savings accounts in broader measures of the
U.S. money supply, because it is easy and inexpensive to move money from
savings accounts to checking accounts.
Most people are surprised to learn that when banks make loans, the loans
create new money in the economy. As we’ve seen, banks earn profits by lending
out some of the money that people have deposited. A bank can make loans
safely because on most days, the amount some customers are depositing in the
bank is about the same amount that other customers are withdrawing. A bank
with many customers holding a lot of deposits can lend out a lot of money and
earn interest on those loans. But of course when that happens, the bank does
not subtract the amount it has loaned out from the accounts of the people who
deposited funds in savings and checking accounts. Instead, these depositors
still have the money in their accounts, but now the people and firms to whom
the bank has loaned money also have that money in their accounts to spend.
That means the total amount of money in the economy has increased. This
process is called fractional reserve banking, because after making loans the
bank retains only a fraction of its deposits as reserves. The bank really
could not pay all of its depositors without calling in the loans it has made.
It also means that money is created when banks make loans but destroyed when
loans are paid off.
At one time the dollar, like most other national currencies, was backed by a
specified quantity of gold or silver held by the federal government. At that
time, people could redeem their dollars for gold or silver. But in practice
paper currency is much easier to carry around than large amounts of gold or
silver. Therefore, most people have preferred to hold paper money or checking
balances, as long as paper currency and checks are accepted as payment for
goods and services and maintain their value in terms of the amount of goods
and services they can buy.
Eventually governments around the world also found it expensive to hold and
guard large quantities of gold or silver. As foreign trade grew, governments
found it especially difficult to transfer gold and silver to other countries
that decided to redeem paper money acquired through international trade.
They, too, changed to using paper currencies and writing checks against
deposits in accounts. In 1971 the United States suspended the international
payment of gold for U.S. currency. This action effectively ended the gold
standard, the name for this official link between the dollar and the price of
gold. Since then, there has been no official link between the dollar and a
set price for gold, or to the amount of gold or other precious metals held by
the U.S. government.
The real value of the dollar today depends only on the amount of goods and
services a dollar can purchase. That purchasing power depends primarily on
the relationship between the number of dollars people are holding as currency
and in their checking and savings accounts, and the quantity of goods and
services that are produced in the economy each year. If the number of dollars
increases much more rapidly than the quantity of goods and services produced
each year, or if people start spending the dollars they hold more rapidly,
the result is likely to be inflation. Inflation is an increase in the average
price of all goods and services. In other words, it is a decrease in the
value of what each dollar can buy.
The Federal Reserve System and Monetary Policy
Governments often attempt to reduce inflation by controlling the supply of
money. Consequently, organizations that control how much money is issued in
an economy play a major role in how the economy performs, in terms of prices,
output and employment levels, and economic growth. In the United States, that
organization is the nation’s central bank, the Federal Reserve System. The
system’s name comes from the fact that the Federal Reserve has the legal
authority to make banks hold some of their deposits as reserves, which means
the banks cannot lend out those deposits. These reserve funds are held in the
Federal Reserve Bank. The Federal Reserve also acts as the banker for the
federal government, but the government does not own the Federal Reserve. It
is actually owned by the nation’s banks, which by law must join the Federal
Reserve System and observe its regulations.
There are 12 regional Federal Reserve banks. These banks are not commercial
banks. They do not accept savings deposits from or provide loans to
individuals or businesses. Instead, the Federal Reserve functions as a
central bank for other banks and for the federal government. In that role the
Federal Reserve System performs several important functions in the national
economy. First, the branches of the Federal Reserve distribute paper currency
in their regions. Dollar bills are actually Federal Reserve notes. You can
look at a dollar bill of any denomination and see the number for the regional
Federal Reserve Bank where the bill was originally issued. But of course the
dollar is a national currency, so a bill issued by any regional Federal
Reserve Bank is good anyplace in the country. The distribution of currency
occurs as commercial banks convert some of their reserve balances at the
Federal Reserve System into currency, and then provide that currency to bank
depositors who decide to hold some of their money balances as currency rather
than deposits in checking accounts. The U.S. Treasury prints new currency for
the Federal Reserve System. The bills are introduced into circulation when
commercial banks use their reserves to buy currency from the Federal Reserve
Second, the regional Federal Reserve banks transfer funds for checks that are
deposited by a bank in one part of the country, but were written by someone
who has a checking account with a bank in another part of the country.
Millions of checks are processed this way every business day. Third, the
regional Federal Reserve Banks collect and analyze data on the economic
performance of their regions, and provide that information and their analysis
of it to the national Federal Reserve System. Each of the 12 regions served
by the Federal Reserve banks has its own economic characteristics. Some of
these regional economies are concerned more with agricultural issues than
others; some with different types of manufacturing and industries; some with
international trade; and some with financial markets and firms. After
reviewing the reports from all different parts of the country, the national
Federal Reserve System then adopts policies that have major effects on the
entire U.S. economy.
By far the most important function of the Federal Reserve System is
controlling the nation’s money supply and the overall availability of credit
in the economy. If the Federal Reserve System wants to put more money in the
economy, it does not ask the Treasury to print more dollar bills. Remember,
much more money is held in checking and savings accounts than as currency,
and it is through those deposit accounts that the Federal Reserve System most
directly controls the money supply. The Federal Reserve affects deposit
accounts in one of three ways.
First, it can allow banks to hold a smaller percentage of their deposits as
reserves at the Federal Reserve System. A lower reserve requirement allows
banks to make more loans and earn more money from the interest paid on those
loans. Banks making more loans increase the money supply. Conversely, a
higher reserve requirement reduces the amount of loans banks can make, which
reduces or tightens the money supply.
The second way the Federal Reserve System can put more money into the economy
is by lowering the rate it charges banks when they borrow money from the
Federal Reserve System. This particular interest rate is known as the
discount rate. When the discount rate goes down, it is more likely that banks
will borrow money from the Federal Reserve System, to cover their reserve
requirements and support more loans to borrowers. Once again, those loans
will increase the nation’s money supply. Therefore, a decrease in the
discount rate can increase the money supply, while an increase in the
discount rate can decrease the money supply.
In practice, however, banks rarely borrow money from the Federal Reserve, so
changes in the discount rate are more important as a signal of whether the
Federal Reserve wants to increase or decrease the money supply. For example,
raising the discount rate may alert banks that the Federal Reserve might take
other actions, such as increasing the reserve requirement. That signal can
lead banks to reduce the amount of loans they are making.
The third way the Federal Reserve System can adjust the supply of money and
the availability of credit in the economy is through its open market
operations—the buying or selling of government bonds. Open market operations
are actually the tool that the Federal Reserve uses most often to change the
money supply. These open-market operations take place in the market for
government securities. The U.S. government borrows money by issuing bonds
that are regularly auctioned on the bond market in New York. The Federal
Reserve System is one of the largest purchasers of those bonds, and the bank
changes the amount of money in the economy when it buys or sells bonds.
Government bonds are not money, because they are not generally accepted as
final payment for goods and services. (Just try paying for a hamburger with a
government savings bond.) But when the Federal Reserve System pays for a
federal government bond with a check, that check is new money—specifically,
it represents a loan to the government. This loan creates a higher balance in
the government’s own checking account after the funds have been transferred
from the privately owned Federal Reserve Bank to the government. That new
money is put into the economy as soon as the government spends the funds. On
the other hand, if the Federal Reserve sells government bonds, it collects
money that is taken out of circulation, since the bonds that the Federal
Reserve sells to banks, firms, or households cannot be used as money until
they are redeemed at a later date.
The Wall Street Journal and other financial media regularly report on
purchases of bonds made by the Federal Reserve and other buyers at auctions of
U.S. government bonds. The Federal Reserve System itself also publishes a
record of its buying and selling in the bond market. In practice, since the
U.S. economy is growing and the money supply must grow with it to keep prices
stable, the Federal Reserve is almost always buying bonds, not selling them.
What changes over time is how fast the Federal Reserve wants the money supply
to grow, and how many dollars worth of bonds it purchases from month to month.
To summarize the Federal Reserve System’s tools of monetary policy: It can
increase the supply of money and the availability of credit by lowering the
percentage of deposits that banks must hold as reserves at the Federal
Reserve System, by lowering the discount rate, or by purchasing government
bonds through open market operations. The Federal Reserve System can decrease
the supply of money and the availability of credit by raising reserve ratios,
raising the discount rate, or by selling government bonds.
The Federal Reserve System increases the money supply when it wants to
encourage more spending in the economy, and especially when it is concerned
about high levels of unemployment. Increasing the money supply usually
decreases interest rates—which are the price of money paid by those who
borrow funds to those who save and lend them. Lower interest rates encourage
more investment spending by businesses, and more spending by households for
houses, automobiles, and other “big ticket” items that are often financed by
borrowing money. That additional spending increases national levels of
production, employment, and income. However, the Federal Reserve Bank must be
very careful when increasing the money supply. If it does so when the economy
is already operating close to full employment, the additional spending will
increase only prices, not output and employment.
Effect of Monetary Policies on the U.S. Economy
The monetary policies adopted by the Federal Reserve System can have dramatic
effects on the national economy and, in particular, on financial markets.
Most directly, of course, when the Federal Reserve System increases the money
supply and expands the availability of credit, then the interest rate, which
determines the amount of money that borrowers pay for loans, is likely to
decrease. Lower interest rates, in turn, will encourage businesses to borrow
more money to invest in capital goods, and will stimulate households to
borrow more money to purchase housing, automobiles, and other goods.
But the Federal Reserve System can go too far in expanding the money supply.
If the supply of money and credit grows much faster than the production of
goods and services in the economy, then prices will increase, and the rate of
inflation will rise. Inflation is a serious problem for those who live on
fixed incomes, since the income of those individuals remains constant while
the amount of goods and services they can purchase with their income
decreases. Inflation may also hurt banks and other financial institutions
that lend money, as well as savers. In a period of unanticipated inflation,
as the value of money decreases in terms of what it will purchase, loans are
repaid with dollars that are worth less. The funds that people have saved are
worth less, too.
When banks and savers anticipate higher inflation, they will try to protect
themselves by demanding higher interest rates on loans and savings accounts.
This will be especially true on long-term loans and savings deposits, if the
higher inflation is considered likely to continue for many years. But higher
interest rates create problems for borrowers and those who want to invest in
If the supply of money and credit grows too slowly, however, then interest
rates are again likely to rise, leading to decreased spending for capital
investments and consumer durable goods (products designed for long-term use,
such as television sets, refrigerators, and personal computers). Such
decreased spending will hurt many businesses and may lead to a recession, an
economic slowdown in which the national output of goods and services falls.
When that happens, wages and salaries paid to individual workers will fall or
grow more slowly, and some workers will be laid off, facing possibly long
periods of unemployment.
For all of these reasons, bankers and other financial experts watch the
Federal Reserve’s actions with monetary policy very closely. There are
regular reports in the media about policy changes made by the Federal Reserve
System, and even about statements made by Federal Reserve officials that may
indicate that the Federal Reserve is going to change the supply of money and
interest rates. The chairman of the Federal Reserve System is widely
considered to be one of the most influential people in the world because what
the Federal Reserve does so dramatically affects the U.S. and world
economies, especially financial markets.
LABOR AND LABOR MARKETS
Labor includes work done for employers and work done in a person’s own
household, but labor markets deal only with work that is done for some form
of financial compensation. Labor markets include all the means by which
workers find jobs and by which employers locate workers to staff their
businesses. A number of factors influence labor and labor markets in the
United States, including immigration, discrimination, labor unions,
unemployment, and income inequality between the rich and poor.
The official definition of the U.S. labor force includes people who are at
least 16 years old and either working, waiting to be recalled from a layoff,
or actively looking for work within the past 30 days. In 1998 the U.S. labor
force included nearly 138 million people, most of them working in full-time
or part-time jobs.
Most people in the United States receive their income as wages and salaries
paid by firms that have hired individuals to work as their employees. Those
wages and salaries are the prices they receive for the labor services they
provide to their employers. Like other prices, wages and salaries are
determined primarily by market forces.
Labor Supply and Demand
The wages and salaries that U.S. workers earn vary from occupation to
occupation, across geographic regions, and according to workers’ levels of
education, training, experience, and skill. As with goods and services
purchased by consumers, labor is traded in markets that reflect both supply
and demand. In general, higher wages and salaries are paid in occupations
where labor is more scarce—that is, in jobs where the demand for workers is
relatively high and the supply of workers with the qualifications and ability
to do that work is relatively low. The demand for workers in particular
occupations depends largely on how much the work they do adds to a firm’s
revenues. In other words, workers who create more products or higher-priced
products will be worth more to employers than workers who make fewer or less
valuable products. The supply of workers in any occupation is affected by the
amount of time and effort required to enter that occupation compared to other
things workers might do.
Workers seeking higher wages often learn skills that will increase the
likelihood of finding a higher-paying job. The knowledge, skills, and
experience a worker has acquired are the worker’s human capital. Education
and training can clearly increase workers’ human capital and productivity,
which makes them more valuable to employers. In general, more educated
individuals make more money at their jobs. However, a greater level of
education does not always guarantee higher wages. Certain professions that
demand a high level of education, such as teaching elementary and secondary
school, are not high-paying. Such situations arise when the number of people
with the training to do that job is relatively large compared with the number
of people that employers want to hire. Of course this situation can change
over time if, for example, fewer young people choose to train for the
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 women—many with little
previous job experience and training—entered the labor markets for the first
time during the 1970s. As a result, wages for entry-level jobs were pushed down
and did not rise as rapidly as they had in the past. This decline in
entry-level wages was further fueled by huge numbers of teens who were also
entering the labor market for the first time. These young people were the
children of the baby boom of 1946 to 1964, a period in which the birth
rate increased dramatically in the United States. So, two changes—one affecting
women’s roles in the labor market, the other in the makeup of the age of the
workforce—combined to affect the labor market.
The baby boomers’ effects have continued to reverberate through the U.S.
economy. For example, starting salaries for people with college degrees
became depressed when large numbers of baby boomers started graduating from
college. And as workers born during the boom have aged, the work force in the
United States has grown progressively older, with the percentage of workers
under the age of 25 falling from 20.3 percent in 1980 to 14.3 percent in
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
Women and many minorities have long faced discrimination in U.S. labor
markets. Employed women earn less, on average, than men with similar levels
of education. In part this wage disparity reflects different educational
choices that women and men have made. In the past, women have been less
likely to study engineering, sciences, and other technical fields that
generally pay more. In part, the wage differences result from women leaving
the job market for a period of years to raise children. Another reason for
the disparity in wages between men and women is that there is still a
considerable degree of occupational segregation between males and females—for
example, nurses are much more likely to be females and dentists males. But
even after allowing for those factors, studies have generally found that, on
average, women earn roughly 10 percent less than men even in comparable jobs,
with equal levels of education, training, and experience.
Analysis of wage discrimination against black Americans leads to similar
conclusions. Specifically, after controlling for differences in age,
education, hours worked, experience, occupation, and region of the country,
wages for black men are roughly 10 percent lower than for white men, though
occupational segregation appears to be less common by race than by gender.
Issues other than wage discrimination are also important to note for black
workers. In particular, unemployment rates for black workers are about twice
as high as they are for white workers. Partly because of that, a much lower
percentage of the U.S. black population is employed than the white
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
Discrimination in competitive labor markets is economically inefficient as
well as unfair. When workers are not paid based on the value of what they add
to employers’ production and profit levels, society loses opportunities to
use labor resources in their most valuable ways. As a result, fewer goods and
services are produced. If employers discriminate against certain groups of
workers, they will pay for that behavior in competitive markets by earning
lower profits. Similarly, if workers refuse to work with (or for) coworkers
of a different gender, race, or ethnic background, they will have to accept
lower wages in competitive markets because their discrimination makes it more
costly for employers to run their businesses. And if customers refuse to be
served by workers of a certain gender, race, or ethnicity in certain kinds of
jobs, they will have to pay higher prices in competitive markets because
their discrimination raises the costs of providing these goods and services.
Those who are discriminated against receive lower wages and often experience
other forms of economic hardship, such as more frequent and longer periods of
unemployment. Beyond that, the lower wage rates and restricted career
opportunities they face will naturally affect their decisions about how much
education and training to acquire and what kinds of careers to pursue. For
that reason, some of the costs of discrimination are paid over very long
periods of time, sometimes for a worker’s entire life.
It is clear that there is still discrimination in the U.S. economy. What is
not always so clear is how much that discrimination costs the economy as a
whole, and that it costs not only those who are discriminated against, but
also those who practice discrimination.
Many U.S. workers belong to unions or to professional associations (such as
the National Education Association for teachers) that act like unions. These
unions and associations represent groups of workers in collective bargaining
with employers to agree on contracts. During this bargaining, workers and
employers establish wages and fringe benefits, such as health care and
pension benefits, for different types of jobs. They also set grievance
procedures to resolve labor disputes during the life of the contract and
often address many other issues, such as procedures for job transfers and
promotions of workers.
Many studies indicate that wages for union workers in the United States are
10 to 15 percent higher than for nonunion workers in similar jobs and that
fringe benefits for union workers also tend to be higher. That compensation
difference is an important consideration both for workers thinking about
joining unions, and for employers who are concerned about paying higher wages
and benefits than their competitors. In some cases, it appears that the
higher wages and benefits are paid because union workers are more productive
than nonunion workers are. But in other cases unions have been found to
decrease productivity, sometimes by limiting the kinds of work that certain
employees can do, or by requiring more workers in some jobs than employers
would otherwise hire. Economists have not reached definite conclusions on
some of these issues, but it is evident that there are many other broad
effects of unions on the economy.
Unions and collective bargaining in the United States are markedly different
from such organizations and procedures in other industrialized nations. U.S.
unions generally practice what is often described as business unionism,
which focuses mainly on the direct economic interests of their members. In
contrast, unions in Europe and South America focus more on influencing national
policy agendas and political parties.
The different focus by U.S. unions partly reflects the special history of
unions in the United States, where the first sustained successes were
achieved by craft unions representing skilled workers such as carpenters,
printers, and plumbers. These skilled workers had more bargaining power and
were more difficult for employers to replace or do without than workers with
less training. Unions representing these skilled workers were also able to
provide special services to employers that allowed both the unions and
employers to operate more efficiently. For example, craft unions in large
cities often ran apprenticeship programs to train young workers in these
occupations. And many craft unions operated hiring halls that employers could
call to find trained workers on short notice or for short periods of time.
Most of these craft unions were members of the American Federation of Labor
(AFL), founded in 1886. The strong bargaining position of these skilled
workers, and the fact that these workers typically earned much higher wages
than most other workers, led the AFL unions to focus on wages and other
financial benefits for their members. Samuel Gompers, the president of the
AFL for nearly all of its first 38 years, once summarized his philosophy of
unions by saying, “What do we want? More. When do we want it? Now.”
By contrast, industrial unions—which represent all of the workers at a firm
or work site, regardless of their function or trade—were generally not
successful in the United States before Congress passed the National Labor
Relations Act of 1935. This law, also known as the Wagner Act after its
sponsor, Senator Robert F. Wagner of New York, changed the way that unions
are recognized as bargaining agents for workers by employers, and made it
easier for unions representing all workers to win that recognition. The
Wagner Act largely put an end to the violent strikes that often occurred when
unions were trying to be recognized as the bargaining agent for employees at
some firm or work site. The act established clear procedures for calling and
holding elections in which the workers decide whether they want to be
represented by a union, and if so by which union. The Wagner Act also
established a government agency known as the National Labor Relations Board
(NLRB) to hear charges of unfair labor practices. Either employees or
employers may file charges of unfair labor practices with the NLRB.
After the Wagner Act was passed, the number of workers who belonged to unions
increased rapidly. This trend continued through World War II (1939-1945),
when unions successfully negotiated more fringe benefits for their members.
These fringe benefits were partly a result of wage and price controls
established during the war, which made large wage increases impossible. In
the 1950s union strength continued to grow, and the national association of
industrial unions, known as the Congress of Industrial Organization (CIO)
merged with the AFL.
Since the late 1970s, total union membership has fallen. The percentage of
the U.S. labor force that belongs to unions has decreased dramatically in the
last half of the 20th century, from more than 25 percent in the mid-1950s to
14 percent in 1997. A number of reasons explain the decline in union
representation of the U.S. labor force. First, unions are traditionally
strong in manufacturing industries, but since the 1950s manufacturing has
accounted for a smaller percentage of overall employment in the U.S. economy.
Employment has grown more rapidly in the service sector, particularly in
professional services and white-collar jobs. Unions have not had as much
success in acquiring new members in the service sector, with the exception of
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
unemployment—not being able to find a job despite actively looking for work
for at least 30 consecutive days. There are three major kinds of
unemployment: frictional, cyclical, and structural. Each type of unemployment
has different causes and consequences, and so public policies designed to
reduce each type of unemployment must be different, too.
Frictional unemployment occurs as a result of labor mobility, when workers
change jobs or wait to begin a new job. Labor mobility is, in general, a good
thing for workers and the economy overall. It allows workers to look for the
best available job for which they are qualified and lets employers find the
best-qualified people for their job openings. Because this searching and
matching by employees and employers takes time, on any given day in a market
economy there will be some workers who are looking for a new job, or waiting
to begin a job. Even when economists describe the economy as being at full
employment there will be some frictional unemployment (as much as 5 to 6
percent of the labor force in some years). This kind of unemployment is
generally not a major economic problem.
Cyclical unemployment occurs when the economy goes into a recession. The
basic causes of cyclical unemployment are decreases in the levels of
consumption, investment, or government spending in the economy, or a decrease
in the demand for goods and services exported to other countries. As national
spending and production levels fall, some employers begin to lay off workers.
Cyclical unemployment varies greatly according to the health of the economy.
Some of the highest unemployment rates for the last decades of the 20th
century took place during the recession of 1982 to 1983, when unemployment
levels reached almost 10 percent. The highest U.S. unemployment rate of the
20th century occurred in 1933, when the Great Depression left almost 25
percent of the labor force without work.
Sometimes the government can use monetary or fiscal policies to increase
spending by businesses and households, for instance by cutting taxes. Or the
government can increase its own spending to fight this kind of unemployment.
. Perhaps the most famous example of this kind of tax cut in the United
States was the one designed in 1963 and passed in 1964 by the administrations
of U.S. president John F. Kennedy and his successor, Lyndon B. Johnson.
Structural unemployment occurs when people who are looking for jobs do not
have the education or skills to fill the jobs that are currently available.
Most policies designed to reduce structural unemployment provide training
programs for these workers, or subsidize education and training programs
available from colleges and universities, technical schools, or businesses.
In some cases, the government provides support for retraining when increased
competition from imported goods and services puts U.S. workers out of work or
when factories are shut down because production is moved to another state or
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.
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.
GOVERNMENT AND THE ECONOMY
Although the market system in the United States relies on private ownership
and decentralized decision-making by households and privately owned
businesses, the government does perform important economic functions. The
government passes and enforces laws that protect the property rights of
individuals and businesses. It restricts economic activities that are
considered unfair or socially unacceptable.
In addition, government programs regulate safety in products and in the
workplace, provide national defense, and provide public assistance to some
members of society coping with economic hardship. There are some products
that must be provided to households and firms by the government because they
cannot be produced profitably by private firms. For example, the government
funds the construction of interstate highways, and operates vaccination
programs to maintain public health. Local governments operate public
elementary and secondary schools to ensure that as many children as possible
will receive an education, even when their parents are unable to afford
Other kinds of goods and services (such as health care and higher education)
are produced and consumed in private markets, but the government attempts to
increase the amount of these products available in the economy. For yet other
goods and services, the government acts to decrease the amount produced and
consumed; these include alcohol, tobacco, and products that create high
levels of pollution. These special cases where markets fail to produce the
right amount of certain goods and services mean that the government has a
large and important role to play in adjusting some production patterns in the
U.S. economy. But economists and other analysts have also found special
reasons why government policies and programs often fail, too.
At the most basic level, the government makes it possible for markets to
function more efficiently by clearly defining and enforcing people’s property
or ownership rights to resources and by providing a stable currency and a
central banking system (the Federal Reserve System in the U.S. economy). Even
these basic functions require a wide range of government programs and
employees. For example, the government maintains offices for recording deeds to
property, courts to interpret contracts and resolve disputes over property
rights, and police and other law enforcement agencies to prevent or punish
theft and fraud. The Treasury Department issues currency and coins and handles
the government’s revenues and expenditures. And as we have seen, the Federal
Reserve System controls the nation’s supply of money and availability of
credit. To perform these basic functions, the government must be able to shift
resources from private to public uses. It does this mainly through taxes, but
also with user fees for some services (such as admission fees to
national parks), and by borrowing money when it issues government bonds.
In the U.S. economy, private markets are generally used to allocate basic
products such as food, housing, and clothing. Most economists—and most
Americans—widely accept that competitive markets perform these functions most
efficiently. One role of government is to maintain competition in these
markets so that they will continue to operate efficiently. In other areas,
however, markets are not allowed to operate because other considerations have
been deemed more important than economic efficiency. In these cases, the
government has declared certain practices illegal. For example, in the United
States people are not free to buy and sell votes in political elections.
Instead, the political system is based on the democratic rule of “one person,
one vote.” It is also illegal to buy and sell many kinds of drugs. After the
Civil War (1861-1865) the Constitution was amended to make slavery illegal,
resulting in a major change in the structure of U.S. society and the economy.
In other cases, the government allows private markets to operate, but
regulates them. For example, the government makes laws and regulations
concerning product safety. Some of these laws and regulations prohibit the
use of highly flammable material in the manufacture of children’s clothing.
Other regulations call for government inspection of food products, and still
others require extensive government review and approval of potential
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 nation’s
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 town’s
mosquito-spraying program. With private goods, like a hamburger, when you pay
for the hamburger, you get to eat it or decide who does. Someone who does not
pay does not get the hamburger.
Because many people can benefit from the same pubic goods and share in their
consumption, and because those who do not pay for these goods still get to
use them, it is usually impossible to produce these goods in private markets.
Or at least it is impossible to produce enough in private markets to reach
the efficient level of output. That happens because some people will try to
consume the goods without paying for them, and get a free ride from those who
do pay. As a result, the government must usually take over the decision about
how much of these products to produce. In some cases, the government actually
produces the good; in other cases it pays private firms to make these
The classic example of a public good is national defense. It is not a rival
consumption product, since protecting one person from an invading army or
missile attack does not reduce the amount of protection provided to others in
the country. The nonexclusion principle also applies to national defense. It
is not possible to protect only the people who pay for national defense while
letting bombs or bullets hit those who do not pay. Instead, the government
imposes broad-based taxes to pay for national defense and other public goods.
Adjusting for External Costs or Benefits
There are some private markets in which goods and services are produced, but
too much or too little is produced. Whether too much or too little is
produced depends on whether the problem is one of external costs or external
benefits. In either case, the government can try to correct these market
failures, to get the right amount of the good or service produced.
External costs occur when not all of the costs involved in the production or
consumption of a product are paid by the producers and consumers of that
product. Instead, some of the costs shift to others. One example is drunken
driving. The consumption of too much alcohol can result in traffic accidents
that hurt or kill people who are neither producers nor consumers of alcoholic
products. Another example is pollution. If a factory dumps some of its wastes
in a river, then people and businesses downstream will have to pay to clean
up the water or they may become ill from using the water.
When people other than producers and consumers pay some of the costs of
producing or consuming a product, those external costs have no effect on the
product’s market price or production level. As a result, too much of the
product is produced considering the overall social costs. To correct this
situation, the government may tax or fine the producers or consumers of such
products to force them to cover these external costs. If that can be done
correctly, less of the product will be produced and consumed.
An external benefit occurs when people other than producers and consumers
enjoy some of the benefits of the production and consumption of the product.
One example of this situation is vaccinations against contagious diseases.
The company that sells the vaccine and the individuals who receive the
vaccine are better off, but so are other people who are less likely to be
infected by those who have received the vaccine. Many people also argue that
education provides external benefits to the nation as a whole, in the form of
lower unemployment, poverty, and crime rates, and by providing more equality
of opportunity to all families.
When people other than the producers and consumers receive some of the
benefits of producing or consuming a product, those external benefits are not
reflected in the market price and production cost of the product. Because
producers do not receive higher sales or profits based on these external
benefits, their production and price levels will be too low–based only on
those who buy and consume their product. To correct this, the government may
subsidize producers or consumers of these products and thus encourage more
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 government’s power to promote
and maintain competition in the U.S. economy. Some states have passed their own
versions of some of these laws.
The government does allow what economists call natural monopolies.
However, the government then regulates those businesses to protect consumers
from high prices and poor service, and often limits the profits these firms can
earn. The classic examples of natural monopolies are local services provided by
public utilities. Economies of scale make it inefficient to have even two
companies distributing electricity, gas, water, or local telephone service to
consumers. It would be very expensive to have even two sets of electric and
telephone wires, and two sets of water, gas, and sewer pipes going to every
house. That is why firms that provide these services are called natural
There have been some famous antitrust cases in which large companies were broken
up into smaller firms. One such example is the breakup of American Telephone
and Telegraph (AT&T) in 1982, which led to the formation of a number of
long-distance and regional telephone companies. Other examples include a ruling
in 1911 by the Supreme Court of the United States, which broke the Standard Oil
Trust into a number of smaller oil companies and ordered a similar breakup of
the American Tobacco Company.
Some government policies intentionally reduce competition, at least for some
period of time. For example, patents on new products and copyrights on books
and movies give one producer the exclusive right to sell or license the
distribution of a product for 17 or more years. These exclusive rights
provide the incentive for firms and individuals to spend the time and money
required to develop new products. They know that no one else will copy and
sell their product when it is introduced into the marketplace, so it pays to
devote more resources to developing these new products.
The benefits of certain other government policies that reduce competition are
not always this clear, however. More controversial examples include policies
that restrict the number of taxicabs in a large city or that limit the number
of companies providing cable television services in a community. It is much
less expensive for cable companies to install and operate a cable television
system than it is for large utilities, such as the electric and telephone
companies, to install the infrastructure they need to provide services.
Therefore, it is often more feasible to have two or more cable companies in
reasonably large cities. There are also more substitutes for cable
television, such as satellite dish systems and broadcast television. But
despite these differences, many cities auction off cable television rights to
a single company because the city receives more revenue that way. Such a
policy results in local monopolies for cable television, even in areas where
more competition might well be possible and more efficient.
Establishing government policies that efficiently regulate markets is
difficult to do. Policies must often balance the benefits of having more
firms competing in an industry against the possible gains from allowing a
smaller number of firms to compete when those firms can achieve economies of
scale. The government must try to weigh the benefits of such regulations
against the advantages offered by more competitive, less regulated markets.
Promoting Full Employment and Price Stability
In addition to the monetary policies of the Federal Reserve System, the
federal government can also use its taxing and spending policies, or fiscal
policies, to counteract inflation or the cyclical unemployment that results
from too much or too little total spending in the economy. Specifically, if
inflation is too high because consumers, businesses, and the government are
trying to buy more goods and services than it is possible to produce at that
time, the government can reduce total spending in the economy by reducing its
own spending. Or the government can raise taxes on households and businesses
to reduce the amount of money the private sector spends. Either of these
fiscal policies will help reduce inflation. Conversely, if inflation is low
but unemployment rates are too high, the government can increase its spending
or reduce taxes on households and businesses. These policies increase total
spending in the economy, encouraging more production and employment.
Some government spending and tax policies work in ways that automatically
stabilize the economy. For example, if the economy is moving into a
recession, with falling prices and higher unemployment, income taxes paid by
individuals and businesses will automatically fall, while spending for
unemployment compensation and other kinds of assistance programs to low-
income families will automatically rise. Just the opposite happens as the
economy recovers and unemployment falls—income taxes rise and government
spending for unemployment benefits falls. In both cases, tax programs and
government-spending programs change automatically and help offset changes in
nongovernment employment and spending.
In some cases, the federal government uses discretionary fiscal policies in
addition to automatic stabilization policies. Discretionary fiscal policies
encompass those changes in government spending and taxation that are made as
a result of deliberations by the legislative and executive branches of
government. Like the automatic stabilization policies, discretionary fiscal
policy can reduce unemployment by increasing government spending or reducing
taxes to encourage the creation of new jobs. Conversely, it can reduce
inflation by decreasing government spending and raising taxes. .
In general, the federal government tries to consider the condition of the
national economy in its annual budgeting deliberations. However,
discretionary spending is difficult to put into practice unless the nation is
in a particularly severe episode of unemployment or inflation. In such
periods, the severity of the situation builds more consensus about what
should be done, and makes it more likely that the problem will still be there
to deal with by the time the changes in government spending or tax programs
take effect. But in general, it takes time for discretionary fiscal policy to
work effectively, because the economic problem to be addressed must first be
recognized, then agreement must be reached about how to change spending and
tax levels. After that, it takes more time for the changes in spending or
taxes to have an effect on the economy.
When there is only moderate inflation or unemployment, it becomes harder to
reach agreement about the need for the government to change spending or
taxes. Part of the problem is this: In order to increase or decrease the
overall level of government spending or taxes, specific expenditures or taxes
have to be increased or decreased, meaning that specific programs and voters
are directly affected. Choosing which programs and voters to help or hurt
often becomes a highly controversial political issue.
Because discretionary fiscal policies affect the government’s annual deficit
or surplus, as well as the national debt, they can often be controversial and
politically sensitive. For these reasons, at the close of the 20th century,
which experienced years with normal levels of unemployment and inflation,
there was more reliance on monetary policies, rather than on discretionary
fiscal policies to try to stabilize the national economy. There have been,
however, some famous episodes of changing federal spending and tax policies
to reduce unemployment and fight inflation in the U.S. economy during the
past 40 years. In the early 1980s, the administration of U.S. president
Ronald Reagan cut taxes. Other notable tax cuts occurred during the
administrations of U.S. presidents John Kennedy and Lyndon Johnson in 1963
Limitations of Government Programs
Government economic programs are not always successful in correcting market
failures. Just as markets fail to produce the right amount of certain kinds
of goods and services, the government will often spend too much on some
programs and too little on others for a number of reasons. One is simply that
the government is expected to deal with some of the most difficult problems
facing the economy, taking over where markets fail because consumers or
producers are not providing clear signals about what they want. This lack of
clear signals also makes it difficult for the government to determine a
policy that will correct the problem.
Political influences, rather than purely economic factors, often play a major
role in inefficient government policies. Elected officials generally try to
respond to the wishes of the voting public when making decisions that affect
the economy. However, many citizens choose not to vote at all, so it is not
clear how good the political signals are that elected officials have to work
with. In addition, most voters are not well informed on complicated matters
of economic policy.
For example, the federal government’s budget director David Stockman and
other officials in the administration of President Reagan proposed cuts in
income tax rates. Congress adopted the cuts in 1981 and 1984 as a way to
reduce unemployment and make the economy grow so much that tax revenues would
actually end up rising, not falling. Most economists and many politicians did
not believe that would happen, but the tax cuts were politically popular.
In fact, the tax cuts resulted in very large budget deficits because the
government did not collect enough taxes to cover its expenditures. The
government had to borrow money, and the national debt grew very rapidly for
many years. As the government borrowed large sums of money, the increased
demand caused interest rates to rise. The higher interest rates made it more
expensive for U.S. firms to invest in capital goods, and increased the demand
for dollars on foreign exchange markets as foreigners bought U.S. bonds
paying higher interest rates. That caused the value of the dollar to rise,
compared with other nations’ currencies, and as a result U.S. exports became
more expensive for foreigners to buy. When that happened in the mid-1980s,
most U.S. companies that exported goods and services faced very difficult
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 world’s largest economy, the United States plays a key
role on the international political and economic stages. The United States is
also the largest trading nation in the world, exporting and importing more
goods and services than any other country.. Some people worry that extensive
levels of international trade may have hurt the U.S. economy, and U.S.
workers in particular. But while some firms and workers have been hurt by
international competition, in general economists view international trade
like any other kind of voluntary trade: Both parties can gain, and usually
do. International trade increases the total level of production and
consumption in the world, lowers the costs of production and prices that
consumers pay, and increases standards of living. How does that happen?
All over the world, people specialize in producing particular goods and
services, then trade with others to get all of the other goods and services
they can afford to buy and consume. It is far more efficient for some people
to be lawyers and other people doctors, butchers, bakers, and teachers than
it is for each person to try to make or do all of the things he or she
In earlier centuries, the majority of trade took place between individuals
living in the same town or city. Later, as transportation and communications
networks improved, individuals began to trade more frequently with people in
other places. The industrial revolution that began in the 18th century
greatly increased the volume of goods that could be shipped to other cities
and regions, and eventually to other nations. As people became more
prosperous, they also traveled more to other countries and began to demand
the new products they encountered during their travels.
The basic motivation and benefits of international trade are actually no
different from those that lead to trade within a nation. But international
trade differs from trade within a nation in two major ways. First,
international trade involves at least two national currencies, which must
usually be exchanged before goods and services can be imported or exported.
Second, nations sometimes impose barriers on international trade that they do
not impose on trade that occurs entirely inside their own country.
A U.S. Imports and Exports
U.S. exports are goods and services made in the United States that are sold
to people or businesses in other countries. Goods and services from other
countries that U.S. citizens or firms purchase are imports for the United
States. Like almost all of the other nations of the world, the United States
has seen a rapid increase in both its imports and exports over the last
several decades. In 1959 the combined value of U.S. imports and exports
amounted to less than 9 percent of the country’s gross domestic product
(GDP); by 1997 that figure had risen to 25 percent. Clearly, the
international trade sector has grown much more rapidly than the overall
Most of this trade occurs between industrialized, developed nations and
involves similar kinds of products as both imports and exports. While it is
true that the U.S. imports some things that are only found or grown in other
parts of the world, most trade involves products that could be made in the
United States or any other industrialized market economies. In fact, some
products that are now imported, such as clothing and textiles, were once
manufactured extensively in the United States. However, economists note that
just because things were or could be made in a country does not mean that
they should be made there.
Just as individuals can increase their standard of living by specializing in
the production of the things they do best, nations also specialize in the
products they can make most efficiently. The kinds of goods and services that
the United States can produce most competitively for export are determined by
its resources. The United States has a great deal of fertile land, is the
most technologically advanced nation in the world, and has a highly educated
and skilled labor force. That explains why U.S. companies produce and
export many agricultural products as well as sophisticated machines, such as
commercial jets and medical diagnostic equipment.
Many other nations have lower labor costs than the United States, which
allows them to export goods that require a lot of labor, such as shoes,
clothing, and textiles. But even in trading with other industrialized
countries—whose workers are similarly well educated, trained, and highly
paid—the United States finds it advantageous to export some high-tech
products or professional services and to import others. For example, the
United States both imports and exports commercial airplanes, automobiles, and
various kinds of computer products. These trading patterns arise because
within these categories of goods, production is further specialized into
particular kinds of airplanes, automobiles, and computer products. For
example, automobile manufacturers in one nation may focus production
primarily on trucks and utility vehicles, while the automobile industries in
other countries may focus on sport cars or compact vehicles.
Greater specialization allows producers to take full advantage of economies
of scale. Manufacturers can build large factories geared toward production of
specialized inventories, rather than spending extra resources on factory
equipment needed to produce a wide variety of goods. Also, by selling more of
their products to a greater number of consumers in global markets,
manufacturers can produce enough to make specialization profitable.
The United States enjoyed a special advantage in the availability of
factories, machinery, and other capital goods after World War II ended in
1945. During the following decade or two, many of the other industrial
nations were recovering from the devastation of the war. But that situation
has largely disappeared, and the quality of the U.S. labor force and the
level of technological innovation in U.S. industry have become more important
in determining trade patterns and other characteristics of the U.S. economy.
A skilled labor force and the ability of businesses to develop or adapt new
technologies are the key to high standards of living in modern global
economies, particularly in highly industrialized nations. Workers with low
levels of education and training will find it increasingly difficult to earn
high wages and salaries in any part of the world, including the United
B Barriers to Trade Despite the mutual advantages of global
trade, governments often adopt policies that reduce or eliminate
international trade in some markets. Historically, the most important trade
barriers have been tariffs (taxes on imports) and quotas (limits on the
number of products that can be imported into a country). In recent decades,
however, many countries have used product safety standards or legal standards
controlling the production or distribution of goods and services to make it
difficult for foreign businesses to sell in their markets. For example,
Russia recently used health standards to limit imports of frozen chicken from
the United States, and the United States has frequently charged Japan with
using legal restrictions and allowing exclusive trade agreements among
Japanese companies. These exclusive agreements make it very difficult for
U.S. banks and other firms to operate or sell products in Japan.
While there are special reasons for limiting imports or exports of certain
kinds of products—such as products that are vital to a nation’s national
defense—economists generally view trade barriers as hurting both importing
and exporting nations. Although the trade barriers protect workers and firms
in industries competing with foreign firms, the costs of this protection to
consumers and other businesses are typically much higher than the benefits to
the protected workers and firms. And in the long run it usually becomes
prohibitively expensive to continue this kind of protection. Instead it often
makes more sense to end the trade barrier and help workers in industries that
are hurt by the increased imports to relocate or retrain for jobs with firms
that are competitive. In the United States, trade adjustment assistance
payments were provided to steelworkers and autoworkers in the late 1970s,
instead of imposing trade barriers on imported cars. Since then, these direct
cash payments have been largely phased out in favor of retraining programs.
During recessions, when national unemployment rates are high or rising,
workers and firms facing competition from foreign companies usually want the
government to adopt trade barriers to protect their industries. But again,
historical experience with such policies shows that they do not work. Perhaps
the most famous example of these policies occurred during the Great
Depression of the 1930s. The United States raised its tariffs and other trade
barriers in legislation such as the Smoot-Hawley Act of 1930. Other nations
imposed similar kinds of trade barriers, and the overall result was to make
the Great Depression even worse by reducing world trade.
C World Trade Organization (WTO) and Its Predecessors
As World War II drew to a close, leaders in the United States and other
Western nations began working to promote freer trade for the post-war world.
They set up the International Monetary Fund (IMF) in 1944 to stabilize
exchange rates across member nations. The Marshall Plan, developed by U.S.
general and economist George Marshall, promoted free trade. It gave U.S. aid
to European nations rebuilding after the war, provided those nations reduced
tariffs and other trade barriers.
In 1947 the United States and many of its allies signed the General Agreement
on Tariffs and Trade (GATT), which was especially successful in reducing
tariffs over the next five decades. In 1995 the member nations of the GATT
founded the World Trade Organization (WTO), which set even greater
obligations on member countries to follow the rules established under GATT.
It also established procedures and organizations to deal with disputes among
member nations about the trading policies adopted by individual nations.
In 1992 the United States also signed the North American Free Trade Agreement
(NAFTA) with its closest neighbors and major trading partners, Canada and
Mexico. The provisions of this agreement took effect in 1994. Since then,
studies by economists have found that NAFTA has benefited all three nations,
although greater competition has resulted in some factories closing. As a
percentage of national income, the benefits from NAFTA have been greater in
Canada and Mexico than in the United States, because international trade
represents a larger part of those economies. While the United States is the
largest trading nation in the world, it has a very large and prosperous
domestic economy; therefore international trade is a much smaller percentage
of the U.S. economy than it is in many countries with much smaller domestic
D Exchange Rates and the Balance of Payments
Currencies from different nations are traded in the foreign exchange market,
where the price of the U.S. dollar, for instance, rises and falls against
other currencies with changes in supply and demand. When firms in the United
States want to buy goods and services made in France, or when U.S. tourists
visit France, they have to trade dollars for French francs. That creates a
demand for French francs and a supply of dollars in the foreign exchange
market. When people or firms in France want to buy goods and services made in
the United States they supply French francs to the foreign exchange market
and create a demand for U.S. dollars.
Changes in people’s preferences for goods and services from other countries
result in changes in the supply and demand for different national currencies.
Other factors also affect the supply and demand for a national currency.
These include the prices of goods and services in a country, the country’s
national inflation rate, its interest rates, and its investment
opportunities. If people in other countries want to make investments in the
United States, they will demand more dollars. When the demand for dollars
increases faster than the supply of dollars on the exchange markets, the
price of the dollar will rise against other national currencies. The dollar
will fall, or depreciate, against other currencies when the supply of dollars
on the exchange market increases faster than the demand.
All international transactions made by U.S. citizens, firms, and the
government are recorded in the U.S. annual balance of payments account. This
account has two basic sections. The first is the current account, which
records transactions involving the purchase (imports) and sale (exports) of
goods and services, interest payments paid to and received from people and
firms in other nations, and net transfers (gifts and aid) paid to other
nations. The second section is the capital account, which records investments
in the United States made by people and firms from other countries, and
investments that U.S. citizens and firms make in other nations.
These two accounts must balance. When the United States runs a deficit on its
current account, often because it imports more that it exports, that deficit
must be offset by a surplus on its capital account. If foreign investments in
the United States do not create a large enough surplus to cover the deficit
on the current account, the U.S. government must transfer currency and other
financial reserves to the governments of the countries that have the current
account surplus. In recent decades, the United States has usually had annual
deficits in its current account, with most of that deficit offset by a
surplus of foreign investments in the U.S. economy.
Economists offer divergent views on the persistent surpluses in the U.S.
capital account. Some analysts view these surpluses as evidence that the
United States must borrow from foreigners to pay for importing more than it
exports. Other analysts attribute the surpluses to a strong desire by
foreigners to invest their funds in the U.S. economy. Both interpretations
have some validity. But either way, it is clear that foreign investors have a
claim on future production and income generated in the U.S. economy.
Whether that situation is good or bad depends how the foreign funds are used.
If they are used mainly to finance current consumption, they will prove
detrimental to the long-term health of the U.S. economy. On the other hand,
their effect will be positive if they are used primarily to fund investments
that increase future levels of U.S. output and income.
X CURRENT TRENDS AND ISSUES
In the early decades of the 21st century, many different social, economic and
technological changes in the United States and around the world will affect
the U.S. economy. The population of the United States will become older and
more racially and ethnically diverse. The world population is expected to
continue to grow at a rapid rate, while the U.S. population will likely grow
much more slowly. World trade will almost certainly continue to expand
rapidly if current trade policies and rates of economic growth are
maintained, which in turn will make competition in the production of many
goods and services increasingly global in scope. Technological progress is
likely to continue at least at current rates, and perhaps faster. How will
all of this affect U.S. consumers, businesses, and government?
Over the next century, average standards of living in the United States will
almost certainly rise, so that on average, people living at the end of the
century are likely to be better off in material terms than people are today.
During the past century, the primary reasons for the increase in living
standards in the United States were technological progress, business
investments in capital goods, and people’s investments in greater education
and training (which were often subsidized by government programs). There is
no evident reason why these same factors will not continue to be the most
important reasons underlying changes in the standard of living in the United
States and other industrialized economies. A comparatively small number of
economists and scientists from other fields argue that limited supplies of
energy or of other natural resources will eventually slow or stop economic
growth. Most, however, expect those limits to be offset by discoveries of new
deposits or new types of resources, by other technological breakthroughs, and
by greater substitution of other products for the increasingly scarce
Although the U.S. economy will likely remain the world’s largest national
economy for many decades, it is far less certain that U.S. households will
continue to enjoy the highest average standard of living among industrialized
nations. A number of other nations have rapidly caught up to U.S. levels of
income and per capita output over the last five decades of the 20th century.
They did this partly by adopting technologies and business practices that
were first developed in the United States, or by developing their own
technological and managerial innovations. But in large part, these nations
have caught up with the United States because of their higher rates of
savings and investment, and in some cases, because of their stronger systems
for elementary and secondary education and for training of workers.
Most U.S. workers and families will still be better off as the U.S. economy
grows, even if some other economies are growing faster and becoming somewhat
more prosperous, as measured per capita. Certainly families in Britain today
are far better off materially than they were 150 to 200 years ago, when
Britain was the largest and wealthiest economy in the world, despite the fact
that many other nations have since surpassed the British economy in size and
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
In most industrialized nations, the demand for highly educated and trained
workers has risen sharply in recent decades. That happened in part because
many kinds of jobs now require higher skill levels, but other factors were
also important. New production methods require workers to frequently and
rapidly change what they do on the job. They also increase the need for
quality products and customer service and the ability of employees to work in
teams. Increased levels of competition, including competition from foreign
producers, have put a higher premium on producing high quality products.
Several other factors help explain why the relative position of low-income
workers has fallen more in the United States than in other industrialized
Western nations. The growth of college graduates has slowed in the United
States but not in other nations. United States immigration policies have not
been as closely tied to job-market requirements as immigration policies in
many other nations have been. Also, government assistance programs for low-
income families are usually not as generous in the United States as they are
in other industrialized nations.
Changes in the make-up of the U.S. population are likely to cause income
disparity to grow, at least through the first half of the 21st century. The
U.S. population is growing most rapidly among the groups that are most likely
to have low incomes and experience some form of discrimination. Children in
these groups are less likely to attend college or to receive other
educational opportunities that might help them acquire higher-paying jobs.
The U.S. population will also be aging during this period. As people born
during the baby boom of 1946 to 1964 reach retirement age, the percentage of
the population that is retired will increase sharply, while the percentage
that is working will fall. The demand for medical care and long-term care
facilities will increase, and the number of people drawing Social Security
benefits will rise sharply. That will increase pressure on government
budgets. Eventually, taxes to pay for these services will have to be
increased, or the level of these services provided by the government will
have to be cut back. Neither of those approaches will be politically popular.
A few economists have called for radical changes in the Social Security
system to deal with these problems. One suggestion has been to allow workers
to save and invest in private retirement accounts rather than pay into Social
Security. Thus far, those approaches have not been considered politically
feasible or equitable. Current retirees strongly oppose changing the system,
as do people who fear that they will lose future benefits from a program they
have paid taxes to support all their working lives. Others worry that private
accounts will not provide adequate retirement income for low-income workers,
or that the government will still be called on to support those who make bad
investment choices in their private retirement accounts.
Political and economic events that occur in other parts of the world are felt
sooner and more strongly in the United States than ever before, as a result
of rising levels of international trade and the unique U.S. position as an
economic, military, and political superpower. The 1991 breakup of the Union
of Soviet Socialist Republics (USSR)—perhaps the most dramatic international
event to unfold since World War II—has presented new opportunities for
economic trade and cooperation. But it also has posed new challenges in
dealing with the turbulent political and economic situations that exist in
many of the independent nations that emerged from the breakup . Some
fledgling democracies in Africa are similarly volatile.
Many U.S. firms are eager to sell their products to consumers and firms in
these nations, and U.S. banks and other financial institutions are eager to
lend funds to support investments in these countries, if they can be
reasonably sure that these loans will be repaid. But there are economic risks
to doing business in these countries, including inflation, low income levels,
high crime rates, and frequent government and company defaults on loans.
Also, political upheavals sometimes bring to power leaders who oppose market
The greater political and economic unification of nations in the European
Union (EU) offers different kinds of issues. There is much less risk of
inflation, crime, and political upheaval to contend with in this area. On the
other hand, there is more competition to face from well-established and
technologically sophisticated firms, and more concern that the EU will put
trade barriers on products produced in the United States and in other
countries that are not members of the Union. Clearly, the United States will
be concerned with maintaining its trading position with those nations. It
will also look to the EU to act as an ally in settling international policies
in political and economic arenas, such as a peace initiative in the Middle
East and treaties on international trade and environmental issues.
The United States has other major economic and political interests in the
Middle East, Asia, and around the world. China is likely to become an even
larger trading partner and an increasingly important political power in the
world. Other Asian nations, including Japan, Korea, Indonesia, and the
Philippines, are also important trading partners, and in some cases strong
political and national security allies, too. The same can be said for
Australia and for Canada, which has long been the largest single trading
partner for the United States. Mexico and the other nations of Central and
South America are, similarly, natural trading partners for the United States,
and likely to play an even larger role over the next century in both economic
and political affairs.
It may once have been possible for the United States to practice an
isolationist policy by developing an economy largely cut off from foreign
trade and international relations, but that possibility is no longer
feasible, nor is it advisable. Economic and technological developments have
made the world’s nations increasingly interdependent.
Greater world trade and cooperation offer an enormous range of mutually
beneficial activities. Trading with other countries inevitably increases
opportunities for travel and cultural exchange, as well as business
opportunities. In a very broad sense, nations that buy and sell goods and
services with each other also have a greater stake in other forms of peaceful
cooperation, and in seeing other countries prosper and grow.
On the other hand, global interdependence also raises major
problems—political, economic, and environmental—that require international
solutions. Many of these problems, such as pollution, global warming, and
assistance for developing nations, have been controversial even when
solutions were discussed only at the national level. Often, controversy
increases with the number of nations that must agree on a solution, but some
problems require global remedies. Such problems will challenge the productive
capacity of the U.S. economy and the wisdom of U.S. citizens and their
No nation has ever had the rich supply of resources to face the future that
the U.S. economy has as it enters the 21st century. Despite that, or perhaps
because of it, U.S. consumers, businesses, and political leaders are still
trying to do more than earlier generations of citizens.
XI CHIEF GOODS AND SERVICES OF THE U.S. ECONOMY
The U.S. economy, the largest in the world, produces many different goods and
services. This can be seen more easily by dividing economic activities into
four sectors that produce different kinds of goods and services. The first
sector provides goods that come directly from natural resources: agriculture,
forestry, fishing, and mining. The second sector includes manufacturing and
the generation of electricity. The third sector, made up of commerce and
services, is now the largest part of the U.S. economy. It encompasses
financial services, retail and wholesale sales, government services,
transportation, entertainment, tourism, and other businesses that provide a
wide variety of services to individuals and businesses. The fourth major
economic sector deals with the recording, processing, and transmission of
information, and includes the communications industry.
A Natural Resource Sector
The United States, more than most countries, enjoys a wide array of natural
resources. Agricultural output in the United States has historically been
among the highest in the world. Rich fishing grounds and coastal habitats
provide abundant seafood. Companies harvest the nation’s large reserves of
timber to use in wood products and housing. Major mineral resources—including
iron ore, lead, and copper, as well as energy resources such as coal, crude
oil, and natural gas—are abundant in the United States.
The United States contains some of the best cropland in the world. Cultivated
farmland constitutes 19 percent of the land area of the country and makes the
United States the world’s richest agricultural nation. In part because of the
nation’s favorable climate, soil, and water conditions, farmers produce huge
quantities of agricultural commodities and a variety of crops and livestock.
The United States is the largest producer of corn, soybeans, and sorghum, and
it ranks second in the production of wheat, oats, citrus fruits, and tobacco.
The United States is also a major producer of sugar cane, potatoes, peanuts,
and beet sugar. It ranks fourth in the world in cattle production and second
in hogs. The total annual value of farm output increased from $55 billion in
1970 to $202 billion in 1996. Farmers in the United States not only produce
enough food to feed the nation’s population, they also export more farm
products than any other nation. Despite this vast output, the U.S. economy is
so large and diversified that agriculture accounted for only 2 percent of
annual GDP and employed only 3 percent of the workforce in 1998.
During the 20th century, many Americans moved from rural to urban areas of
the United States, resulting in large population decreases in farming
regions. Even though the number of farms has been declining since the 1930s,
overall production has increased because of more efficient operations. Bigger
farms, operated as large businesses, have increasingly replaced small family
farms. The owners of larger farms make greater use of modern machinery and
other equipment. By the 1990s, farm operations were highly mechanized. By
applying mechanization, technology, efficient business practices, and
scientific advances in agricultural methods, larger farms produce great
quantities of agricultural output using small amounts of labor and land.
In 1999 there were 2,194,070 farms in the United States, down from a high of
6.8 million in 1935. As smaller farms have been consolidated into larger
units, the average farm size in the United States increased from about 63
hectares (about 155 acres) to 175 hectares (432 acres) by 1999.
Cattle production is widespread throughout the United States. Texas leads in
the production of range cattle, which are allowed to graze freely. Iowa and
Illinois are important for nonrange feeder cattle, which are cattle that eat
feed grain provided by cattle farmers. The Dairy Belt continues to be
concentrated in southern Wisconsin but is also prominent in the rural
landscapes of most northeastern states and fairly common in other states,
too. Hog production tends to be concentrated in Iowa, Illinois, and
surrounding states, where hogs are fattened for market. Chicken production is
widespread, but southern states, including Texas, Arkansas, and Alabama,
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 fruits—lemons, oranges, and grapefruits—thrive in Florida,
southern Texas, and southern California. Nuts grow on irrigated land in the
Central Valley of California and in parts of southern California.
Production of specialty crops and livestock has increased in recent years,
particularly along the East and West coasts and in the Southeast. Ranches in
New York and Texas have introduced exotic game, such as emu, fallow deer, and
nilgai and black buck antelope. Deer and antelope meat, known as venison, is
served mainly in restaurants. Specialty vegetable and fruit operations
produce dwarf apples, brown and green cotton, canola, and jasmine rice.
Farmers raise more than 60 specialty crops in the United States for Asian-
American markets, including bean sprouts, snow peas, and Chinese cabbage.
In the 1990s, less than 1 percent of the country’s workforce was involved in
the lumber industry, and forestry accounted for less than 0.5 percent of the
nation’s gross domestic product (GDP). Nevertheless, forests represent a
crucial resource for U.S. industry. Forest resources are used in producing
housing, fuel, foodstuffs, and manufactured goods. The United States leads
the world in lumber production and is second in the production of wood for
pulp and paper manufacture. These high production levels, however, do not
satisfy all of the U.S. demand for forest products. The United States is the
world’s largest importer of lumber, most of which comes from Canada.
When European settlers first arrived in North America, half of the land on
the continent was covered with forests. The forests of the eastern and
northern portions of the country were fairly continuous. Beginning with the
early colonists, the natural vegetation was altered drastically as farmers
cleared land for crops and pastures, and cut trees for firewood and lumber.
In the north and east, lumbermen quickly cut all of the valuable trees before
moving on to other locations. Only 10 percent of the original virgin timber
remains. Almost two thirds of the forests that remain have been classified as
Forests still cover 23 percent of the United States. The trees in the
nation’s forests contain an estimated 7.1 billion cu m (249.3 billion cu ft)
of wood suitable for lumber. Private individuals and businesses, including
farmers, lumber companies, paper mills, and other wood-using industries, own
about 73 percent of the commercial forestland. Federal, state, and local
governments own the remaining 27 percent.
Softwoods (wood harvested from cone-bearing trees) make up about three-
fourths of forestry production and hardwoods (wood harvested from broad-
leafed trees) about one-fourth. Nearly half the timber output is used for
making lumber boards, and about one-third is converted to pulpwood, which is
subsequently used to manufacture paper. Most of the remaining output goes
into plywood and veneer. Douglas fir and southern yellow pine are the primary
softwoods used in making lumber, and oak is the most important hardwood.
About half of the nation’s lumber and all of its fir plywood come from the
forests of the Pacific states, an area dominated by softwoods. In addition to
the Douglas fir forests in Washington and Oregon, this area includes the
famous California redwoods and the Sitka spruce along the coast of Alaska.
Forests in the mountain states of the West cover a relatively small area, yet
they account for more than 10 percent of the nation’s lumber production.
Ponderosa pine is the most important species cut from the forests of this
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
The U.S. waters off the coast of North America provide a rich marine harvest,
which is about evenly split in commercial value between fish and shellfish.
Humans consume approximately 80 percent of the catch as food. The remaining
20 percent goes into the manufacturing of products such as fish oil,
fertilizers, and animal food.
In 1997 the United States had a commercial fish catch of 5.4 million metric
tons. The value of the catch was an estimated $3.1 billion in 1998. In most
years, the United States ranks fifth among the nations of the world in weight
of total catch, behind China, Peru, Chile, and Japan.
Marine species dominate U.S. commercial catches, with freshwater fish
representing only a small portion of the total catch. Shellfish account for
only one-sixth of the weight of the total catch but nearly one-half of the
value; finfish represent the remaining share of weight and value. Alaskan
pollock and menhaden, a species used in the manufacture of oil and
fertilizer, are the largest catches by tonnage. The most valuable seafood
harvests are crabs, salmon, and shrimp, each representing about one-sixth of
the total value. Other important species include lobsters, clams, flounders,
scallops, Pacific cod, and oysters.
Alaska leads all states in both volume and value of the catch; important
species caught off Alaska’s coast include pollock and salmon. Other leading
fishing states, ranked by value, are Louisiana, Massachusetts, Texas, Maine,
California, Florida, Washington, and Virginia. Important species caught in
the New England region include lobsters, scallops, clams, oysters, and cod;
in the Chesapeake Bay, crabs; and in the Gulf of Mexico, menhaden and shrimp.
Much of the annual U.S. tonnage of commercial freshwater fish comes from
aquatic farms. The most important species raised on farms are catfish, trout,
salmon, oysters, and crawfish. The total annual output of private catfish and
trout farms in the mid-1990s was 235,800 metric tons, valued at more than
$380 million. In the 1970s catfish farming became important in states along
the lower Mississippi River. Mississippi leads all states in the production
of catfish on farms.
As a country of continental proportions, the United States has within its
borders substantial mineral deposits. America leads the world in the
production of phosphate, an important ingredient in fertilizers, and ranks
second in gold, silver, copper, lead, natural gas, and coal. Petroleum
production is third in the world, after Russia and Saudi Arabia.
Mining contributes 1.5 percent of annual GDP and employs 0.5 percent of all
U.S. workers. Although mining accounts for only a small share of the nation’s
economic output, it was historically essential to U.S. industrial development
and remains important today. Coal and iron ore are the basis for the steel
industry, which fabricates components for manufactured items such as
automobiles, appliances, machinery, and other basic products. Petroleum is
refined into gasoline, heating oil, and the petrochemicals used to make
plastics, paint, pharmaceuticals, and synthetic fibers.
The nation’s three chief mineral products are fuels. In order of value, they
are natural gas, petroleum, and coal. In 1996 the United States produced 23
percent of the world’s natural gas, 21 percent of its coal, and 13 percent of
its crude oil. From 1990 to 1995, as the inflation-adjusted prices for these
products declined, the extraction of these fossil fuels declined, increasing
U.S. dependence on foreign sources of oil and natural gas.
The United States contains huge fields of natural gas and oil. These fields
are scattered across the country, with concentrations in the midcontinent
fields of Texas and Oklahoma, the Gulf Coast region of Texas and Louisiana,
and the North Slope of Alaska. Texas and Louisiana account for almost 60
percent of the country’s natural gas production. Today, oil and natural gas
are pumped to the surface, then sent by pipeline to refineries located in all
parts of the nation. Offshore deposits account for 13 percent of total
production. Coal production, important for industry and for the generation of
electric power, comes primarily from Wyoming (29 percent of U.S. production
in 1997), West Virginia (18 percent), and Kentucky (16 percent).
Important metals mined in the United States include gold, copper, iron ore,
zinc, magnesium, lead, and silver. Iron ore is found mainly in Minnesota, and
to a lesser degree in northern Michigan. The ore consists of low-grade
taconite; U.S. deposits of high-grade ores, such as hematite, magnetite, and
limonite, have been consumed. Leading industrial minerals include materials
used in construction—mainly clays, lime, salt, phosphate rock, boron, and
potassium salts. The United States also produces large percentages of the
world’s output for a number of important minerals. In 1997 the United States
produced 42 percent of the world’s molybdenum, 34 percent of its phosphate
rock, 22 percent of its elemental sulfur, 17 percent of its copper, and 16
percent of its lead. Major deposits of many of these minerals are found in
the western states.
B Manufacturing and Energy Sector B1
The United States leads all nations in the value of its yearly manufacturing
output. Manufacturing employs about one-sixth of the nation’s workers and
accounts for 17 percent of annual GDP. In 1996 the total value added by
manufacturing was $1.8 trillion. Value added is the price of finished goods
minus the cost of the materials used to make them. Although manufacturing
remains a key component of the U.S. economy, it has declined in relative
importance since the late 1960s. From 1970 to 1995 the number of employees in
manufacturing declined slightly from 20.7 million to 20.5 million, while the
total U.S. labor force grew by more than 46.2 million people.
One of the most important changes in the pattern of U.S. industry in recent
decades has been the growth of manufacturing in regions outside the Northeast
and North Central regions. The nation’s industrial core first developed in
the Northeast. This area still has the greatest number of industrial firms,
but its share of these firms is smaller than in the past. In 1947 about 75
percent of the nation’s manufacturing employees lived in the 21 Northeast and
Midwest states that extend from New England to Kansas. By the early 1990s,
however, only about one-half of manufacturing employees resided in the same
region. Since 1947, the South’s share of the nation’s manufacturing workers
increased from 19 to 32 percent, and the West’s share grew from 7 to 18
In the North, manufacturing is centered in the Middle Atlantic and East North
Central states, which accounted for 38 percent of the value added by all
manufacturing in the United States in 1996. Located in this area are five of
the top seven manufacturing statesa—New York, Ohio, Illinois, Pennsylvania,
and Michigan—which together were responsible for approximately 27 percent of
the value added by manufacturing in all states. Important products in this
region include motor vehicles, fabricated metal products, and industrial
equipment. New York, New Jersey, and Pennsylvania specialize in the
production of machinery and chemicals. This area bore the brunt of the
decline in manufacturing’s value of national output, losing a total of
800,000 jobs from the early 1980s to the early 1990s.
In the South the greatest gains in manufacturing have been in Texas. The most
phenomenal growth in the West has been in California, which in the late 1990s
was the leading manufacturing state, accounting for more than one-tenth of
the annual value added by U.S. manufacturing. California dominates the
Pacific region, which specializes in the production of transportation
equipment, food products, and electrical and electronic equipment.
B1a International Manufacturing
United States industry has become much more international in recent years.
Most major industries are multinational, which means that they not only
market products in foreign countries but maintain production facilities and
administrative headquarters in other nations. In the late 1990s, giant U.S.
corporations began a wave of international partnerships, with U.S. companies
sometimes merging with foreign companies.
Beginning in the early 1980s, U.S. companies increasingly produced component
parts and even finished goods in foreign countries. The practice of a company
sending work to outside factories to reduce production costs is called
outsourcing. Foreign outsourcing sends production to countries where labor
costs are lower than in the United States. One of the first methods of foreign
outsourcing was the maquiladora (Spanish for “mill”) in Mexican border
towns. Manufacturers built twin plants, one on the Mexican side and one on the
United States side. Companies in the United States sent partially manufactured
products into Mexico where labor-intensive plants finished the product and sent
it back to the United States for sale. Outsourcing to Mexico became more
widespread after the North American Free Trade Agreement went into effect in
1994. Firms in the United States also outsource to many other nations,
including South Korea, Indonesia, Malaysia, Jamaica, and the Philippines.
In the 1990s, few products were made entirely within the United States.
Although a product may be fabricated in the United States, some component
parts may have been produced in foreign countries. Despite outsourcing and
the international operations of multinational firms, the United States is
still a major producer of thousands of industrial items and has a comparative
advantage over most foreign countries in several industrial categories.
B1b Principal Products
Ranked by value added by manufacturing, in 1996 the leading categories of
U.S. manufactured goods were chemicals, industrial machinery, electronic
equipment, processed foods, and transportation equipment. The chemical
industry accounted for about 11.1 percent of the overall annual value added
by manufacturing. Texas and Louisiana are leaders in chemical manufacturing.
The petroleum and natural gas produced and refined in both states are basic
raw materials used in manufacturing many chemical products.
Industrial machinery accounted for 10.7 percent of the yearly value added by
manufacture. Industrial machinery includes engines, farm equipment, various
kinds of construction machinery, computers, and refrigeration equipment.
California led all states in the annual value added by industrial machinery,
followed by Illinois, Ohio, and Michigan.
Factories in the United States build millions of computers, and the United
States occupies second place in the world in the production of electronic
components (semiconductors, microprocessors, and computer equipment).
Electronic equipment accounted for 10.5 percent of the yearly value added by
manufacturing, and it was one of the fastest growing manufacturing sectors
during the 1990s; production of electronics and electric equipment increased
by 77 percent from 1987 to 1994. High-technology research and production
facilities have developed in the Silicon Valley of California, south of San
Francisco; the area surrounding Boston; the Research Triangle of Raleigh,
Chapel Hill, and Durham in North Carolina; and the area around Austin, Texas.
In addition, the United States has world leadership in the development and
production of computer software. Leading software producers are located in
areas around Seattle, Washington; Boston, Massachusetts; and San Francisco,
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
nation’s industrial core region. Iron ore from the Lake Superior district,
plus that imported from Canada and other countries, and Appalachian coal are
the basis for a large iron and steel industry. Pennsylvania, Ohio, Indiana,
Illinois, and Michigan are leading states in the value of primary metal
output. The fabricated metal industry, which includes the manufacture of cans
and other containers, hardware, and metal forgings and stampings, is
important in the same states. The primary metals industry of these states
provides the basic raw materials, especially steel, that are used in making
Printing and publishing is a widespread industry, with newspapers published
throughout the country. New York, with its book-publishing industry, is the
leading state, but California, Illinois, and Pennsylvania also have sizable
printing and publishing industries.
The manufacture of paper products is important in several states,
particularly those with large timber resources, especially softwood trees
used to make most paper. The manufacture of paper and paperboard contributes
significantly to the economies of Wisconsin, Alabama, Georgia, Washington,
New York, Maine, and Pennsylvania.
Other major U.S. manufactures include textiles, clothing, precision
instruments, lumber, furniture, tobacco products, leather goods, and stone,
clay, and glass items.
B2 Energy Production
The energy to power the nation's economy—to provide fuels for its vehicles
and furnaces and electricity for its machinery and appliances—is derived
primarily from petroleum, natural gas, and coal. Measured in terms of heat-
producing capacity (British thermal units, or Btu), petroleum provides 39
percent of the total energy consumed in the United States. It supplies nearly
all of the energy used to power the nation’s transportation system and heats
millions of houses and factories.
Natural gas is the source of 24 percent of the energy consumed. Many
industrial plants use natural gas for heat and power, and several million
households burn it for heating and cooking. Coal provides 22 percent of the
energy consumed. Its major uses are in the generation of electricity, which
uses more than three-fourths of all the coal consumed, and in the manufacture
Waterpower generates 4 to 5 percent of the nation’s energy, and nuclear power
supplies about 10 percent. Both are employed mainly to produce electricity
for residential and industrial use. Nuclear energy has been viewed as an
important alternative to expensive petroleum and natural gas, but its
development has proceeded somewhat more slowly than originally anticipated.
People are reluctant to live near nuclear plants for fear of a radiation-
releasing accident. Another obstacle to the expansion of nuclear power use is
that it is very expensive to dispose of radioactive material used to power
the plants. These nuclear fuel materials remain radioactive for thousands of
years and pose health risks if they are not properly contained.
Some 33 percent of the energy consumed in the United States is used in the
generation of electricity. In 1999 the nation’s generating plants had a total
installed capacity of 728,259 megawatts and produced 3.62 trillion kilowatt-
hours of electricity. Coal is the most common fuel used by electric power
plants, and 57 percent of the nation’s yearly electricity is generated in
coal-fired plants. The states producing the most coal-generated electricity
are Ohio, Texas, Indiana, Pennsylvania, Illinois, West Virginia, Kentucky,
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
In 1970 domestic crude-oil production reached a record high of 3.5 billion
barrels, but this had to be supplemented by imports amounting to 12 percent
of the nation’s overall crude oil supply. Most Americans were unaware of the
dependence of the country on foreign petroleum until an oil embargo imposed
by some Middle Eastern nations in 1973 and 1974 led to government price
ceilings for gasoline and other energy products, which in turn led to
shortages. In 1973 the nation imported about one-fourth of its total supply
of crude oil. Imports continued to rise until 1977, when about half of the
crude and refined oil supply was imported. Imports then declined for a time,
largely because energy-conservation measures were introduced and because
other domestic energy sources such as coal were used increasingly. As of
1997, however, 47 percent of the crude oil needs of the United States were
met by net imports. Energy Supply, World.
The United States consumes 25 percent of the world’s energy, far more than
any other country, despite having less than 5 percent of the world’s
population. The United States also produces a disproportionate share of the
world’s total output of goods and services, which is the main reason the
nation consumes so much energy. In addition, the U.S. population is spread
over a larger area than are the populations in many other industrialized
nations, such as Japan and the countries of Western Europe. This lower
population density in the United States results in a greater consumption of
energy for transportation, as truck, trains, and planes are needed to move
goods and people to the far-flung American citizenry.
As a result of the nation’s high energy consumption, the United States
accounts for nearly 20 percent of the global emissions of greenhouse gases.
These gases—carbon dioxide, methane, and oxides of nitrogen—result from the
burning of fossil fuels, and they can have a harmful effect on the
environment. C Service and Commerce Sector
By far the largest sector of the economy in terms of output and employment is
the service and commerce sector. This sector grew rapidly during the last
part of the 20th century, creating many new jobs and more than offsetting the
slight loss of jobs in manufacturing industries. In 1998 commerce and service
industries generated 72 percent of the GDP and employed 75 percent of the
U.S. workforce. Most of these jobs are classified as white collar, and many
require advanced education. They include many high-paying jobs in financing,
banking, education, and health services, as well as lower-paying positions
that require little educational background, such as retail store clerks,
janitors, and fast-food restaurant workers.
C1 Service Industries The service sector is extremely diverse. It
includes an assortment of private businesses and government agencies that
provide a wide spectrum of services to the U.S. public. Services industries
can be very different from each other, ranging from health-care providers to
vacation resorts to automobile repair shops. Although it would be almost
impossible to list every kind of service industry operating in the United
States, many of these businesses fall into one of several large service
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 visitors—chiefly from western Europe, Japan, Latin
America, and the Caribbean—was 48 million. Millions of visitors from Canada
and Mexico also cross the border every year. Estimated annual expenditures in
the United States by Canadian travelers totaled $6 billion, and spending by
Mexicans was $5 billion.
America’s historic sites and national parks draw many visitors. In 1998, 287
million visits were made to the more than 350 areas administered by the
National Park Service. Millions of people each year visit the national
monuments, buildings, and museums in the Washington, D.C., area. More than 14
million visits are made annually to Golden Gate National Recreation Area in
the San Francisco region. More than 19 million people per year travel on the
Blue Ridge Parkway in North Carolina and Virginia, and about 6 million visit
the Natchez Trace Parkway in Mississippi, Alabama, and Tennessee. Located
within a day’s drive from most parts of the eastern United States, Great
Smoky Mountains National Park is the most popular national park in the United
States, receiving nearly 10 million visitors annually.
Transportation-related businesses are an important part of the service
industry. Trucks, railroads, and ships transport goods to markets across the
country. Commercial airlines, railroads, bus companies, and taxis move
tourists and commuters to their destinations. The U.S. Postal Service and a
number of private carriers deliver goods as well as mail to consumers. The
U.S. transportation network spreads into all sections of the country, but the
web of railroads and highways is much denser in the eastern half of the
United States, where it serves the nation’s largest urban, industrial, and
As of 1996 the 10 largest railroad companies in the United States operated 72
percent of tracks. Takeovers and mergers among the major private railroad
companies were common during the 1980s and 1990s. Amtrak (the National
Railroad Passenger Corporation), a federally subsidized organization,
operates almost all the intercity passenger trains in the United States. It
carried 20.2 million passengers in 1997. Although rail passenger travel has
declined in importance during the 20th century, some U.S. cities still
maintain extensive subways or commuter railways, including New York City,
Washington, D.C., Chicago, and the San Francisco-Oakland area of California.
During the early decades of the 20th century, motor vehicle transport
developed as a serious competitor of the railroads, both for passengers and
freight. Federal aid to states for highway construction began with the
passage of the Federal-Aid Road Act of 1916.
The federal aid program was greatly expanded in 1956 when the government
began an ambitious expansion of the Interstate Highway System, a 74,165-km
(46,084-mi) network of limited-access highways that connects the nation’s
principal cities. This carefully designed system enables motorists to drive
across the country without encountering an intersection or traffic signal. It
carries about 20 percent of U.S. motor-vehicle traffic, though it accounts
for just over 1 percent of U.S. roads and streets. The system is designed for
safe, efficient driving, with gentle curves, easy grades and long sight
distances. Entering and exiting the highway system is permitted only at
Air transport began to compete with other modes of transport in the United
States after World War I (1914-1918). The first commercial flights in the
United States were made in 1918 and carried small amounts of mail. Passenger
service began to gain importance in the late 1920s, but air transport did not
become a leading mode of travel until the advent of commercial jet craft
after World War II. By the 1990s a growing number of Americans flew for
personal and business travel, in part because of the need to cover long
distances and in part because they like to get to their destinations quickly.
In 1997 airlines in the United States carried 598.1 million passengers, the
vast majority of whom were domestic travelers.
By the end of the 20th century, large and small airports across the nation
formed a network providing air transportation to individual travelers. The
nation had 5,129 public and 13,263 private airports in 1996. The largest
airports in the United States by passenger arrivals and departures are
William B. Hartsfield International Airport near Atlanta, Georgia; Chicago-
O’Hare International Airport in Illinois; Dallas-Fort Worth Airport in Texas;
and Los Angeles International Airport in California.
The United States has a relatively small commercial shipping fleet. In 1998
only 473 vessels of 1,000 gross tons and larger were registered in the United
States. Only 56 percent were in use; most of the remainder formed part of a
government-owned military reserve fleet. However, many American ship owners
register their vessels in foreign countries such as Liberia and Panama, where
crew wages, taxes, and operating costs are lower.
In terms of the number of ships docking, New Orleans, Louisiana, is the
busiest port in the nation; each year it handles more than 6,000 vessels.
Other leading ports include Los Angeles-Long Beach, California; Houston,
Texas; New York, New York; San Francisco-Oakland, California; Miami, Florida;
and Philadelphia, Pennsylvania. Crude petroleum accounts for 22 percent of
the waterborne tonnage of the United States. Petroleum products make up 18
percent. Coal accounts for 14 percent, and farm products for 14 percent.
The inland waterway network of the United States has three main
components—the Mississippi River system, the Great Lakes, and the coastal
waterways. Some 66 percent of the annual water freight traffic is on the
Mississippi River and its tributaries, 17 percent is on the Great Lakes, and
most of the remainder is on the coastal waterways. A major thoroughfare of
the coastal waterways is the Intracoastal Waterway, a navigable, toll-free
shipping route extending for about 1,740 km (about 1,080 mi) along the
Atlantic Coast and for about 1,770 km (about 1,100 mi) along the Gulf of
Mexico coast. About 45 percent of the total annual traffic on all coastal
waterways travels on the Gulf Intracoastal Waterway, about 30 percent is on
the Atlantic Intracoastal Waterway, and about 25 percent is on Pacific Coast
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
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.
Another leading industry is the entertainment business. Motion picture
production has been centered in Hollywood, California, since the early
decades of the 20th century, when the budding motion picture industry
discovered that the warm climate and sunny skies of southern California
provided ideal conditions for film production. Other entertainment industries
include theater, which tends to be located in larger urban areas,
particularly New York City, and television, with major networks operating out
of the New York City area. .
C2 Commerce The 1990s have been years of unrivaled prosperity in
the United States, with per capita GDP reaching $30,450 by 1998. This high
quality of life results partly from a rapid expansion of commerce in the
years following World War II.
C2a Domestic Trade
Convenience is the key to consumer markets in the United States, whether it
is fast food, movie theaters, clothing, or any of hundreds of different types
of consumer goods. Products are being delivered to citizens in a more
efficient manner, as industries and business firms have decentralized to more
closely fit the distribution of population. Malls have sprung up in suburban
areas, making the downtown department store obsolete in many smaller cities.
Manufacturers also market their goods directly to customers in factory outlet
malls. Prices are often lower in these outlets than in regular retail stores.
Customers often travel hundreds of miles to shop at larger factory outlet
malls. At the other end of the spectrum, mail order catalogs and Internet
sites have made it possible for many consumers to purchase products directly
from companies by mail or using personal computers.
Wholesalers and retailers carry on most domestic commerce, or trade, in the
United States. Wholesalers buy goods from producers and sell them mainly to
retail business firms. Retailers sell goods to the final consumer. Wholesale
and retail trade together account for 16 percent of annual GDP of the United
States and employ 21 percent of the labor force.
Wholesale establishments conducted aggregate annual sales of $3.2 trillion in
1992. The leading type of wholesale business is the distribution of groceries
and related products, which accounts for 16 percent of all wholesale
activity. Next in rank are motor-vehicle parts and supplies; petroleum and
petroleum products; professional and commercial equipment, and machinery,
equipment, and supplies. Wholesalers tend to be located in large urban
centers that enable them to distribute goods over wide sections of the
nation. The New York City metropolitan area is the country’s leading
wholesale center. It serves as the national distribution center for a variety
of goods and as the main regional center for the eastern United States. Other
leading wholesale centers include Los Angeles, the main center for the
western part of the United States; Chicago; San Francisco; Philadelphia;
Houston; Dallas; and Atlanta.
In the mid-1990s retail establishments in the United States had aggregate
annual sales of $2.2 trillion. Automotive dealers, with 23 percent of the
total yearly retail trade, and food stores, with 18 percent, are the leading
retailers. The volume of retail sales is directly related to the number of
consumers in an area. The four leading states in annual retail
sales—California, Texas, Florida, and New York—are also the four most
C2b Foreign Trade
The United States is the world’s leading trading nation, with total
merchandise exports amounting to $683 billion, and imports to $944.6 billion.
Despite its massive size, large population, and economic prosperity, the
United States economy can provide a higher quality of life for consumers and
more opportunity for businesses by trading with other nations. Foreign, or
international, trade enables the United States to specialize in producing
those goods that it is best suited to make given its available resources. It
then imports products that other nations can make more efficiently, lowering
prices of these goods for U.S. consumers.
Nonagricultural products usually account for 90 percent of the yearly value
of exports, and agricultural products account for about 10 percent. Machinery
and transportation equipment make up the leading categories of exports,
amounting together to one-third of the value of all exports. Other leading
exports include electrical equipment, chemicals, precision instruments, and
food products. Beginning in the mid-1970s, the nation’s imports of petroleum
from the Middle East and manufactured goods from Canada and Asia (especially
Japan) created a trade imbalance.
D Information and Technology Sector
By the end of the 20th century, many technological innovations had been
introduced in the United States. Communications satellites orbited the earth,
computers performed day-to-day functions in many businesses, and the Internet
provided instant information on most aspects of U.S. life via computer.
Developments in communications and technology have transformed many aspects
of daily life in the United States, from improvements in kitchen appliances
to advances in medical treatment to television broadcasts that are
transmitted live via satellite from around the world.
An increasing number of job opportunities are opening in fields related to
the research and application of new technology. Entirely new industries have
emerged, such as companies that build the equipment used in space
explorations. In addition, technology has opened new opportunities for
investment and employment in established industries, such as those that
manufacture medicines and machines used in the detection and treatment of
diseases and individuals who market and sell products via the Internet.
The communications systems in the United States are among the most developed
in the world. Television, radio, newspapers, and other publications, provide
most of the country’s news and entertainment. On average there are two radios
and one television set for every person in the United States. Although the
economic output of the communications industry is relatively small, the
industry has enormous importance to the political, social, and intellectual
activity of the nation. Most communication media in the United States are
privately owned and operate independently of government control.
The Federal Communications Commission must license all radio and television
broadcasting stations in the United States. In 1997, 1,285 television
broadcasters were in operation. All states had television stations, and more
than 40 percent of the stations were concentrated in nine states: Texas,
California, Florida, New York, Pennsylvania, Ohio, Illinois, Michigan, and
North Carolina. A rapidly growing number of U.S. households (estimated at 64
million in 1997) subscribed to cable television. An estimated 98.3 percent of
U.S. households had at least one television set. Telephone communication
changed as cellular phones allowed people to communicate via telephone while
away from their homes and businesses or while traveling. There were 69
million cellular phones in use in 1998.
There were 1,489 daily newspapers published in the United States in 1998, 8
fewer than the year before. Daily newspapers had a circulation of approximately
60.1 million copies in 1998. The top daily newspapers in the United States
according to circulation were the Wall Street Journal (published in New
York City), USA Today (published in Arlington, Virginia), the New
York Times, and the Los Angeles Times, each with a circulation in
excess of 1 million. Other leading newspapers included the Washington Post
, the New York Daily News, the Chicago Tribune, the Detroit
Free Press, the San Francisco Chronicle, the Chicago Sun-Times
, the Dallas Morning News, the Boston Globe, and the
Nearly 21,300 periodicals were published in 1997. These ranged from specialized
journals reaching only a small number of professionals to major newsmagazines
such as Time, with a circulation of 4.1 million a week, and
Newsweek, with a circulation of 3.2 million a week. Other mass publications
with vast audiences included the weekly TV Guide, reaching 13.2 million
readers, and the monthly Reader’s Digest, with a circulation of 15.1
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.