INTRODUCTION OF UNITED STATES ECONOMY
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 and continuing into the 21st 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.
This article consists of ten major sections. The first section of this article discusses how individual people, business and labor organizations, and social institutions make up the U.S. economic system. Next, the article discusses the production of goods and services. The third section describes the different types of businesses that operate in the United States, such as proprietorships, partnerships, and corporations. It also discusses how entrepreneurs acquire and organize the funding and resources needed to run a business.
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.
This is one of seven major articles that together provide a comprehensive discussion of the United States of America. For more information on the United States, please see the other six major articles: United States (Overview), United States (Geography), United States (People), United States (Culture), United States (Government), and United States (History).
U.S. ECONOMIC SYSTEM
An economic system refers to the laws and institutions in a nation that determine who owns economic resources, how people buy and sell those resources, and how the production process makes use of resources in providing goods and services. The U.S. economy is made up of individual people, business and labor organizations, and social institutions. People have many different economic roles—they function as consumers, workers, savers, and investors. In the United States, people also vote on public policies and for the political leaders who set policies that have major economic effects. Some of the most important organizations in the U.S. economy are businesses that produce and distribute goods and services to consumers. Labor unions, which represent some workers in collective bargaining with employers, are another important kind of economic organization. So, too, are cooperatives—organizations formed by producers or consumers who band together to share resources—as well as a wide range of nonprofit organizations, including many charities and educational organizations, that provide services to families or groups with special problems or interests.
For the most part, the United States has a market economy in which individual producers and consumers determine the kinds of goods and services produced and the prices of those products. The most basic economic institution in market economies is the system of markets in which goods and services are bought and sold. That is where consumers buy most of the food, clothing, and shelter they use, and any number of things that they simply want to have or that they enjoy doing. Private businesses make and sell most of those goods and services. These markets work by bringing together buyers and sellers who establish market prices and output levels for thousands of different goods and services.
A guiding principle of the U.S. economy, dating back to the colonial period, has been that individuals own the goods and services they make for themselves or purchase to consume. Individuals and private businesses also control the factors of production. They own buildings and equipment, and are free to hire workers, and acquire things that businesses use to produce goods and services. Individuals also own the businesses that are established in the United States. In other economic systems, some or all of the factors of production are owned communally or by the government.
For the most part, U.S. producers decide which goods and services to make and offer to sell, and what prices to charge for those products. Goods are tangible things—things you can touch—that satisfy wants. Examples of goods are cars, clothing, food, and toys. Services are activities that people do for themselves or for other people to satisfy their wants. Examples of services are cutting hair, polishing shoes, teaching school, and providing police or fire protection.
Producers decide which goods and services to make and sell, and how much to ask for those products. At the same time, consumers decide what they will purchase and how much money they are willing to pay for different goods and services. The interaction between competing producers, who attempt to make the highest possible profit, and consumers, who try to pay as little as possible to acquire what they want, ultimately determines the price of goods and services.
In a market economy, government plays a limited role in economic decision making. However, the United States does not have a pure market economy, and the government plays an important role in the national economy. It provides services and goods that the market cannot provide effectively, such as national defense, assistance programs for low-income families, and interstate highways and airports. The government also provides incentives to encourage the production and consumption of certain types of products, and discourage the production and consumption of others. It sets general guidelines for doing business and makes policy decisions that affect the economy as a whole. The government also establishes safety guidelines that regulate consumer products, working conditions, and environmental protection.
Factors of Production
The factors of production, which in the United States are controlled by individuals, fall into four major categories: natural resources, labor, capital, and entrepreneurship.
Natural Resources
Natural resources, which come directly from the land, air, and sea, can satisfy people’s wants directly (for example, beautiful mountain scenery or a clear lake used for fishing and swimming), or they can be used to produce goods and services that satisfy wants (such as a forest used to make lumber and furniture).
The United States has many natural resources. They include vast areas of fertile land for growing crops, extensive coastlines with many natural harbors, and several large navigable rivers and lakes on which large ships and barges carry products to and from most regions of the nation. The United States has a generally moderate climate, and an incredible diversity of landscapes, plants, and wildlife.
Labor
Labor refers to the routine work that people do in their jobs, whether it is performing manual labor, managing employees, or providing skilled professional services. Manual labor usually refers to physical work that requires little formal education or training, such as shoveling dirt or moving furniture. Managers include those who supervise other workers. Examples of skilled professionals include doctors, lawyers, and dentists.
Of the 295 million people living in the United States in 2005, more than 150 million adults were working full-time or part-time jobs. This is the nation’s labor force, which includes those who work for wages and salaries and those who file government tax forms for income earned through self-employment. It does not include homemakers or others who perform unpaid labor in the home, such as raising, caring for, and educating children; preparing meals and maintaining the home; and caring for family members who are ill. Nor, of course, does it count those who do not report income to avoid paying taxes, in some cases because their work involves illegal activities.
Capital
Capital includes buildings, equipment, and other intermediate products that businesses use to make other goods or services. For example, an automobile company builds factories and buys machines to stamp out parts for cars; those buildings and machines are capital. Roughly half of the capital goods used by private businesses is equipment and the other half buildings or other structures. Businesses have additional capital investments in their inventories of finished products, raw materials, and partially completed goods.
Entrepreneurship
Entrepreneurship is an ability some people have to accept risks and combine factors of production in order to produce goods and services. Entrepreneurs organize the various components necessary to operate a business. They raise the necessary financial backing, acquire a physical site for the business, assemble a team of workers, and manage the overall operation of the enterprise. They accept the risk of losing the money they spend on the business in the hope that eventually they will earn a profit. If the business is successful, they receive all or some share of the profits. If the business fails, they bear some or all of the losses.
Many people mistakenly believe that anyone who manages a large company is an entrepreneur. However, many managers at large companies simply carry out decisions made by higher-ranking executives. These managers are not entrepreneurs because they do not have final control over the company and they do not make decisions that involve risking the companies resources. On the other hand, many of the nation’s entrepreneurs run small businesses, including restaurants, convenience stores, and farms. These individuals are true entrepreneurs, because entrepreneurship involves not merely the organization and management of a business, but also an individual’s willingness to accept risks in order to make a profit.
Throughout its history, the United States has had many notable entrepreneurs, including 18th-century statesman, inventor, and publisher Benjamin Franklin, and early-20th-century figures such as inventor Thomas Edison and automobile producer Henry Ford. More recently, internationally recognized leaders have emerged in a number of fields: Bill Gates of Microsoft Corporation and Steve Jobs of Apple Inc. 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; and Ray Kroc of McDonald’s, Harland Sanders of Kentucky Fried Chicken (KFC), and Dave Thomas of Wendy’s in fast food.
Acquiring the Factors of Production
All four factors of production—natural resources, labor, capital, and entrepreneurship—are traded in markets where businesses buy these inputs or productive resources from individuals. These are called factor markets. Unlike a grocery market, which is a specific physical store where consumers purchase goods, the markets mentioned above comprise a wide range of locations, businesses, and individuals involved in the exchange of the goods and services needed to run a business.
Businesses turn to the factor markets to acquire the means to make goods and services, which they then try to sell to consumers in product or output markets. For example, an agricultural firm that grows and sells wheat can buy or rent land from landowners. The firm may shop for this natural resource by consulting real estate agents and farmers throughout the Midwest. This same firm may also hire many kinds of workers. It may find some of its newly hired workers by recruiting recent graduates of high schools, colleges, or technical schools. But its market for labor may also include older workers who have decided to move to a new area, or to find a new job and employer where they currently live.
Firms often buy new factories and machines from other firms that specialize in making these kinds of capital goods. That kind of investment often requires millions of dollars, which is usually financed by loans from banks or other financial institutions.
Entrepreneurship is perhaps the most difficult resource for a firm to acquire, but there are many examples of even the largest and most well-established firms seeking out new presidents and chief executive officers to lead their companies. Small firms that are just beginning to do business often succeed or fail based on the entrepreneurial skills of the people running the business, who in many cases have little or no previous experience as entrepreneurs.
Markets and the Problem of Scarcity
A basic principle in every economic system—even one as large and wealthy as the U.S. economy—is that few, if any, individuals ever satisfy all of their wants for goods and services. That means that when people buy goods and services in different markets, they will not be able to buy all of the things they would like to have. In fact, if everyone did have all of the things they wanted, there would be no reason for anyone to worry about economic problems. But no nation has ever been able to provide all of the goods and services that its citizens wanted, and that is true of the U.S. economy as much as any other.
Scarcity is also the reason why making good economic choices is so important, because even though it is not possible to satisfy everyone’s wants, all people are able to satisfy some of their wants. Similarly, every nation is able to provide some of the things its citizens want. So the basic problem facing any nation’s economy is how to make sure that the resources available to the people in the nation are used to satisfy as many as possible of the wants people care about most.
The U.S. economy, with its system of private ownership, has an extensive set of markets for final products and for the factors of production. The economy has been particularly successful in providing material goods and services to most of its citizens. That is even more striking when results in the U.S. economy are compared with those of other nations and economic systems. Nevertheless, most U.S. consumers say they would like to be able to buy and use more goods and services than they have today. And some U.S. citizens are calling for significant changes in how the economic system works, or at least in how the purchasing power and the goods and services in the system are divided up among different individuals and families.
Not surprisingly, low-income families would like to receive more income, and often favor higher taxes on upper-income households. But many upper-income families complain that government already taxes them too much, and some argue that government is taking over too many things in the economy that were, in the past, left up to individuals, families, and private firms or charities.
These debates take place because of the problem of scarcity. For individuals and governments, resources that satisfy a particular want cannot be used to satisfy other wants. Therefore, deciding to satisfy one want means paying the cost of not satisfying another. Such choices take place every time the government decides how to spend its tax revenues.
What Are Markets?
Goods and services are traded in markets. Usually a market is a physical place where buyers and sellers meet to make exchanges, once they have agreed on a price for the product. One kind of marketplace is a grocery store, where people go to buy food and household products. However, many markets are not confined to specific locations. In a broader sense, markets include all the places and sources where goods and services are exchanged. For example, the labor market does not exist in a specific physical building, as does a grocery market. Instead, the term labor market describes a multitude of individuals offering their labor for sale as well as all the businesses searching for employees.
Traders do not always have to meet in person to buy and sell. Markets can operate via technology, such as a telephone line or a computer site. For example, stocks and other financial securities have long been traded electronically or by telephone. It is becoming increasingly common in the United States for many other kinds of goods and services to be sold this way. For instance, many people today use the Internet—the worldwide computer-based network of information systems—to buy airline tickets, make hotel reservations, and rent a car for their vacation. Other people buy and sell items ranging from books, clothing, and airline tickets to baseball cards and other rare collectibles over the Internet. Although these Internet buyers and sellers may never meet face to face the way buyers and sellers do in more traditional markets, these markets share certain basic features.
How a Single Market Works
Buyers hope to buy at low prices and will purchase more units of a product at lower prices than they do at higher prices. Sellers are just the opposite. They hope to sell at high prices, and typically they will be willing to produce and sell more units of a product at higher prices than at lower prices.
The price for a product is determined in the market if prices are allowed to rise and fall, and are not legally required to be above some minimum price floor or below some maximum price ceiling. When a product, for example, a personal computer, reaches the market, consumers learn what producers want to charge for it and producers learn what consumers are willing to pay. The interaction of producers and consumers quickly establishes what the market price for the computer will actually be. Some people who were considering buying a computer decide that the price is higher than they are willing to pay. And some producers may determine that consumers are not willing to pay a price high enough for them profitably to produce and sell this computer.
But all of the buyers who are willing and able to pay the market price get the computer, and all of the sellers willing and able to produce it for this price find buyers. If more consumers want to buy a computer at a specific market price than there are suppliers are willing to sell at that price—or in other words, if the quantity demanded is greater than the quantity supplied—the price for the computer increases. When producers try to sell more of their computers at a price higher than consumers are willing to buy, the quantity supplied exceeds the quantity demanded and the price falls.
The price stops rising or falling at the price where the amount consumers are willing and able to buy is just equal to the amount sellers are willing and able to produce and sell. This is called the market clearing price. Market clearing prices for many goods and services change frequently, for reasons that will be discussed below. But some market prices are stable for long periods of time, such as the prices of candy bars and sodas sold in vending machines, and the prices of pizzas and hamburgers. Most buyers of these products have come to know the general price they will have to pay for these items. Sellers know what prices they can charge, given what consumers will pay and considering the competition they face from other sellers of identical, or very similar, products.
A System of Markets for All Goods and Services
How markets determine price is simple enough to understand for a single good or service in a single location. But consider what happens when there are markets for nearly all of the goods and services produced and consumed in an economy, across the entire country. In that context, this reasonably simple process of setting market prices allows an economic system as large and complex as the U.S. economy to operate with great efficiency and a high degree of freedom for consumers and producers.
Efficiency here means producing what consumers want to buy, at prices that are as low as they can be for producers to stay in business. And it turns out this efficiency is directly linked to the freedom that buyers and sellers have in a market economy. No central authority has to decide how many shirts or cars or sandwiches to produce each day, or where to produce them, or what price to charge for them. Instead, consumers spend their money for the products that give them the most satisfaction, and they try to find the best deal they can in terms of price, quality, convenience, assurances that defective products will be replaced or repaired, or other considerations.
What consumers are willing and able to buy tells producers what they should produce, if they hope to make a profit. Usually consumers have many options to choose from, because more than one producer offers the same or reasonably similar products (such as two or more kinds of cars, colas, and carpets). Producers then compete energetically for the dollars that consumers spend.
Competition among producers determines the best ways to produce a good or service. For example, in the early 1900s automobiles were made largely by hand, one at a time. But once Henry Ford discovered how to lower the cost of producing cars by using assembly lines, other car makers had to adopt the same production methods or be driven out of business (as many were).
Competition also determines what features and quality standards go into products. And competition holds down the costs of production because producers know that consumers compare their prices to the prices charged by other firms and for other products they might buy. In markets where a large number of producers compete, inefficient producers will be driven out of the market.
For example, at one time most towns and cities had independently owned cafes and drive-in restaurants that sold hamburgers, French fries, and soft drinks. Some of these businesses are still operating, but many closed down after larger fast-food chains began opening local franchises all around the nation, with well-known product standards and relatively low prices. The increased competition led to prices that were too low for many of the old cafes and drive-ins to make a profit. The private cafes that did survive were able to meet that level of efficiency, or they managed to make their products different enough from the national chains to keep their customers.
Prices for goods and services can only fall so far, however. Even the most efficient producers have to pay for the natural resources, labor, capital, and entrepreneurship they use to make and sell products. The market price cannot stay below the level of those costs for long without driving all of the producers out of this market. Therefore, if consumers want to buy some good or service not just today but also in the future, they have to pay a price at least high enough to cover the costs of producing it, including enough profit to make it worthwhile for sellers to stay in that market.
Once market prices for various goods and services are set, consumers are free to choose what to buy, and producers are free to choose what to produce and sell. They both follow their self-interest and do what makes them as well off as they can be. When all buyers and sellers do that in an economic system of competitive markets, the overall economy will also be very efficient and responsive to individual preferences.
This economic process is extremely decentralized. For example, it is likely that no one person or government agency knows how many corned beef sandwiches are sold in any large U.S. city on any given day. Individual sellers decide how many sandwiches they are likely to sell and arrange to have enough meat and bread available to meet the demand from their customers.
Consumers usually do not make up their mind about what to eat for lunch or dinner until they walk into the restaurant, grocery store, or sandwich shop. But they know they can go to several different places and choose many different things to eat and drink, while individual sellers know about how much they are likely to sell on an average business day.
Other businesses sell bread and meat and drinks to the restaurants and grocers, but they do not really know how many different sandwiches the different food stores are selling either. They only know how much bread and meat they need to have on hand to satisfy the orders they get from their customers.
Each buyer and seller knows his or her small part of the market very well and makes choices carefully to avoid wasting money and other resources. When everyone acts this carefully while facing competition from other consumers or producers, the overall system uses its scarce resources very efficiently. Efficiency implies two things here: taking into account the preferences and alternative choices that individual buyers and sellers face, and producing goods and services at the lowest possible cost.
How and Why Market Prices Change
Another advantage of any competitive market system is a high level of flexibility and speed in responding to changing economic conditions. In economies where government agencies and central planners set prices, it often takes much longer to adjust prices to new conditions. The U.S. market economy makes these adjustments very quickly, even compared with other market economies in Europe, Canada, and Japan.
Market prices change whenever something causes a change in demand (the amount people are willing to buy at different prices) or a change in supply (the amount producers are willing and able to make and sell at different prices) (see Supply and Demand). Because these changes can occur rapidly, with little or no advance warning, it is important for both consumers and producers to understand what can cause prices to rise and fall. Those who anticipate price changes correctly can often gain financially from their foresight. Those who do not understand why prices have changed are likely to feel bewildered and frustrated, and find it more difficult to know how to respond to changing prices. Market economies are, in fact, sometimes called price systems. It is important to understand why prices rise and fall to understand how a market system works.
Changes in Demand
Demand for most products changes whenever there is a significant change in the level of consumers’ income. In the United States, incomes have risen substantially over the past 200 years. As that happened, the demand for most goods and services also increased. There are, however, a few products that people buy less of as income rises. Examples of these inferior goods include low-quality foods and fabrics.
Demand for a product also changes when the price of a substitute product changes. For example, if the price for one brand of blue jeans sharply increases while other brands do not, many consumers will switch to the other brands, so the demand for those brands will increase. Conversely, if the price for beef drops, then many people will buy less pork and chicken.
Some products are complements rather than substitutes. Complements are products that are consumed together, for example cameras and film, or tennis balls and tennis rackets. When the price of a complementary good rises, the demand for a product falls. For example, if the price of cameras rises, the demand for film will fall. On the other hand, if the price of a complementary good falls, the demand for a product will rise. If the price of tennis rackets falls, for example, more people will buy rackets and the demand for tennis balls will increase.
Demand can also increase or decrease as a product goes in or out of style. When famous athletes or movie stars create a popular new look in clothing or tennis shoes, demand soars. When something goes out of style, it soon disappears from stores, and eventually from people’s closets, too.
If people expect the price of something to go up in the future, they start to buy more of the product now, which increases demand. If they believe the price is going to fall in the future, they wait to buy and hope they were right. Sometimes these choices involve very serious decisions and large amounts of money. For example, people who buy stocks on the stock market are hoping that prices will rise, while at least some of the people selling those stocks expect the prices to fall. But not all economic decisions are this serious. For example, in the 1970s there was a brief episode when toilet paper disappeared from the shelves of grocery stores, because people were afraid that there were going to be shortages and rising prices. It turns out that some of these unfounded fears were based on remarks made by a comedian on a late-night talk show.
The final factor that affects the demand for most goods and services is the number of consumers in the market for a product. In cities where population is rising rapidly, the demand for houses, food, clothing, and entertainment increases dramatically. In areas where population is falling—as it has in many small towns where farm populations are shrinking—demand for these goods and services falls.
Changes in Supply
The supply of most products is also affected by a number of factors. Most important is the cost of producing products. If the price of natural resources, labor, capital, or entrepreneurship rises, sellers will make less profit and will not be as motivated to produce as many units as they were before the cost of production increased. On the other hand, when production costs fall, the amount producers are willing and able to sell increases.
Technological change also affects supply. A new invention or discovery can allow producers to make something that could not be made before. It could also mean that producers can make more of a product using the same or fewer inputs. The most dramatic example of technological change in the U.S. economy over the past few decades has been in the computer industry. In the 1990s, laptop computers that people carried to and from work each day were more powerful and many times less expensive than computers that filled entire rooms just 20 to 30 years earlier.
Opportunities to make profits by producing different goods and services also affect the supply of any individual product. Because many producers are willing to move their resources to completely different markets, profits in one part of the economy can affect the supply of almost any other product. For example, if someone running a barbershop decided to sign a contract to provide and operate the machines that clean runways at a large airport, this would decrease the supply of haircutting services and increase the supply of runway sweeping services.
When suppliers believe the price of the good or service they provide is going to rise in the future, they often wait to sell their product, reducing the current supply of the product. On the other hand, if they believe that the price is going to fall in the future, they try to sell more today, increasing the current supply. We see this behavior by large and small sellers. Examples include individuals who are thinking about selling a house or car, corn and wheat farmers deciding whether to sell or store their crops, and corporations selling manufactured products or reserves of natural resources.
Finally, the number of sellers in a market can also affect the level of supply. Generally, markets with a larger number of sellers are more competitive and have a greater supply of the product to be sold than markets with fewer sellers. But in some cases, the technology of producing a product makes it more efficient to produce large quantities at just a few production sites, or perhaps even at just one. For example, it would not make sense to have two or more water and sewage companies running pipes to every house and business in a city. And automobiles can be produced at a much lower cost in large plants than in small ones, because large plants can take greater advantage of assembly-line production methods.
All these different factors can lead to changes in what consumers demand and what producers supply. As a result, on any given day prices for some things will be rising and those for others will be falling. This creates opportunities for some individuals and firms, and problems for others. For example, firms producing goods for which the demand and the price are falling may have to lay off workers or even go out of business. But for the economy as a whole, allowing prices to rise and fall quickly in response to changes in any of the market forces that affect supply and demand offers important advantages. It provides an extremely flexible and decentralized system for getting goods and services produced and delivered to households while responding to a vast number of unpredictable changes.
Creative Destruction
Taking advantage of new opportunities while curtailing production of things that are no longer in demand or no longer competitive was described as the process of creative destruction by 20th century Austrian-American economist Joseph Schumpeter. For example, Schumpeter discussed how the United States, Britain, and other market economies helped many new businesses 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 were several examples of such events in the U.S. economy in the 1990s. Higher coffee prices occurred after poor harvests of coffee beans in South America, and U.S. banks lost large sums of money following financial and political crises in places such as Indonesia and Russia.
The ability to respond quickly to an increasingly volatile economic and political environment is, in many ways, one of the greatest strengths of the U.S. economic system. But these changes can result in hardships for some people or even some large segments of the economy. For example, importing clothing produced in other nations has benefited U.S. consumers by keeping clothing prices lower. In addition, it has been profitable for the firms that import and sell this clothing. However, it has also reduced the number of jobs available in clothing manufacturing for U.S. workers.
Many people think the most important general issue facing the U.S. economy today is how to balance the benefits of quickly adapting to changing economic conditions against the costs of abandoning the old ways. It is vital for the economy to adapt quickly to changing conditions and to focus on producing goods and services that will meet the most recent demands of the market place. However, when businesses close because their products no longer meet the demands of the market, it is important to make retraining or new jobs available to workers who lost their means of making a living.
PRODUCTION OF GOODS AND SERVICES
Before goods and services can be distributed to households and consumed, they must be produced by someone, or by some business or organization. In the United States and other market economies, privately owned firms produce most goods and services using a variety of techniques. One of the most important is specialization, in which different firms make different kinds of products and individual workers perform specific jobs within a company.
Successful firms earn profits for their owners, who accept the risk of losing money if the products the firms try to sell are not purchased by consumers at prices high enough to cover the costs of production. In the modern economy, most firms and workers have found that to be competitive with other firms and workers they must become very good at producing certain kinds of goods and services.
Most businesses in the United States also operate under one of three different legal forms: corporations, partnerships, or sole proprietorships. Each of these forms has certain advantages and disadvantages. Because of that, these three types of business organizations often operate in different kinds of markets. For example, most firms with large amounts of money invested in factories and equipment are organized as corporations.
Specialization and the Division of Labor
In earlier centuries, especially in frontier areas, families in the United States were much more self-sufficient, producing for themselves most of the goods and services they consumed. But as the U.S. population and economy grew, it became easier for people to buy more and more things in the marketplace. Once that happened, people faced a choice they still face today: In terms of time, money, and other things that they could do, is it less expensive to make something themselves or to let someone else produce it and buy it from them?
Over the years, most people and businesses realized that they could make better use of their time and resources by concentrating on one particular kind of work, rather than trying to produce for themselves all the items they want to consume. Most people now work in jobs where they do one kind of work; they are carpenters, bankers, cooks, mechanics, and so forth. Likewise, most businesses produce only certain kinds of goods or services, such as cars, tacos, or gardening services. This feature of production is known as specialization. A high degree of specialization is a key part of the economic system in the United States and all other industrialized economies. When businesses specialize, they focus on providing a particular product or type of product. For instance, some large companies produce only automobiles and trucks, or even special parts of cars and trucks, such as tires.
At almost all businesses, when goods and services are produced, labor is divided among workers, with different employees responsible for completing different tasks. This is known as division of labor. For example, the individual parts of cars and televisions are made by many different workers and then put together in an assembly line. Other well-known examples of this specialization and division of labor are seen in the production of computers and electrical appliances. But even kitchens in large restaurants have different chefs for different items, and professional workers such as doctors and dentists have also become more specialized during the past century.
Advantages of Specialization
By specializing in what they produce, workers become more expert at a particular part of the production process. As a result, they become more efficient in these jobs, which lowers the costs of production. Specialization also makes it possible to develop tools and machines that help workers do highly specialized tasks. Carpenters use many tools that plumbers and painters do not. Commercial bakeries have much larger ovens and mixers than those used by people who only bake bread and pies once a year. And unlike a household kitchen, a commercial bakery has machines to slice and package bread. All of these tools and machines help workers and businesses produce more efficiently, and lower the cost of producing goods and services.
The advantages of specialization have led to the creation of many very large production facilities in the United States and other industrialized nations. This trend is especially prevalent in the manufacturing sector. For example, many automobile factories produce thousands of cars each day, and some shipyards employ more than 10,000 workers. One open-pit mine in the western United States has dug a crater so large that it can be seen from space.
When the market for a product is very large, and a company can sell enough goods or services in that market to support a very large production facility, it will often choose to produce on a large scale to take advantage of specialization and division of labor. As long as producing more in larger facilities lowers the average costs of production, the producer enjoys what are known as economies of scale.
But bigger is not always better, and eventually almost all producers encounter diseconomies of scale in which larger plants or production sites become less efficient and more costly to operate. Usually that happens because monitoring and managing increasingly larger production facilities becomes more difficult. That is why most large manufacturers have more than one factory to make their products, instead of one massive facility where they make everything they produce. In recent years, many steel companies have found it more efficient to build and operate smaller steel mills than they once operated.
Specialization and International Trade
Over the past few decades, foreign trade has led to greater specialization and competition among producers in the United States and throughout the world. By selling worldwide, companies in the United States and in other countries can reach many more customers. Specialization is ultimately limited by the size of the market for a good or service. In other words, larger markets always allow for greater levels of specialization. For example, in small towns with few customers to serve, there is often only one clothing store that carries a small selection of many different kinds of clothing. In large cities with a million or more potential customers, there are much larger clothing stores with many more choices of items and styles, and even some stores that sell only hats, gloves, or some other particular kind of clothing.
International trade is a dramatic way of expanding the size of a firm’s market. In markets where transportation costs are low compared with the selling price of a product, it has become possible for producers to compete globally to take full advantage of highly specialized production. But international trade also means that businesses must compete more efficiently against firms from all around the world. That competition also makes them try to take advantage of greater specialization and the division of labor.
In many cases, products are produced and sold by firms from two or more countries that have large production and employment levels in the same industry. Often, however, these firms still specialize in the kinds of products they produce. For example, though many small cars and small pickup trucks are made in Japan and sent to the United States, large pickups and four-wheel drive sport utility vehicles are often exported from the United States to Japan and other nations. Similarly, the United States exports large commercial passenger jets to most countries, but imports many small jets from Canada, Brazil, and other nations. While this may seem strange at first glance, it allows greater specialization in production for particular kinds of products.
Transportation costs can also help 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 early 2000s only 17 percent worked in goods-producing industries, and 83 percent worked in service-producing industries. This change was driven by powerful market forces, including technological change and increased levels of world trade, competition, and income.
Some observers worried that this growth of employment in service-producing industries would result in declining living standards for most U.S. workers, but in fact most of this growth has occurred in industries where job skill requirements and wages have risen or at least remained high. That is less surprising when you consider that this employment includes business and repair services, entertainment and recreation occupations, and professional and related services (including health care, education, and legal services). United States consumers and families are, on average, financially better off today than they were 50 or 100 years ago, and they have more leisure time, which is one of the reasons why the demand for services has increased so rapidly.
During the 20th century, businesses and their workers had to adjust to many changes in the kinds of goods and services people demanded. These changes naturally led to changes in where jobs were available, and in what kinds of education, training, and skills employees were expected to have. As the base of employment in the United States has changed from predominantly agriculture to manufacturing to services, individuals, firms, and communities have faced often-difficult adjustments. Many workers lost jobs in traditional occupations and had to seek employment in jobs that required completely different sets of skills. Standards of living declined in some communities whose economies centered on farming or around large factories that shut down. In recent decades, populations have decreased in some states where agriculture provides a significant number of jobs. While high-technology industries in places such as California’s Silicon Valley were booming and attracting larger populations, traditional manufacturing industries in other parts of the country 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. Another exception occurred in 2008 when the Federal Reserve System and the Department of the Treasury rescued a number of major banks and the world’s largest insurance firm as a financial crisis brought on by a rapid decline in housing prices and risky investments in mortgage securities and derivatives resulted in the worst financial crisis since the Great Depression. See also Banking.
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 2004 the U.S. economy included about 21 million proprietorships, excluding farms; 2.5 million partnerships; and about 5.6 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 grew far more slowly than the number of sole proprietorships and corporations. Even many of the professions that once operated predominantly as partnerships have found it important to take advantage of the special features of corporations.
Corporations
In the United States a corporation is chartered by one of the 50 states as a legal body. That means it is, in law, a separate entity from its owners, who own shares of stock in the corporation. In the United States, corporate names often end with the abbreviation Inc., which stands for incorporated and refers to the idea that the business is a separate legal body.
Limited Liability
The key feature of corporations is limited liability. Unlike proprietorships and partnerships, the owners of a corporation are not personally responsible for any debts of the business. The only thing stockholders risk by investing in a corporation is what they have paid for their ownership shares, or stocks. Those who are owed money by the corporation cannot claim stockholders’ savings and other personal assets, even if the corporation goes into bankruptcy. Instead, the corporation is a separate legal entity, with the right to enter into contracts, to sue or be sued, and to continue to operate as long as it is profitable, which could be hundreds of years.
When the stockholders who own the corporation die, their stock is part of their estate and will be inherited by new owners. The corporation can go on doing business and usually will, unless the corporation is a small, closely held firm that is operated by one or two major stockholders. The largest U.S. corporations often have millions of stockholders, with no one person owning as much as 1 percent of the business. Limited liability and the possibility of operating for hundreds of years make corporations an attractive business structure, especially for large-scale operations where millions or even billions of dollars may be at risk.
When a new corporation is formed, a legal document called a prospectus is prepared to describe what the business will do, as well as who the directors of the corporation and its major investors will be. Those who buy this initial stock offering become the first owners of the corporation, and their investments provide the funds that allow the corporation to begin doing business.
Separation of Ownership and Control
The advantages of limited liability and of an unlimited number of years to operate have made corporations the dominant form of business for large-scale enterprises in the United States. However, there is one major drawback to this form of business. With sole proprietorships, the owners of the business are usually the same people who manage and operate the business. But in large corporations, corporate officers manage the business on behalf of the stockholders. This separation of management and ownership creates a potential conflict of interest. In particular, managers may care about their salaries, fringe benefits, or the size of their offices and support staffs, or perhaps even the overall size of the business they are running, more than they care about the stockholders’ profits.
The top managers of a corporation are appointed or dismissed by a corporation’s board of directors, which represents stockholders’ interests. However, in practice, the board of directors is often made up of people who were nominated by the top managers of the company. Members of the board of directors are elected by a majority of voting stockholders, but most stockholders vote for the nominees recommended by the current board members. Stockholders can also vote by proxy—a process in which they authorize someone else, usually the current board, to decide how to vote for them.
There are, however, two strong forces that encourage the managers of a corporation to act in stockholders’ interests. One is competition. Direct competition from other firms that sell in the same markets forces a corporation’s managers to make sound business decisions if they want the business to remain competitive and profitable. The second is the threat that if the corporation does not use its resources efficiently, it will be taken over by a more efficient company that wants control of those resources. If a corporation becomes financially unsound or is taken over by a competing company, the top managers of the firm face the prospect of being replaced. As a result, corporate managers will often act in the best interests of a corporation’s stockholders in order to preserve their own jobs and incomes.
In practice, the most common way for a takeover to occur is for one company to purchase the stock of another company, or for the two companies to merge by legal agreement under some new management structure. Stock purchases are more common in what are called hostile takeovers, where the company that is being taken over is fighting to remain independent. Mergers are more common in friendly takeovers, where two companies mutually agree that it makes sense for the companies to combine. Examples of mergers include the purchase of Lotus Development Corporation, a computer software company, by computer manufacturer International Business Machines Corporation (IBM) and the acquisition of Miramax Films by entertainment and media giant Walt Disney Company.
Takeovers by other firms became commonplace in the closing decades of the 20th century, and the merger trend continued into the 21st century, especially in telecommunications and banking. Some research indicates that these takeovers made firms operate more efficiently and profitably. Some of those outcomes represented good news for shareholders and for consumers. In the long run, takeovers can help protect a firm’s workers, too, because their jobs will be more secure if the firm is operating efficiently. But initially takeovers often result in job losses, which force many workers to relocate, retrain, or in some cases retire sooner than they had planned. Such workforce reductions happen because if a firm was not operating efficiently, it was probably either operating in markets where it could not compete effectively, or it was using too many workers and other inputs to produce the goods and services it was selling. Sometimes corporate mergers can result in job losses because management combines and streamlines departments within the newly merged companies. Although this streamlining leads to greater efficiency, it often results in fewer jobs. In many cases, some workers are likely to be laid off and face a period of unemployment until they can find work with another firm.
How Corporations Raise Funds for Investment
By investing in new issues of a company’s stock, shareholders provide the funds for a company to begin new or expanded operations. However, most stock sales do not involve new issues of stock. Instead, when someone who owns stock decides to sell some or all of their shares, that stock is typically traded on one of the national stock exchanges, which are specialized markets for buying and selling stocks. In those transactions, the person who sells the stock—not the corporation whose stock is traded—receives the funds from that sale.
An existing corporation that wants to secure funds to expand its operations has three options. It can issue new shares of stock, using the process described earlier. That option will reduce the share of the business that current stockholders own, so a majority of the current stockholders have to approve the issue of new shares of stock. New issues are often approved because if the expansion proves to be profitable, the current stockholders are likely to benefit from higher stock prices and increased dividends. Dividends are corporate profits that some companies periodically pay out to shareholders.
The second way for a corporation to secure funds is by borrowing money from banks, from other financial institutions, or from individuals. To do this the corporation often issues bonds, which are legal obligations to repay the amount of money borrowed, plus interest, at a designated time. If a corporation goes out of business, it is legally required to pay off any bonds it has issued before any money is returned to stockholders. That means that stocks are riskier investments than bonds. On the other hand, all a bondholder will ever receive is the amount of money specified in the bond. Stockholders can enjoy much larger returns, if the corporation is profitable.
The final way for a corporation to pay for new investments is by reinvesting some of the profits it has earned. After paying taxes, profits are either paid out to stockholders as dividends or held as retained earnings to use in running and expanding the business. Those retained earnings come from the profits that belong to the stockholders, so reinvesting some of those profits increases the value of what the stockholders own and have risked in the business, which is known as stockholders’ equity. On the other hand, if the corporation incurs losses, the value of what the stockholders own in the business goes down, so stockholders’ equity decreases.
Entrepreneurs and Profits
Entrepreneurs raise money to invest in new enterprises that produce goods and services for consumers to buy—if consumers want these products more than other things they can buy. Entrepreneurs often make decisions on which businesses to pursue based on consumer demands. Making decisions to move resources into more profitable markets, and accepting the risk of losses if they make bad decisions—or fail to produce products that stand the test of competition—is the key role of entrepreneurs in the U.S. economy.
Profits are the financial incentives that lead business owners to risk their resources making goods and services for consumers to buy. But there are no guarantees that consumers will pay prices high enough to cover a firm’s costs of production, so there is an inherent risk that a firm will lose money and not make profits. Even during good years for most businesses, about 70,000 businesses fail in the United States. In years when business conditions are poor, the number approaches 100,000 failures a year. And even among the largest 500 U.S. industrial corporations, a few of these firms lose money in any given year.
Entrepreneurs invest money in firms with the expectation of making a profit. Therefore, if the profits a company earns are not high enough, entrepreneurs will not continue to invest in that firm. Instead, they will invest in other companies that they hope will be more profitable. Or if they want to reduce their risk, they can put their money into savings accounts where banks guarantee a minimum return. They can also invest in other kinds of financial securities (such as government or corporate bonds) that are riskier than savings accounts, but less risky than investments in most businesses. Generally, the riskier the investment, the higher the return investors will require to invest their money.
Calculating Profits
The dollar value of profits earned by U.S. businesses—about $1.2 trillion in 2004—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;, Inc. or automobile manufacturer General Motors (GM).
To take into consideration the size of the firm, profits are calculated as a percentage of several different aspects of the business, including the firm’s level of sales, employment, and stockholders’ equity. Various individuals will use one of these different methods to evaluate a company’s performance, depending on what they want to know about how the firm operates. For example, an efficiency expert might examine the firm’s profits as a percentage of employment to determine how much profit is generated by the average worker in that firm. On the other hand, potential investors and a company’s chief executive would be more interested in profit as a percentage of stockholder equity, which allows them to gauge what kind of return to expect on their investments. A sales executive in the same firm might be more interested in learning about the company’s profit as a percentage of sales in order to compare its performance to the performances of competing firms in the same industry.
Using these different accounting methods often results in different profit percent figures for the same company. For example, suppose a firm earned a yearly profit of $1 million, with sales of $20 million. That represents a 5-percent rate of profit as a return on sales. But if stockholders’ equity in the corporation is $10 million, profits as a percent of stockholders’ equity will be 10 percent.
Return on Sales
Year after year, U.S. manufacturing firms average profits of about 5 percent of sales. Many business owners with profits at this level or lower like to say that they earn only about what people can earn on the interest from their savings accounts. That sounds low, especially considering that the federal government insures many savings accounts, so that most people with deposits at a bank run no risk of losing their savings if the bank goes out of business. And in fact, given the risks inherent in almost all businesses, few stockholders would be satisfied with a return on their investment that was this low.
Although it is true that on average, U.S. manufacturing firms only make about a 5-percent return on sales, that figure has little to do with the risks these businesses take. To see why, consider a specific example.
Most grocery stores earn a return on sales of only 1 to 2 percent, while some other kinds of firms typically earn more than the 5-percent average profit on sales. But selling more or less does not really increase what the owners of a grocery store (or most other businesses) are risking. Each time a grocery store sells $100 worth of canned spinach, it keeps about one or two dollars as profit, and uses the rest of the money to put more cans of spinach on the shelves for consumers to buy. At the end of the year, the grocery store may have sold thousands of dollars worth of canned spinach, but it never really risked those thousands of dollars. At any given time, it only risked what it spent for the cans that were at the store. When some cans were sold, the store bought new cans to put on the shelves, and it turned over its inventory of canned spinach many times during the year.
But the total value of these sales at the end of the year says little or nothing about the actual level of risk that the grocery store owners accepted at any point during the year. And in fact, the grocery industry is a relatively low-risk business, because people buy food in good times and bad. Providing goods or services where production or consumer demand is more variable—such as exploring for oil and uranium, or making movies and high fashion clothing—is far riskier.
Return on Equity
What stockholders risk—the amount they stand to lose if a business incurs losses and shuts down—is the money they have invested in the business, their equity. These are the funds stockholders provide for the firm whenever it offers a new issue of stock, or when the firm keeps some of the profits it earns to use in the business as retained earnings, rather than paying those profits out to stockholders as dividends.
Profits as a return on stockholders’ equity for U.S. corporations usually average from 12 to 16 percent, for larger and smaller corporations alike. That is more than people can earn on savings accounts, or on long-term government and corporate bonds. That is not surprising, however, because stockholders usually accept more risk by investing in companies than people do when they put money in savings accounts or buy bonds. The higher average yield for corporate profits is required to make up for the fact that there are likely to be some years when returns are lower, or perhaps even some when a company loses money.
At least part of any firm’s profits are required for it to continue to do business. Business owners could put their funds into savings accounts and earn a guaranteed level of return, or put them in government bonds that carry hardly any risk of default. If a business does not earn a rate of return in a particular market at least as high as a savings account or government bonds, its owners will decide to get out of that market and use the resources elsewhere—unless they expect higher levels of profits in the future.
Over time, high profits in some businesses or industries are a signal to other producers to put more resources into those markets. Low profits, or losses, are a signal to move resources out of a market into something that provides a better return for the level of risk involved. That is a key part of how markets work and respond to changing demand and supply conditions. Markets worked exactly that way in the U.S. economy when people left the blacksmith business to start making automobiles at the beginning of the 20th century. They worked the same way at the end of the century, when many companies stopped making typewriters and started making computers and printers.
CAPITAL, SAVINGS, AND INVESTMENT
In the United States and in other market economies, financial firms and markets channel savings into capital investments. Financial markets, and the economy as a whole, work much better when the value of the dollar is stable, experiencing neither rapid inflation nor deflation. In the United States, the Federal Reserve System functions as the central banking institution. It has the primary responsibility to keep the right amount of money circulating in the economy.
Investments are one of the most important ways that economies are able to grow over time. Investments allow businesses to purchase factories, machines, and other capital goods, which in turn increase the production of goods and services and thus the standard of living of those who live in the economy. That is especially true when capital goods incorporate recently developed technologies that allow new goods and services to be produced, or existing goods and services to be produced more efficiently with fewer resources.
Investing in capital goods has a cost, however. For investment to take place, some resources that could have been used to produce goods and services for consumption today must be used, instead, to make the capital goods. People must save and reduce their current consumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those funds to buy capital goods. Banks and other financial institutions in the economy play a key role by providing incentives for some people to save, and then lend those funds to firms and other people who are investing in capital goods.
Interest rates are the price someone pays to borrow money. Savings institutions pay interest to people who deposit funds with the institution, and borrowers pay interest on their loans. Like any other price in a market economy, supply and demand determine the interest rate. The demand for money depends on how much money people and organizations want to have to meet their everyday expenses, how much they want to save to protect themselves against times when their income may fall or their expenses may rise, and how much they want to borrow to invest. The supply of money is largely controlled by a nation’s central bank—which in the United States is the Federal Reserve System. The Federal Reserve increases or decreases the money supply to try to keep the right amount of money in the economy. Too much money leads to inflation. Too little results in high interest rates that make it more expensive to invest and may lead to a slowdown in the national economy, with rising levels of unemployment.
Providing Funds for Investments in Capital
To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.
Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.
Among the three major sectors of the U.S. economy—households, businesses, and government—only households are net savers. In other words, households save more money than they borrow. Conversely, businesses and government are net borrowers. A few businesses may save more than they invest in business ventures. However, overall, businesses in the United States, like businesses in virtually all countries, invest far more than they save. Many companies borrow funds to finance their investments. And while some local and state governments occasionally run budget surpluses, overall the government sector is also a large net borrower in the U.S. economy. The government borrows money by issuing various forms of bonds. Like corporate bonds, government bonds are contractual obligations to repay what is borrowed, plus some specified rate of interest, at a specified time.
Matching Borrowers and Lenders in Financial Markets
Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.
Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans. The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T; often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.
Other kinds of loans also have greater risks of default, so banks and other lenders charge different rates of interest. Mortgage loans are backed by the collateral of the property the loan was used to purchase. If someone does not pay his or her mortgage, the bank has the right to sell the property that was pledged as collateral and to collect the proceeds as payment for what it is owed. That means the bank’s risks are lower, so interest rates on these loans are typically lower, too. The money that is loaned to people who do not pay off the balances on their credit cards every month represents a greater risk to banks, because no collateral is provided. Because the bank does not hold any title to the consumer’s property for these loans, it charges a higher interest rate than it charges on mortgages. The higher rate allows the bank to collect enough money overall so that it can cover its losses when some of these riskier loans are not repaid.
If a bank makes too many loans that are not repaid, it will go out of business. The effects of bank failures on depositors and the overall economy can be very severe, especially if many banks fail at the same time and the deposits are not insured. In the United States, the most famous example of this kind of financial disaster occurred during the Great Depression of the 1930s, when a large number of banks failed. Many other businesses also closed and many people lost both their jobs and savings.
Bank failures are fairly rare events in the U.S. economy. Banks do not want to lose money or go out of business, and they try to avoid making loans to individuals and businesses who will be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal Deposit Insurance Corporation (FDIC) insures most bank and savings-and-loan deposits. 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 beginning of the 21st 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. In 2006 the U.S. savings rate reached its lowest point since 1933 when the United States was mired in the Great Depression. According to the U.S. Department of Commerce, the savings rate for 2006 was a negative 1 percent, meaning that Americans, on average, spent all that they earned and also either borrowed or spent part of their savings.
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. During the housing bubble of the early 21st century, when home prices increased, on average, year after year from 2000 to 2005, many people felt it was safe to spend money and take on debt, counting on the future value of their home to meet their obligations. But other considerations may also be important. There are significant differences among nations in how savings, dividends, investment income, housing expenditures, and retirement programs are taxed and financed. These differences may lead to different decisions about saving.
For example, many other nations do not tax interest on savings accounts as much as they do other forms of income, and some countries do not tax at least part of the income people earn on savings accounts at all. In the United States, such favorable tax treatment does not apply to regular savings accounts. The government does offer more limited advantages on special retirement accounts, but such accounts have many restrictions on how much people can deposit or withdraw before retirement without facing tax penalties. See also Retirement Plans.
In addition, U.S. consumers can deduct from their taxes the interest they pay on mortgages for the homes they live in. That encourages people to spend more on housing than they otherwise would. As a result, some funds that would otherwise be saved are, instead, put into housing.
Another factor that has a direct effect on the U.S. savings rate is the Social Security system, the government program that provides some retirement income to most older people. The money that workers pay into the Social Security system does not go into individual savings accounts for those workers. Instead, it is used to make Social Security payments to current retirees. No savings are created under this system unless it happens that the total amount being paid into the system is greater than the current payments to retirees. Even when that has happened in the past, the federal government often used the surplus to pay for some of its other expenditures. Individuals are also likely to save less for their own retirement because they expect to receive Social Security benefits when they retire.
The low U.S. savings rate has two significant consequences. First, with fewer dollars available as savings to banks and other financial institutions, interest rates are higher for both savers and borrowers than they would otherwise be. That makes it more costly to finance investment in factories, equipment, and other goods, which slows growth in national output and income levels. Second, the higher U.S. interest rates attract funds from savers and investors in other nations. As we will see below, such foreign investments can have several effects on the U.S. economy.
Borrowing from Foreign Savers
The flow of funds from other nations enables U.S. firms to finance more investments in capital goods, but it also creates concerns. For example, in order for foreigners to invest in U.S. savings accounts and U.S. government or corporate bonds, they must have dollars. As they demand dollars for these investments, the price of the dollar in terms of other nations’ currencies rises. When the price of the dollar is rising, people in other countries who want to buy U.S. exports will have to pay more for them. That means they will buy fewer goods and services produced in the United States, which will hurt U.S. export industries. This happened in the early 1980s, when U.S. companies such as Caterpillar, which makes large engines and industrial equipment, saw the sales of their products to their international customers plummet. The higher value of the dollar also makes it cheaper for U.S. citizens to import products from other nations. Imports will rise, leading to a larger deficit (or smaller surplus) in the U.S. balance of trade, the amount of exports compared to imports.
Foreign investment has other effects on the U.S. economy. Eventually the money borrowed must be repaid. How those repayments will affect the U.S. economy will depend on how the borrowed money is invested. If the money borrowed from foreign individuals and companies is put into capital projects that increase levels of output and income in the United States, repayments can be made without any decrease in U.S. living standards. Otherwise, U.S. living standards will decline as goods and services are sent overseas to repay the loans. The concern is that instead of using foreign funds for additional investments in capital goods, today these funds are simply making it possible for U.S. consumers and government agencies to spend more on consumption goods and social services, which will not increase output and living standards.
In the early history of the United States, many U.S. capital projects were financed by people in Britain, France, and other nations that were then the wealthiest countries in the world. These loans helped the fledgling U.S. economy to grow and were paid off without lowering the U.S. standard of living. It is not clear that current U.S. borrowing from foreign nations will turn out as well and will be used to invest in capital projects, now that the United States, with the largest and wealthiest economy in the world, faces a low national savings rate.
MONEY AND FINANCIAL MARKETS
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. See also Banking.
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. see Inflation and Deflation.
The Federal Reserve System and Monetary Policy
Governments often attempt to reduce inflation by controlling the supply of money. Consequently, organizations that control how much money is issued in an economy play a major role in how the economy performs, in terms of prices, output and employment levels, and economic growth. In the United States, that organization is the nation’s central bank, the Federal Reserve System. The system’s name comes from the fact that the Federal Reserve has the legal authority to make banks hold some of their deposits as reserves, which means the banks cannot lend out those deposits. These reserve funds are held in the Federal Reserve Bank. The Federal Reserve also acts as the banker for the federal government, but the government does not own the Federal Reserve. It is actually owned by the nation’s banks, which by law must join the Federal Reserve System and observe its regulations.
There are 12 regional Federal Reserve banks. These banks are not commercial banks. They do not accept savings deposits from or provide loans to individuals or businesses. Instead, the Federal Reserve functions as a central bank for other banks and for the federal government. In that role the Federal Reserve System performs several important functions in the national economy. First, the branches of the Federal Reserve distribute paper currency in their regions. Dollar bills are actually Federal Reserve notes. You can look at a dollar bill of any denomination and see the number for the regional Federal Reserve Bank where the bill was originally issued. But of course the dollar is a national currency, so a bill issued by any regional Federal Reserve Bank is good anyplace in the country. The distribution of currency occurs as commercial banks convert some of their reserve balances at the Federal Reserve System into currency, and then provide that currency to bank depositors who decide to hold some of their money balances as currency rather than deposits in checking accounts. The U.S. Treasury prints new currency for the Federal Reserve System. The bills are introduced into circulation when commercial banks use their reserves to buy currency from the Federal Reserve Bank.
Second, the regional Federal Reserve banks transfer funds for checks that are deposited by a bank in one part of the country, but were written by someone who has a checking account with a bank in another part of the country. Millions of checks are processed this way every business day. Third, the regional Federal Reserve Banks collect and analyze data on the economic performance of their regions, and provide that information and their analysis of it to the national Federal Reserve System. Each of the 12 regions served by the Federal Reserve banks has its own economic characteristics. Some of these regional economies are concerned more with agricultural issues than others; some with different types of manufacturing and industries; some with international trade; and some with financial markets and firms. After reviewing the reports from all different parts of the country, the national Federal Reserve System then adopts policies that have major effects on the entire U.S. economy.
By far the most important function of the Federal Reserve System is controlling the nation’s money supply and the overall availability of credit in the economy. If the Federal Reserve System wants to put more money in the economy, it does not ask the Treasury to print more dollar bills. Remember, much more money is held in checking and savings accounts than as currency, and it is through those deposit accounts that the Federal Reserve System most directly controls the money supply. The Federal Reserve affects deposit accounts in one of three ways.
First, it can allow banks to hold a smaller percentage of their deposits as reserves at the Federal Reserve System. A lower reserve requirement allows banks to make more loans and earn more money from the interest paid on those loans. Banks making more loans increase the money supply. Conversely, a higher reserve requirement reduces the amount of loans banks can make, which reduces or tightens the money supply.
The second way the Federal Reserve System can put more money into the economy is by lowering the rate it charges banks when they borrow money from the Federal Reserve System. This particular interest rate is known as the discount rate. When the discount rate goes down, it is more likely that banks will borrow money from the Federal Reserve System, to cover their reserve requirements and support more loans to borrowers. Once again, those loans will increase the nation’s money supply. Therefore, a decrease in the discount rate can increase the money supply, while an increase in the discount rate can decrease the money supply.
In practice, however, banks rarely borrow money from the Federal Reserve, so changes in the discount rate are more important as a signal of whether the Federal Reserve wants to increase or decrease the money supply. For example, raising the discount rate may alert banks that the Federal Reserve might take other actions, such as increasing the reserve requirement. That signal can lead banks to reduce the amount of loans they are making.
The third way the Federal Reserve System can adjust the supply of money and the availability of credit in the economy is through its open market operations—the buying or selling of government bonds. Open market operations are actually the tool that the Federal Reserve uses most often to change the money supply. These open-market operations take place in the market for government securities. The U.S. government borrows money by issuing bonds that are regularly auctioned on the bond market in New York. The Federal Reserve System is one of the largest purchasers of those bonds, and the bank changes the amount of money in the economy when it buys or sells bonds.
Government bonds are not money, because they are not generally accepted as final payment for goods and services. (Just try paying for a hamburger with a government savings bond.) But when the Federal Reserve System pays for a federal government bond with a check, that check is new money—specifically, it represents a loan to the government. This loan creates a higher balance in the government’s own checking account after the funds have been transferred from the privately owned Federal Reserve Bank to the government. That new money is put into the economy as soon as the government spends the funds. On the other hand, if the Federal Reserve sells government bonds, it collects money that is taken out of circulation, since the bonds that the Federal Reserve sells to banks, firms, or households cannot be used as money until they are redeemed at a later date.
The Wall Street Journal and other financial media regularly report on purchases of bonds made by the Federal Reserve and other buyers at auctions of U.S. government bonds. The Federal Reserve System itself also publishes a record of its buying and selling in the bond market. In practice, since the U.S. economy is growing and the money supply must grow with it to keep prices stable, the Federal Reserve is almost always buying bonds, not selling them. What changes over time is how fast the Federal Reserve wants the money supply to grow, and how many dollars worth of bonds it purchases from month to month.
To summarize the Federal Reserve System’s tools of monetary policy: It can increase the supply of money and the availability of credit by lowering the percentage of deposits that banks must hold as reserves at the Federal Reserve System, by lowering the discount rate, or by purchasing government bonds through open market operations. The Federal Reserve System can decrease the supply of money and the availability of credit by raising reserve ratios, raising the discount rate, or by selling government bonds.
The Federal Reserve System increases the money supply when it wants to encourage more spending in the economy, and especially when it is concerned about high levels of unemployment. Increasing the money supply usually decreases interest rates—which are the price of money paid by those who borrow funds to those who save and lend them. Lower interest rates encourage more investment spending by businesses, and more spending by households for houses, automobiles, and other “big ticket” items that are often financed by borrowing money. That additional spending increases national levels of production, employment, and income. However, the Federal Reserve Bank must be very careful when increasing the money supply. If it does so when the economy is already operating close to full employment, the additional spending will increase only prices, not output and employment.
Effect of Monetary Policies on the U.S. Economy
The monetary policies adopted by the Federal Reserve System can have dramatic effects on the national economy and, in particular, on financial markets. Most directly, of course, when the Federal Reserve System increases the money supply and expands the availability of credit, then the interest rate, which determines the amount of money that borrowers pay for loans, is likely to decrease. Lower interest rates, in turn, will encourage businesses to borrow more money to invest in capital goods, and will stimulate households to borrow more money to purchase housing, automobiles, and other goods.
But the Federal Reserve System can go too far in expanding the money supply. If the supply of money and credit grows much faster than the production of goods and services in the economy, then prices will increase, and the rate of inflation will rise. Inflation is a serious problem for those who live on fixed incomes, since the income of those individuals remains constant while the amount of goods and services they can purchase with their income decreases. Inflation may also hurt banks and other financial institutions that lend money, as well as savers. In a period of unanticipated inflation, as the value of money decreases in terms of what it will purchase, loans are repaid with dollars that are worth less. The funds that people have saved are worth less, too.
When banks and savers anticipate higher inflation, they will try to protect themselves by demanding higher interest rates on loans and savings accounts. This will be especially true on long-term loans and savings deposits, if the higher inflation is considered likely to continue for many years. But higher interest rates create problems for borrowers and those who want to invest in capital goods.
If the supply of money and credit grows too slowly, however, then interest rates are again likely to rise, leading to decreased spending for capital investments and consumer durable goods (products designed for long-term use, such as television sets, refrigerators, and personal computers). Such decreased spending will hurt many businesses and may lead to a recession, an economic slowdown in which the national output of goods and services falls. When that happens, wages and salaries paid to individual workers will fall or grow more slowly, and some workers will be laid off, facing possibly long periods of unemployment.
For all of these reasons, bankers and other financial experts watch the Federal Reserve’s actions with monetary policy very closely. There are regular reports in the media about policy changes made by the Federal Reserve System, and even about statements made by Federal Reserve officials that may indicate that the Federal Reserve is going to change the supply of money and interest rates. The chairman of the Federal Reserve System is widely considered to be one of the most influential people in the world because what the Federal Reserve does so dramatically affects the U.S. and world economies, especially financial markets.
LABOR AND LABOR MARKETS
Labor includes work done for employers and work done in a person’s own household, but labor markets deal only with work that is done for some form of financial compensation. Labor markets include all the means by which workers find jobs and by which employers locate workers to staff their businesses. A number of factors influence labor and labor markets in the United States, including immigration, discrimination, labor unions, unemployment, and income inequality between the rich and poor.
The official definition of the U.S. labor force includes people who are at least 16 years old and either working, waiting to be recalled from a layoff, or actively looking for work within the past 30 days. In 2006 the U.S. labor force was estimated at 157 million people, most of them working in full-time or part-time jobs.
Most people in the United States receive their income as wages and salaries paid by firms that have hired individuals to work as their employees. Those wages and salaries are the prices they receive for the labor services they provide to their employers. Like other prices, wages and salaries are determined primarily by market forces.
Labor Supply and Demand
The wages and salaries that U.S. workers earn vary from occupation to occupation, across geographic regions, and according to workers’ levels of education, training, experience, and skill. As with goods and services purchased by consumers, labor is traded in markets that reflect both supply and demand. In general, higher wages and salaries are paid in occupations where labor is more scarce—that is, in jobs where the demand for workers is relatively high and the supply of workers with the qualifications and ability to do that work is relatively low. The demand for workers in particular occupations depends largely on how much the work they do adds to a firm’s revenues. In other words, workers who create more products or higher-priced products will be worth more to employers than workers who make fewer or less valuable products. The supply of workers in any occupation is affected by the amount of time and effort required to enter that occupation compared to other things workers might do.
Workers seeking higher wages often learn skills that will increase the likelihood of finding a higher-paying job. The knowledge, skills, and experience a worker has acquired are the worker’s human capital. Education and training can clearly increase workers’ human capital and productivity, which makes them more valuable to employers. In general, more educated individuals make more money at their jobs. However, a greater level of education does not always guarantee higher wages. Certain professions that demand a high level of education, such as teaching elementary and secondary school, are not high-paying. Such situations arise when the number of people with the training to do that job is relatively large compared with the number of people that employers want to hire. Of course this situation can change over time if, for example, fewer young people choose to train for the profession.
Supply and demand factors change in labor markets, just as they do in markets for goods and services. As a result, occupations that paid high wages and salaries in the past sometimes become outdated, while entirely new occupations are created as a result of technological change or changes in the goods and services consumers demand. For example, blacksmiths were once among the most skilled workers in the United States; today, computer programmers and software developers are in great demand.
The process of creative destruction carries over from product markets to labor markets because the demand for particular goods and services creates a demand for the labor to produce them. Conversely, when the demand for particular goods or services decreases, the demand for labor to produce them will also fall. Similarly, when new technologies create new products or new ways of producing existing products, some workers will have new job opportunities, but other workers might have to retrain, relocate, or take new jobs.
Factors Affecting Labor Markets
Changes in society and in the makeup of the population also affect labor markets. For example, starting in the 1960s it became more common for married women to work outside the home. Unprecedented numbers of women—many with little previous job experience and training—entered the labor markets for the first time during the 1970s. As a result, wages for entry-level jobs were pushed down and did not rise as rapidly as they had in the past. This decline in entry-level wages was further fueled by huge numbers of teens who were also entering the labor market for the first time. These young people were the children of the baby boom of 1946 to 1964, a period in which the birth rate increased dramatically in the United States. So, two changes—one affecting women’s roles in the labor market, the other in the makeup of the age of the workforce—combined to affect the labor market.
The baby boomers’ effects have continued to reverberate through the U.S. economy. For example, starting salaries for people with college degrees became depressed when large numbers of baby boomers started graduating from college. And as workers born during the boom have aged, the workforce 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 about 15 percent in 2004.
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 as the baby boomers begin to retire in the early decades of the 21st century.
Immigration
Labor markets in the United States have also been significantly affected by the immigration of families and workers from other nations. Most families and workers in the United States can trace their heritage to immigrants. In fact, before the 20th century, while the United States was trying to settle its frontiers, it allowed essentially unlimited immigration. See Immigration: A Nation of Immigrants. In these periods the U.S. economy had more land and other natural resources than it was able to use, because labor was so scarce. Immigration served as one of the main remedies for this shortage of labor.
Generally, immigration raises national output and income levels. These changes occur because immigration increases the number of workers in the economy, which allows employers to produce more goods and services. Capital resources in the economy may also become more valuable as immigration increases. The number of workers available to work with machines and tools increases, as does the number of consumers who want to buy goods and services. However, wages for jobs that are filled by large numbers of immigrants may decrease. This wage decline stems from greater competition for these jobs and from the fact that many immigrants are willing to work for lower wages than other U.S. workers.
Immigration into the United States is now regulated by a system of quotas that limits the number of immigrants who can legally enter the country each year. In 1964 Congress changed immigration policies to give preference to those with families already in the United States, to refugees facing political persecution, and to individuals with other humanitarian concerns. Before that time, more weight had been placed on immigrants’ labor-market skills. Although this change in policy helped reunite families, it also increased the supply of unskilled labor in the nation, especially in the states of California, Florida, and New York. In 1990 Congress modified the immigration legislation to set a separate annual quota for immigrants with job skills needed in the United States. But people with family members who are already U.S. citizens remain the largest category of immigrants, and U.S. immigration law still puts less focus on job skills than do immigration laws in many other market economies, including Canada and many of the nations of Western Europe.
Discrimination
Women and many minorities have long faced discrimination in U.S. labor markets. Employed women earn less, on average, than men with similar levels of education. In part this wage disparity reflects different educational choices that women and men have made. In the past, women have been less likely to study engineering, sciences, and other technical fields that generally pay more. In part, the wage differences result from women leaving the job market for a period of years to raise children. Another reason for the disparity in wages between men and women is that there is still a considerable degree of occupational segregation between males and females—for example, nurses are much more likely to be females and dentists males. But even after allowing for those factors, studies have generally found that, on average, women earn roughly 10 percent less than men even in comparable jobs, with equal levels of education, training, and experience.
Analysis of wage discrimination against black Americans leads to similar conclusions. Specifically, after controlling for differences in age, education, hours worked, experience, occupation, and region of the country, wages for black men are roughly 10 percent lower than for white men, though occupational segregation appears to be less common by race than by gender. Issues other than wage discrimination are also important to note for black workers. In particular, unemployment rates for black workers are about twice as high as they are for white workers. Partly because of that, a much lower percentage of the U.S. black population is employed than the white population.
Hispanic workers generally receive wages about 5 percent lower than white workers, after adjusting for differences in education, training, experience, and other characteristics that affect workers’ productivity. Some studies suggest that differences in the ability to speak English are particularly important in understanding wage differences for Hispanic workers.
The differences between the earnings of white males and earnings of females and minorities slowly decreased in the closing decades of the 20th century. Some laws and regulations prohibiting discrimination seem to have helped in this process. A large part of those gains occurred shortly after the adoption of the 1964 Civil Rights Act, which among other things, outlawed discrimination by employers and unions. Many economists worry that the discrimination that remains may be more difficult to identify and eliminate through legislation.
Discrimination in competitive labor markets is economically inefficient as well as unfair. When workers are not paid based on the value of what they add to employers’ production and profit levels, society loses opportunities to use labor resources in their most valuable ways. As a result, fewer goods and services are produced. If employers discriminate against certain groups of workers, they will pay for that behavior in competitive markets by earning lower profits. Similarly, if workers refuse to work with (or for) coworkers of a different gender, race, or ethnic background, they will have to accept lower wages in competitive markets because their discrimination makes it more costly for employers to run their businesses. And if customers refuse to be served by workers of a certain gender, race, or ethnicity in certain kinds of jobs, they will have to pay higher prices in competitive markets because their discrimination raises the costs of providing these goods and services.
Those who are discriminated against receive lower wages and often experience other forms of economic hardship, such as more frequent and longer periods of unemployment. Beyond that, the lower wage rates and restricted career opportunities they face will naturally affect their decisions about how much education and training to acquire and what kinds of careers to pursue. For that reason, some of the costs of discrimination are paid over very long periods of time, sometimes for a worker’s entire life.
It is clear that there is still discrimination in the U.S. economy. What is not always so clear is how much that discrimination costs the economy as a whole, and that it costs not only those who are discriminated against, but also those who practice discrimination.
Unions
Many U.S. workers belong to unions or to professional associations (such as the National Education Association for teachers) that act like unions. These unions and associations represent groups of workers in collective bargaining with employers to agree on contracts. During this bargaining, workers and employers establish wages and fringe benefits, such as health care and pension benefits, for different types of jobs. They also set grievance procedures to resolve labor disputes during the life of the contract and often address many other issues, such as procedures for job transfers and promotions of workers.
Many studies indicate that wages for union workers in the United States are 10 to 15 percent higher than for nonunion workers in similar jobs and that fringe benefits for union workers also tend to be higher. That compensation difference is an important consideration both for workers thinking about joining unions, and for employers who are concerned about paying higher wages and benefits than their competitors. In some cases, it appears that the higher wages and benefits are paid because union workers are more productive than nonunion workers are. But in other cases unions have been found to decrease productivity, sometimes by limiting the kinds of work that certain employees can do, or by requiring more workers in some jobs than employers would otherwise hire. Economists have not reached definite conclusions on some of these issues, but it is evident that there are many other broad effects of unions on the economy.
Unions and collective bargaining in the United States are markedly different from such organizations and procedures in other industrialized nations. U.S. unions generally practice what is often described as business unionism, which focuses mainly on the direct economic interests of their members. In contrast, unions in Europe and South America focus more on influencing national policy agendas and political parties.
The different focus by U.S. unions partly reflects the special history of unions in the United States, where the first sustained successes were achieved by craft unions representing skilled workers such as carpenters, printers, and plumbers. These skilled workers had more bargaining power and were more difficult for employers to replace or do without than workers with less training. Unions representing these skilled workers were also able to provide special services to employers that allowed both the unions and employers to operate more efficiently. For example, craft unions in large cities often ran apprenticeship programs to train young workers in these occupations. And many craft unions operated hiring halls that employers could call to find trained workers on short notice or for short periods of time.
Most of these craft unions were members of the American Federation of Labor (AFL), founded in 1886. see American Federation of Labor and Congress of Industrial Workers. 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 decreased dramatically in the last half of the 20th century, from more than 25 percent in the mid-1950s to 14 percent in 1999. A number of reasons explain the decline in union representation of the U.S. labor force. First, unions are traditionally strong in manufacturing industries, but since the 1950s manufacturing has accounted for a smaller percentage of overall employment in the U.S. economy. Employment has grown more rapidly in the service sector, particularly in professional services and white-collar jobs. Unions have not had as much success in acquiring new members in the service sector, with the exception of government employees.
Union membership has also declined as the government established laws and regulations that mandate for all workers many of the benefits and guarantees that unions had achieved for their members. These mandates include minimum wage, workplace safety, higher pay rates for overtime, and oversight of the management of pension funds if employers fund or partially fund pensions.
Third, many U.S. firms have become more aggressive in opposing the recognition of unions as bargaining agents for their employees, and in dealing with confrontations involving existing unions. For example, it is increasingly common for firms to hire permanent replacement workers if strikes occur at a firm or work site.
Finally, workers with college degrees held a larger percentage of jobs in the U.S. economy in the late 1990s than in earlier decades. These workers were more likely to be in jobs with some level of managerial responsibilities, and less likely to think of themselves as potential union members.
Unions, however, continue to play many valuable roles in representing their members on economic issues. Equally or perhaps more importantly, unions provide workers with a stronger voice in how work is done and how workers are treated. This is particularly true in jobs where it is difficult to identify clearly how much an individual worker contributes to total output in the production process. During the 1990s, many U.S. manufacturing firms adopted team production methods, in which small groups of workers function as a team. Any member of the team can suggest ideas for different ways of doing jobs. But management is likely to consider more carefully those that are recommended by the union or have union support. Workers may also be more willing to present ideas for job improvements to union representatives than to managers. In some cases, workers feel that the union would consider how the changes can be made without reducing jobs, wages, or other benefits.
Unemployment
A persistent problem for the U.S. economy and some of its workers is unemployment—not being able to find a job despite actively looking for work for at least 30 consecutive days. There are three major kinds of unemployment: frictional, cyclical, and structural. Each type of unemployment has different causes and consequences, and so public policies designed to reduce each type of unemployment must be different, too.
Frictional unemployment occurs as a result of labor mobility, when workers change jobs or wait to begin a new job. Labor mobility is, in general, a good thing for workers and the economy overall. It allows workers to look for the best available job for which they are qualified and lets employers find the best-qualified people for their job openings. Because this searching and matching by employees and employers takes time, on any given day in a market economy there will be some workers who are looking for a new job, or waiting to begin a job. Even when economists describe the economy as being at full employment there will be some frictional unemployment (as much as 5 to 6 percent of the labor force in some years). This kind of unemployment is generally not a major economic problem.
Cyclical unemployment occurs when the economy goes into a recession. The basic causes of cyclical unemployment are decreases in the levels of consumption, investment, or government spending in the economy, or a decrease in the demand for goods and services exported to other countries. As national spending and production levels fall, some employers begin to lay off workers. Cyclical unemployment varies greatly according to the health of the economy. Some of the highest unemployment rates for the last decades of the 20th century took place during the recession of 1982 to 1983, when unemployment levels reached almost 10 percent. The highest U.S. unemployment rate of the 20th century occurred in 1933, when the Great Depression left almost 25 percent of the labor force without work.
Sometimes the government can use monetary or fiscal policies to increase spending by businesses and households, for instance by cutting taxes. Or the government can increase its own spending to fight this kind of unemployment. Perhaps the most famous example of this kind of tax cut in the United States was the one designed in 1963 and passed in 1964 by the administrations of U.S. president John F. Kennedy and his successor, Lyndon B. Johnson.
Structural unemployment occurs when people who are looking for jobs do not have the education or skills to fill the jobs that are currently available. Most policies designed to reduce structural unemployment provide training programs for these workers, or subsidize education and training programs available from colleges and universities, technical schools, or businesses. In some cases, the government provides support for retraining when increased competition from imported goods and services puts U.S. workers out of work or when factories are shut down because production is moved to another state or country.
Unemployment rates also vary sharply by occupation and educational levels. As a group, workers with college degrees experience far lower unemployment rates than workers with less education. In 1998 the unemployment rate for U.S. workers who had not graduated from high school was 7.1 percent; for high school graduates, the rate was 4.0 percent; for those with some college the rate was 3.0 percent; and for college graduates the unemployment rate was only 1.8 percent.
Income Inequality
Another issue involving the operation of labor markets in the U.S. economy has been the growing difference between the earnings of high-income and low-income workers at the end of the 20th century and the beginning of the 21st century. From 1977 to 2003, 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 47.6 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 4.1 percent. This trend is the result of several factors.
Wages for skilled workers, those with more education and training, have increased quickly because the supply of these workers in the U.S. has not risen as quickly as demand for these workers. In addition, wages for unskilled labor in the United States have been held down more than in other nations as a result of U.S. immigration policies. The United States has admitted a larger number of unskilled workers than other industrialized nations. Other countries often consider job market factors more heavily in determining who will be allowed to immigrate. As a result, the supply of unskilled workers in the United States has increased faster than in other countries, pushing wages in low-paying jobs lower.
Finally, government assistance programs for low-income families tend to be more extensive and generous in other industrialized market economies than they are in the United States. That is perhaps one of the reasons that workers in those countries are less willing to accept jobs that pay lower wages, and why unemployment rates in those countries are substantially higher than they are in the United States. The exact relationship between those factors has not been determined, however.
It is clear that it has become increasingly difficult for U.S. workers who have not at least completed high school to achieve a high or moderate level of income. In 2004 the median annual income for college graduates was $54,278 for males and $33,591 for females, while the median annual income for those who did not graduate from high school was only $15,767 for males and $9,578 for females.
GOVERNMENT AND THE ECONOMY
Although the market system in the United States relies on private ownership and decentralized decision-making by households and privately owned businesses, the government does perform important economic functions. The government passes and enforces laws that protect the property rights of individuals and businesses. It restricts economic activities that are considered unfair or socially unacceptable.
In addition, government programs regulate safety in products and in the workplace, provide national defense, and provide public assistance to some members of society coping with economic hardship. There are some products that must be provided to households and firms by the government because they cannot be produced profitably by private firms. For example, the government funds the construction of interstate highways, and operates vaccination programs to maintain public health. Local governments operate public elementary and secondary schools to ensure that as many children as possible will receive an education, even when their parents are unable to afford private schools.
Other kinds of goods and services (such as health care and higher education) are produced and consumed in private markets, but the government attempts to increase the amount of these products available in the economy. For yet other goods and services, the government acts to decrease the amount produced and consumed; these include alcohol, tobacco, and products that create high levels of pollution. These special cases where markets fail to produce the right amount of certain goods and services mean that the government has a large and important role to play in adjusting some production patterns in the U.S. economy. But economists and other analysts have also found special reasons why government policies and programs often fail, too.
At the most basic level, the government makes it possible for markets to function more efficiently by clearly defining and enforcing people’s property or ownership rights to resources and by providing a stable currency and a central banking system (the Federal Reserve System in the U.S. economy). Even these basic functions require a wide range of government programs and employees. For example, the government maintains offices for recording deeds to property, courts to interpret contracts and resolve disputes over property rights, and police and other law enforcement agencies to prevent or punish theft and fraud. The Treasury Department issues currency and coins and handles the government’s revenues and expenditures. And as we have seen, the Federal Reserve System controls the nation’s supply of money and availability of credit. To perform these basic functions, the government must be able to shift resources from private to public uses. It does this mainly through taxes, but also with user fees for some services (such as admission fees to national parks), and by borrowing money when it issues government bonds.
In the U.S. economy, private markets are generally used to allocate basic products such as food, housing, and clothing. Most economists—and most Americans—widely accept that competitive markets perform these functions most efficiently. One role of government is to maintain competition in these markets so that they will continue to operate efficiently. In other areas, however, markets are not allowed to operate because other considerations have been deemed more important than economic efficiency. In these cases, the government has declared certain practices illegal. For example, in the United States people are not free to buy and sell votes in political elections. Instead, the political system is based on the democratic rule of “one person, one vote.” It is also illegal to buy and sell many kinds of drugs. After the Civil War (1861-1865) the Constitution was amended to make slavery illegal, resulting in a major change in the structure of U.S. society and the economy. see Slavery in the United States.
In other cases, the government allows private markets to operate, but regulates them. For example, the government makes laws and regulations concerning product safety. Some of these laws and regulations prohibit the use of highly flammable material in the manufacture of children’s clothing. Other regulations call for government inspection of food products, and still others require extensive government review and approval of potential prescription drugs.
In still other situations, the government determines that private markets result in too much production and consumption of some goods, such as alcohol, tobacco, and products that contribute to environmental pollution. The government is also concerned when markets provide too little of other products, such as vaccinations that prevent contagious diseases. The government can use its spending and taxing authority to change the level of production and consumption of these products, for example, by subsidizing vaccinations.
Even the staunchest supporters of private markets have recognized a role for the government to provide a safety net of support for U.S. citizens. This support includes providing income, housing, food, and medicine for those who cannot provide a basic standard of living for themselves or their families.
Because the federal government has become such a large part of the U.S. economy over the past century, it sometimes tries to reduce levels of unemployment or inflation by changing its overall level of spending and taxes. This is done with an eye to the monetary policies carried out by the Federal Reserve System, which also have an effect on the national rates of inflation, unemployment, and economic growth. The Federal Reserve System itself is chartered by federal legislation, and the president of the United States appoints board members of the Federal Reserve, with the approval of the U.S. Senate. However, the private banks that belong to the system own the Federal Reserve, and its policy and operational decisions are made independently of Congress and the president.
Correcting Market Failures
The government attempts to adjust the production and consumption of particular goods and services where private markets fail to produce efficient levels of output for those products. The two major examples of these market failures are what economists call public goods and external benefits or costs.
Providing Public Goods
Private markets do not provide some essential goods and services, such as national defense. Because national defense is so important to the nation’s existence, the government steps in and entirely funds and administers this product.
Public goods differ from private goods in two key respects. First, a public good can be used by one person without reducing the amount available for others to use. This is known as shared consumption. An example of a public good that has this characteristic is a spraying or fogging program to kill mosquitoes. The spraying reduces the number of mosquitoes for all of the people who live in an area, not just for one person or family. The opposite occurs in the consumption of private goods. When one person consumes a private good, other people cannot use the product. This is known as rival consumption. A good example of rival consumption is a hamburger. If someone else eats the sandwich, you cannot.
The second key characteristic of public goods is called the nonexclusion principle: It is not possible to prevent people from using a public good, regardless of whether they have paid for it. For example, a visitor to a town who does not pay taxes in that community will still benefit from the town’s mosquito-spraying program. With private goods, like a hamburger, when you pay for the hamburger, you get to eat it or decide who does. Someone who does not pay does not get the hamburger.
Because many people can benefit from the same public goods and share in their consumption, and because those who do not pay for these goods still get to use them, it is usually impossible to produce these goods in private markets. Or at least it is impossible to produce enough in private markets to reach the efficient level of output. That happens because some people will try to consume the goods without paying for them, and get a free ride from those who do pay. As a result, the government must usually take over the decision about how much of these products to produce. In some cases, the government actually produces the good; in other cases it pays private firms to make these products.
The classic example of a public good is national defense. It is not a rival consumption product, since protecting one person from an invading army or missile attack does not reduce the amount of protection provided to others in the country. The nonexclusion principle also applies to national defense. It is not possible to protect only the people who pay for national defense while letting bombs or bullets hit those who do not pay. Instead, the government imposes broad-based taxes to pay for national defense and other public goods.
Adjusting for External Costs or Benefits
There are some private markets in which goods and services are produced, but too much or too little is produced. Whether too much or too little is produced depends on whether the problem is one of external costs or external benefits. In either case, the government can try to correct these market failures, to get the right amount of the good or service produced.
External costs occur when not all of the costs involved in the production or consumption of a product are paid by the producers and consumers of that product. Instead, some of the costs shift to others. One example is drunken driving. The consumption of too much alcohol can result in traffic accidents that hurt or kill people who are neither producers nor consumers of alcoholic products. Another example is pollution. If a factory dumps some of its wastes in a river, then people and businesses downstream will have to pay to clean up the water or they may become ill from using the water.
When people other than producers and consumers pay some of the costs of producing or consuming a product, those external costs have no effect on the product’s market price or production level. As a result, too much of the product is produced considering the overall social costs. To correct this situation, the government may tax or fine the producers or consumers of such products to force them to cover these external costs. If that can be done correctly, less of the product will be produced and consumed.
An external benefit occurs when people other than producers and consumers enjoy some of the benefits of the production and consumption of the product. One example of this situation is vaccinations against contagious diseases. The company that sells the vaccine and the individuals who receive the vaccine are better off, but so are other people who are less likely to be infected by those who have received the vaccine. Many people also argue that education provides external benefits to the nation as a whole, in the form of lower unemployment, poverty, and crime rates, and by providing more equality of opportunity to all families.
When people other than the producers and consumers receive some of the benefits of producing or consuming a product, those external benefits are not reflected in the market price and production cost of the product. Because producers do not receive higher sales or profits based on these external benefits, their production and price levels will be too low–based only on those who buy and consume their product. To correct this, the government may subsidize producers or consumers of these products and thus encourage more production.
Maintaining Competition
Competitive markets are efficient ways to allocate goods and services while maintaining freedom of choice for consumers, workers, and entrepreneurs. If markets are not competitive, however, much of that freedom and efficiency can be lost. One threat to competition in the market is a firm with monopoly power. Monopoly power occurs when one producer, or a small group of producers, controls a large part of the production of some product. If there are no competitors in the market, a monopoly can artificially drive up the price for its products, which means that consumers will pay more for these products and buy less of them. One of the most famous cases of monopoly power in U.S. history was the Standard Oil Company, owned by U.S. industrialist John D. Rockefeller. Rockefeller bought out most of his business rivals and by 1878 controlled 90 percent of the petroleum refineries in the United States.
Largely in reaction to the business practices of Standard Oil and other trusts or monopolistic firms, the United States passed laws limiting monopolies. Since 1890, when the Sherman Antitrust Act was passed, the federal government has attempted to prevent firms from acquiring monopoly power or from working together to set prices and limit competition in other ways. A number of later antitrust laws were passed to extend the government’s power to promote and maintain competition in the U.S. economy. Some states have passed their own versions of some of these laws.
The government does allow what economists call natural monopolies. However, the government then regulates those businesses to protect consumers from high prices and poor service, and often limits the profits these firms can earn. The classic examples of natural monopolies are local services provided by public utilities. Economies of scale make it inefficient to have even two companies distributing electricity, gas, water, or local telephone service to consumers. It would be very expensive to have even two sets of electric and telephone wires, and two sets of water, gas, and sewer pipes going to every house. That is why firms that provide these services are called natural monopolies.
There have been some famous antitrust cases in which large companies were broken up into smaller firms. One such example is the breakup of American Telephone and Telegraph (AT&T;) in 1982, which led to the formation of a number of long-distance and regional telephone companies. Other examples include a ruling in 1911 by the Supreme Court of the United States, which broke the Standard Oil Trust into a number of smaller oil companies and ordered a similar breakup of the American Tobacco Company.
Some government policies intentionally reduce competition, at least for some period of time. For example, patents on new products and copyrights on books and movies give one producer the exclusive right to sell or license the distribution of a product for 17 or more years. These exclusive rights provide the incentive for firms and individuals to spend the time and money required to develop new products. They know that no one else will copy and sell their product when it is introduced into the marketplace, so it pays to devote more resources to developing these new products.
The benefits of certain other government policies that reduce competition are not always this clear, however. More controversial examples include policies that restrict the number of taxicabs in a large city or that limit the number of companies providing cable television services in a community. It is much less expensive for cable companies to install and operate a cable television system than it is for large utilities, such as the electric and telephone companies, to install the infrastructure they need to provide services. Therefore, it is often more feasible to have two or more cable companies in reasonably large cities. There are also more substitutes for cable television, such as satellite dish systems and broadcast television. But despite these differences, many cities auction off cable television rights to a single company because the city receives more revenue that way. Such a policy results in local monopolies for cable television, even in areas where more competition might well be possible and more efficient.
Establishing government policies that efficiently regulate markets is difficult to do. Policies must often balance the benefits of having more firms competing in an industry against the possible gains from allowing a smaller number of firms to compete when those firms can achieve economies of scale. The government must try to weigh the benefits of such regulations against the advantages offered by more competitive, less regulated markets.
Promoting Full Employment and Price Stability
In addition to the monetary policies of the Federal Reserve System, the federal government can also use its taxing and spending policies, or fiscal policies, to counteract inflation or the cyclical unemployment that results from too much or too little total spending in the economy. Specifically, if inflation is too high because consumers, businesses, and the government are trying to buy more goods and services than it is possible to produce at that time, the government can reduce total spending in the economy by reducing its own spending. Or the government can raise taxes on households and businesses to reduce the amount of money the private sector spends. Either of these fiscal policies will help reduce inflation. Conversely, if inflation is low but unemployment rates are too high, the government can increase its spending or reduce taxes on households and businesses. These policies increase total spending in the economy, encouraging more production and employment.
Some government spending and tax policies work in ways that automatically stabilize the economy. For example, if the economy is moving into a recession, with falling prices and higher unemployment, income taxes paid by individuals and businesses will automatically fall, while spending for unemployment compensation and other kinds of assistance programs to low-income families will automatically rise. Just the opposite happens as the economy recovers and unemployment falls—income taxes rise and government spending for unemployment benefits falls. In both cases, tax programs and government-spending programs change automatically and help offset changes in nongovernment employment and spending.
In some cases, the federal government uses discretionary fiscal policies in addition to automatic stabilization policies. Discretionary fiscal policies encompass those changes in government spending and taxation that are made as a result of deliberations by the legislative and executive branches of government. Like the automatic stabilization policies, discretionary fiscal policy can reduce unemployment by increasing government spending or reducing taxes to encourage the creation of new jobs. Conversely, it can reduce inflation by decreasing government spending and raising taxes.
In general, the federal government tries to consider the condition of the national economy in its annual budgeting deliberations. However, discretionary spending is difficult to put into practice unless the nation is in a particularly severe episode of unemployment or inflation. In such periods, the severity of the situation builds more consensus about what should be done, and makes it more likely that the problem will still be there to deal with by the time the changes in government spending or tax programs take effect. But in general, it takes time for discretionary fiscal policy to work effectively, because the economic problem to be addressed must first be recognized, then agreement must be reached about how to change spending and tax levels. After that, it takes more time for the changes in spending or taxes to have an effect on the economy.
When there is only moderate inflation or unemployment, it becomes harder to reach agreement about the need for the government to change spending or taxes. Part of the problem is this: In order to increase or decrease the overall level of government spending or taxes, specific expenditures or taxes have to be increased or decreased, meaning that specific programs and voters are directly affected. Choosing which programs and voters to help or hurt often becomes a highly controversial political issue.
Because discretionary fiscal policies affect the government’s annual deficit or surplus, as well as the national debt, they can often be controversial and politically sensitive. For these reasons, at the close of the 20th century, which experienced years with normal levels of unemployment and inflation, there was more reliance on monetary policies, rather than on discretionary fiscal policies to try to stabilize the national economy. There have been, however, some famous episodes of changing federal spending and tax policies to reduce unemployment and fight inflation in the U.S. economy during the past 40 years. In the early 1980s the administration of U.S. president Ronald Reagan cut taxes. Other notable tax cuts occurred during the administrations of U.S. presidents John F. Kennedy and Lyndon Johnson in 1963 and 1964, and George W. Bush in 2001 and 2003.
Limitations of Government Programs
Government economic programs are not always successful in correcting market failures. Just as markets fail to produce the right amount of certain kinds of goods and services, the government will often spend too much on some programs and too little on others for a number of reasons. One is simply that the government is expected to deal with some of the most difficult problems facing the economy, taking over where markets fail because consumers or producers are not providing clear signals about what they want. This lack of clear signals also makes it difficult for the government to determine a policy that will correct the problem.
Political influences, rather than purely economic factors, often play a major role in inefficient government policies. Elected officials generally try to respond to the wishes of the voting public when making decisions that affect the economy. However, many citizens choose not to vote at all, so it is not clear how good the political signals are that elected officials have to work with. In addition, most voters are not well informed on complicated matters of economic policy.
For example, the federal government’s budget director David Stockman and other officials in the administration of President Reagan proposed cuts in income tax rates. Congress adopted the cuts in 1981 and 1984 as a way to reduce unemployment and make the economy grow so much that tax revenues would actually end up rising, not falling. Most economists and many politicians did not believe that would happen, but the tax cuts were politically popular.
In fact, the tax cuts resulted in very large budget deficits because the government did not collect enough taxes to cover its expenditures. The government had to borrow money, and the national debt grew very rapidly for many years. As the government borrowed large sums of money, the increased demand caused interest rates to rise. The higher interest rates made it more expensive for U.S. firms to invest in capital goods, and increased the demand for dollars on foreign exchange markets as foreigners bought U.S. bonds paying higher interest rates. That caused the value of the dollar to rise, compared with other nations’ currencies, and as a result U.S. exports became more expensive for foreigners to buy. When that happened in the mid-1980s, most U.S. companies that exported goods and services faced very difficult times.
In addition, whenever resources are allocated through the political process, the problem of special interest groups looms large. Many policies, such as tariffs or quotas on imported goods, create very large benefits for a small group of people and firms, while the costs are spread out across a large number of people. That gives those who receive the benefits strong reasons to lobby for the policy, while those who each pay a small part of the cost are unlikely to oppose it actively. This situation can occur even if the overall costs of the program greatly exceed its overall benefits.
For instance, the United States limits sugar imports. The resulting higher U.S. price for sugar greatly benefits farmers who grow sugarcane and sugar beets in the United States. U.S. corn farmers also benefit because the higher price for sugar increases demand for corn-based sweeteners that substitute for sugar. Companies in the United States that refine sugar and corn sweeteners also benefit. But candy and beverage companies that use sweeteners pay higher prices, which they pass on to millions of consumers who buy their products. However, these higher prices are spread across so many consumers that the increased cost for any one is very small. It therefore does not pay a consumer to spend much time, money, or effort to oppose the import barriers.
For sugar growers and refiners, of course, the higher price of sugar and the greater quantity of sugar they can produce and sell makes the import barriers something they value greatly. It is clearly in their interest to hire lobbyists and write letters to elected officials supporting these programs. When these officials hear from the people who benefit from the policies, but not from those who bear the costs, they may well decide to vote for the import restrictions. This can happen despite the fact that many studies indicate the total costs to consumers and the U.S. economy for these programs are much higher than the benefits received by sugar producers.
Special interest groups and issues are facts of life in the political arena. One striking way to see that is to drive around the U.S. national capital, Washington D.C., or a state capital and notice the number of lobbying groups that have large offices near the capitol building. Or simply look at the list of trade and professional associations in the yellow pages for those cities. These lobbying groups are important and useful to the political process in many ways. They provide information on issues and legislation affecting their interests. But these special interest groups also favor legislation that often benefits their members at the expense of the overall public welfare.
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 and on into the 21st century. Federal revenues totaled less than 5 percent of total GDP in the early 1930s. In 2005 they made up 20 percent.
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 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.
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. See also Globalization.
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 (see Foreign Trade). Some people worry that extensive levels of international trade may have hurt the U.S. economy, and U.S. workers in particular. But while some firms and workers have been hurt by international competition, in general economists view international trade like any other kind of voluntary trade: Both parties can gain, and usually do. International trade increases the total level of production and consumption in the world, lowers the costs of production and prices that consumers pay, and increases standards of living. How does that happen?
All over the world, people specialize in producing particular goods and services, then trade with others to get all of the other goods and services they can afford to buy and consume. It is far more efficient for some people to be lawyers and other people doctors, butchers, bakers, and teachers than it is for each person to try to make or do all of the things he or she consumes.
In earlier centuries, the majority of trade took place between individuals living in the same town or city. Later, as transportation and communications networks improved, individuals began to trade more frequently with people in other places. The Industrial Revolution that began in the 18th century greatly increased the volume of goods that could be shipped to other cities and regions, and eventually to other nations. As people became more prosperous, they also traveled more to other countries and began to demand the new products they encountered during their travels.
The basic motivation and benefits of international trade are actually no different from those that lead to trade within a nation. But international trade differs from trade within a nation in two major ways. First, international trade involves at least two national currencies, which must usually be exchanged before goods and services can be imported or exported. Second, nations sometimes impose barriers on international trade that they do not impose on trade that occurs entirely inside their own country.
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 2004 that figure had risen to 25 percent. Clearly, the international trade sector has grown much more rapidly than the overall economy.
Most of this trade occurs between industrialized, developed nations and involves similar kinds of products as both imports and exports. While it is true that the U.S. imports some things that are only found or grown in other parts of the world, most trade involves products that could be made in the United States or any other industrialized market economies. In fact, some products that are now imported, such as clothing and textiles, were once manufactured extensively in the United States. However, economists note that just because things were or could be made in a country does not mean that they should be made there.
Just as individuals can increase their standard of living by specializing in the production of the things they do best, nations also specialize in the products they can make most efficiently. The kinds of goods and services that the United States can produce most competitively for export are determined by its resources. The United States has a great deal of fertile land, is the most technologically advanced nation in the world, and has a highly educated and skilled labor force. That explains why U.S. companies produce and export many agricultural products as well as sophisticated machines, such as commercial jets and medical diagnostic equipment.
Many other nations have lower labor costs than the United States, which allows them to export goods that require a lot of labor, such as shoes, clothing, and textiles. But even in trading with other industrialized countries—whose workers are similarly well educated, trained, and highly paid—the United States finds it advantageous to export some high-tech products or professional services and to import others. For example, the United States both imports and exports commercial airplanes, automobiles, and various kinds of computer products. These trading patterns arise because within these categories of goods, production is further specialized into particular kinds of airplanes, automobiles, and computer products. For example, automobile manufacturers in one nation may focus production primarily on trucks and utility vehicles, while the automobile industries in other countries may focus on sport cars or compact vehicles.
Greater specialization allows producers to take full advantage of economies of scale. Manufacturers can build large factories geared toward production of specialized inventories, rather than spending extra resources on factory equipment needed to produce a wide variety of goods. Also, by selling more of their products to a greater number of consumers in global markets, manufacturers can produce enough to make specialization profitable.
The United States enjoyed a special advantage in the availability of factories, machinery, and other capital goods after World War II ended in 1945. During the following decade or two, many of the other industrial nations were recovering from the devastation of the war. But that situation largely disappeared, and the quality of the U.S. labor force and the level of technological innovation in U.S. industry became more important in determining trade patterns and other characteristics of the U.S. economy. A skilled labor force and the ability of businesses to develop or adapt new technologies are the key to high standards of living in modern global economies, particularly in highly industrialized nations. Workers with low levels of education and training will find it increasingly difficult to earn high wages and salaries in any part of the world, including the United States.
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.
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. See also Globalization.
In 1992 the United States also signed the North American Free Trade Agreement (NAFTA) with its closest neighbors and major trading partners, Canada and Mexico. The provisions of this agreement took effect in 1994. Since then, studies by economists have found that NAFTA has benefited all three nations, although greater competition has resulted in some factories closing. As a percentage of national income, the benefits from NAFTA have been greater in Canada and Mexico than in the United States, because international trade represents a larger part of those economies. While the United States is the largest trading nation in the world, it has a very large and prosperous domestic economy; therefore international trade is a much smaller percentage of the U.S. economy than it is in many countries with much smaller domestic economies.
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 euros. That creates a demand for euros 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 euros 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.
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 last 100 years, the primary reasons for the increase in living standards in the United States were technological progress, business investments in capital goods, and people’s investments in greater education and training (which were often subsidized by government programs). There is no evident reason why these same factors will not continue to be the most important reasons underlying changes in the standard of living in the United States and other industrialized economies. A comparatively small number of economists and scientists from other fields argue that limited supplies of energy or of other natural resources will eventually slow or stop economic growth. Most, however, expect those limits to be offset by discoveries of new deposits or new types of resources, by other technological breakthroughs, and by greater substitution of other products for the increasingly scarce resources.
Although the U.S. economy will likely remain the world’s largest national economy for many decades, it is far less certain that U.S. households will continue to enjoy the highest average standard of living among industrialized nations. A number of other nations 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 caught up with the United States because of their higher rates of savings and investment, and in some cases, because of their stronger systems for elementary and secondary education and for training of workers.
Most U.S. workers and families will still be better off as the U.S. economy grows, even if some other economies are growing faster and becoming somewhat more prosperous, as measured per capita. Certainly families in Britain today are far better off materially than they were 150 to 200 years ago, when Britain was the largest and wealthiest economy in the world, despite the fact that many other nations have since surpassed the British economy in size and affluence.
A more important problem for the U.S. economy in the next few decades is the unequal distribution of gains from growth in the economy. In recent decades, the wealth created by economic growth has not been as evenly distributed as was the wealth created in earlier periods. Incomes for highly educated and trained workers have risen faster than average, while incomes for workers with low levels of education and training have not increased and have even fallen for some groups of workers, after adjusting for inflation. Other industrialized market economies have also experienced rising disparity between high-income and low-income families, but wages of low-income workers have not actually fallen in real terms in those countries as they have in the United States.
In most industrialized nations, the demand for highly educated and trained workers has risen sharply in recent decades. That happened in part because many kinds of jobs now require higher skill levels, but other factors were also important. New production methods require workers to frequently and rapidly change what they do on the job. They also increase the need for quality products and customer service and the ability of employees to work in teams. Increased levels of competition, including competition from foreign producers, have put a higher premium on producing high quality products.
Several other factors help explain why the relative position of low-income workers has fallen more in the United States than in other industrialized Western nations. The growth of college graduates has slowed in the United States but not in other nations. United States immigration policies have not been as closely tied to job-market requirements as immigration policies in many other nations have been. Also, government assistance programs for low-income families are usually not as generous in the United States as they are in other industrialized nations.
Changes in the make-up of the U.S. population are likely to cause income disparity to grow, at least through the first half of the 21st century. The U.S. population is growing most rapidly among the groups that are most likely to have low incomes and experience some form of discrimination. Children in these groups are less likely to attend college or to receive other educational opportunities that might help them acquire higher-paying jobs.
The U.S. population will also be aging during this period. As people born during the baby boom of 1946 to 1964 reach retirement age, the percentage of the population that is retired will increase sharply, while the percentage that is working will fall. The demand for medical care and long-term care facilities will increase, and the number of people drawing Social Security benefits will rise sharply. That will increase pressure on government budgets. Eventually, taxes to pay for these services will have to be increased, or the level of these services provided by the government will have to be cut back. Neither of those approaches will be politically popular.
A few economists have called for radical changes in the Social Security system to deal with these problems. One suggestion has been to allow workers to save and invest in private retirement accounts rather than pay into Social Security. Thus far, those approaches have not been considered politically feasible or equitable. Current retirees strongly oppose changing the system, as do people who fear that they will lose future benefits from a program they have paid taxes to support all their working lives. Others worry that private accounts will not provide adequate retirement income for low-income workers, or that the government will still be called on to support those who make bad investment choices in their private retirement accounts. In 2005 President George W. Bush proposed privatizing Social Security, and it failed to gain political support. The drastic decline in the stock market in 2008, which saw the largest single-day point drop in the history of the Dow Jones Industrial Average (known as the Dow), appeared to reinforce opposition to privatizing Social Security.
Political and economic events that occur in other parts of the world are felt sooner and more strongly in the United States than ever before, as a result of rising levels of international trade and the unique U.S. position as an economic, military, and political superpower. The 1991 breakup of the Union of Soviet Socialist Republics (USSR)—perhaps the most dramatic international event to unfold since World War II—has presented new opportunities for economic trade and cooperation. But it also has posed new challenges in dealing with the turbulent political and economic situations that exist in many of the independent nations that emerged from the breakup. Some fledgling democracies in Africa are similarly volatile.
Many U.S. firms are eager to sell their products to consumers and firms in these nations, and U.S. banks and other financial institutions are eager to lend funds to support investments in these countries, if they can be reasonably sure that these loans will be repaid. But there are economic risks to doing business in these countries, including inflation, low income levels, high crime rates, and frequent government and company defaults on loans. Also, political upheavals sometimes bring to power leaders who oppose market reforms.
The greater political and economic unification of nations in the European Union (EU) offers different kinds of issues. There is much less risk of inflation, crime, and political upheaval to contend with in this area. On the other hand, there is more competition to face from well-established and technologically sophisticated firms, and more concern that the EU will put trade barriers on products produced in the United States and in other countries that are not members of the Union. Clearly, the United States will be concerned with maintaining its trading position with those nations. It will also look to the EU to act as an ally in settling international policies in political and economic arenas, such as a peace initiative in the Middle East and treaties on international trade and environmental issues.
The United States has other major economic and political interests in the Middle East, Asia, and around the world. China is likely to become an even larger trading partner and an increasingly important political power in the world. Other Asian nations, including Japan, South 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. See also Globalization.
Greater world trade and cooperation offer an enormous range of mutually beneficial activities. Trading with other countries inevitably increases opportunities for travel and cultural exchange, as well as business opportunities. In a very broad sense, nations that buy and sell goods and services with each other also have a greater stake in other forms of peaceful cooperation, and in seeing other countries prosper and grow.
On the other hand, global interdependence also raises major problems—political, economic, and environmental—that require international solutions. Many of these problems, such as pollution, global warming, and assistance for developing nations, have been controversial even when solutions were discussed only at the national level. Often, controversy increases with the number of nations that must agree on a solution, but some problems require global remedies. Such problems will challenge the productive capacity of the U.S. economy and the wisdom of U.S. citizens and their political leaders.
No nation has ever had the rich supply of resources to face the future that the U.S. economy has as it enters the 21st century. Despite that, or perhaps because of it, U.S. consumers, businesses, and political leaders are still trying to do more than earlier generations of citizens.
Another issue facing the U.S. economy in the 21st century is the extent of government regulation of the economy and whether a lack of regulation has increased the harm from speculative manias known as bubbles. Beginning in the 1970s and gaining strength in the 1980s, free-market theories emphasizing government deregulation held sway. This ideology held that a market economy functioned best when it was entirely free of government oversight. Many industries were deregulated, but perhaps the most important deregulation took place in the financial industry. The deregulation of the financial industry reached its pinnacle in 1999 when the U.S. Congress passed the Gramm-Leach-Bliley Act, named for the congressmen who sponsored it. This law removed the last vestiges of the New Deal-era Glass-Steagall Act, which had imposed a rigid separation between investment banking and commercial banking in an attempt to prevent banks that held deposits from engaging in speculative, or risky, investing. Many economists believed risky investments on the part of commercial banks helped produce the Great Depression.
During a speculative bubble over the rise of Internet companies in the early part of the 21st century, known as the dot-com bubble, many observers cited lapses in regulatory oversight by such agencies as the Securities and Exchange Commission. Some of these lapses led to the Enron scandal, which revealed accounting fraud on the part of the Enron Corporation, and a similar scandal involving a major telecommunications firm known as WorldCom, Inc. (present-day MCI, Inc.). The scandals resulted in new legislation, known as the Sarbanes-Oxley Act, which stiffened government regulation of corporate accounting procedures. See also History of United States Business.
Another bubble later in the decade, this time a bubble in housing prices, renewed the debate over regulation vs. deregulation. The debate surfaced in 2008 after the Federal Reserve and the U.S. Treasury had to rescue a number of banks and key financial institutions in a $700-billion bailout. The extraordinary intervention involved the federal government becoming shareholders in the nation’s largest banks and taking control of two mortgage-lending institutions known as Fannie Mae and Freddie Mac. It came after one of the country’s largest and oldest investment banks, Lehman Brothers, filed for bankruptcy and other banks teetered on the edge of failure. The Federal Reserve had to seize the nation’s largest savings-and-loan institution, Washington Mutual, to prevent depositors from withdrawing all their money, which is known as a run on the bank. Bank runs were a major feature of the Great Depression.
The financial crisis was widely regarded as the worst since the Great Depression. It began after home prices plunged and many banks were left with bad debt. From 2000 to 2005, home prices on average rose steadily in the United States, particularly in such popular areas as Arizona, California, and Florida. Many banks and mortgage lenders took advantage of what became known as the housing bubble to issue risky subprime (low credit rating) mortgages to people who would not ordinarily qualify for a mortgage. Often these loans had adjustable rates that could rise or fall. From 2002 to 2007 about $3.2 trillion in loans were made to homebuyers with poor credit histories or undocumented income. When home prices began to decline in 2006 and the housing bubble burst, many people found themselves owing more on their mortgage than their home was worth. When rates rose for those with adjustable-rate mortgages, many could not afford their mortgage payments. The number of foreclosures began to rise. During the second quarter of 2008 a record 1.2 million homes were in foreclosure, and total foreclosures for the entire year were expected to number 2.3 million, compared with an average of 1 million in previous years.
Complicating the situation was the fact that many banks and other lenders had repackaged their mortgages in the form of financial investments known as mortgage securities. These widely traded mortgage securities were based on many of the bad loans. From 2000 to 2005 the amount of subprime mortgages involved in these securities increased from $56 billion to $508 billion. In 2006 investors bought at least $2.1 trillion in mortgage and other debt securities, a figure that declined only slightly to $1.6 trillion in 2007. Beginning in 2008 banks that held these securities began reporting huge losses as subprime borrowers defaulted. The banks suffered a reported $523 billion in losses. Suddenly they stopped lending, throwing the economy into a credit crisis. Banks and other financial institutions had also invested heavily in derivatives, complicated financial instruments that were supposed to help investors hedge against losses but that proved to be as toxic as mortgage securities. The world’s largest insurance firm, American International Group (AIG), received a $150-billion bailout from the federal government after one of its units suffered huge losses in derivatives. In 2009 AIG received an additional $30 billion line of credit from the U.S. government.
After the U.S. Congress passed the $700-billion bailout, congressional committees began investigating what went wrong and whether more government regulation or oversight was needed. The head of the Securities and Exchange Commission admitted that its program of encouraging voluntary self-regulation by the financial industry had failed. Former Federal Reserve chairman Alan Greenspan, who presided over the Fed from 1987 to 2006, came under criticism for failing to prevent the housing bubble by raising interest rates. Greenspan also conceded that he had been mistaken in opposing greater government regulation, having believed that the financial industry could best regulate itself. Derivatives, which had never been regulated, also came under scrutiny as the free-market theories opposing government regulation came into disrepute.
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.
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.
Agriculture
The United States contains some of the best cropland in the world. Cultivated farmland constitutes 19 percent of the land area of the country and makes the United States the world’s richest agricultural nation. In part because of the nation’s favorable climate, soil, and water conditions, farmers produce huge quantities of agricultural commodities and a variety of crops and livestock.
The United States is the largest producer of corn, soybeans, and sorghum, and it ranks second in the production of wheat, oats, citrus fruits, and tobacco. The United States is also a major producer of sugar cane, potatoes, peanuts, and beet sugar. It ranks fourth in the world in cattle production and second in hogs. The total annual value of farm output increased from $55 billion in 1970 to $207 billion in 2002. 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 less than 1 percent of annual GDP and employed less than 2 percent of the workforce in 2004.
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 2008 there were 2,200,000 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 169 hectares (418 acres) by 2008.
Cattle production is widespread throughout the United States. Texas leads in the production of range cattle, which are allowed to graze freely. Iowa and Illinois are important for nonrange feeder cattle, which are cattle that eat feed grain provided by cattle farmers. The Dairy Belt continues to be concentrated in southern Wisconsin but is also prominent in the rural landscapes of most northeastern states and fairly common in other states, too. Hog production tends to be concentrated in Iowa, Illinois, and surrounding states, where hogs are fattened for market. Chicken production is widespread, but southern states, including Texas, Arkansas, and Alabama, dominate.
Corn and soybean production is concentrated heavily in Iowa and Illinois and is also important in surrounding states, including Missouri, Indiana, Nebraska, and the southern regions of Minnesota and Wisconsin. Wheat is another important U.S. crop. Kansas usually leads all states in yearly wheat production. North Dakota, Montana, Oklahoma, Washington, Idaho, South Dakota, Colorado, Texas, Minnesota, and Nebraska also are major wheat producers.
For more than a century and a half, cotton was the predominant cash crop in the South. Today, however, it is no longer important in some of the traditional cotton-growing areas east of the Mississippi River. While some cotton is still produced in the Old South, it has become more important in the Mississippi Valley, the Panhandle of Texas, and the Central Valley of California. Cotton is shipped to mills in the eastern United States and is exported to cotton textile plants in Japan, South Korea, Indonesia, and Taiwan.
Vegetables are grown widely in the United States. Outside major U.S. cities, small farms and gardens, known as truck farms, grow vegetables and some varieties of fruits for urban markets. California is the leading vegetable producing state; much of its cropland is irrigated.
Most fruits grown in the United States fall in the categories of midlatitude and citrus fruits. Midlatitude fruits, such as apples, pears, and plums, grow in northern states including Washington, Michigan, Pennsylvania, and New York. Citrus fruits—lemons, oranges, and grapefruits—thrive in Florida, southern Texas, and southern California. Nuts grow on irrigated land in the Central Valley of California and in parts of southern California.
Production of specialty crops and livestock has increased in recent years, particularly along the East and West coasts and in the Southeast. Ranches in New York and Texas have introduced exotic game, such as emu, fallow deer, and nilgai and black buck antelope. Deer and antelope meat, known as venison, is served mainly in restaurants. Specialty vegetable and fruit operations produce dwarf apples, brown and green cotton, canola, and jasmine rice. Farmers raise more than 60 specialty crops in the United States for Asian-American markets, including bean sprouts, snow peas, and Chinese cabbage.
Forestry
At the beginning of the 21st century, less than 1 percent of the country’s workforce was involved in the lumber industry, and forestry accounted for less than 0.5 percent of the nation’s gross domestic product (GDP). Nevertheless, forests represent a crucial resource for U.S. industry. Forest resources are used in producing housing, fuel, foodstuffs, and manufactured goods. The United States leads the world in lumber production and is second in the production of wood for pulp and paper manufacture. These high production levels, however, do not satisfy all of the U.S. demand for forest products. The United States is the world’s largest importer of lumber, most of which comes from Canada.
When European settlers first arrived in North America, half of the land on the continent was covered with forests. The forests of the eastern and northern portions of the country were fairly continuous. Beginning with the early colonists, the natural vegetation was altered drastically as farmers cleared land for crops and pastures, and cut trees for firewood and lumber. In the north and east, lumbermen quickly cut all of the valuable trees before moving on to other locations. Only 10 percent of the original virgin timber remains. Almost two thirds of the forests that remain have been classified as commercial resources.
Forests still cover 31 percent of the United States. The trees in the nation’s forests contain an estimated 7.1 billion cu m (249.3 billion cu ft) of wood suitable for lumber. Private individuals and businesses, including farmers, lumber companies, paper mills, and other wood-using industries, own about 73 percent of the commercial forestland. Federal, state, and local governments own the remaining 27 percent.
Softwoods (wood harvested from cone-bearing trees) make up about three-fourths of forestry production and hardwoods (wood harvested from broad-leafed trees) about one-fourth. Nearly half the timber output is used for making lumber boards, and about one-third is converted to pulpwood, which is subsequently used to manufacture paper. Most of the remaining output goes into plywood and veneer. Douglas fir and southern yellow pine are the primary softwoods used in making lumber, and oak is the most important hardwood.
About half of the nation’s lumber and all of its fir plywood come from the forests of the Pacific states, an area dominated by softwoods. In addition to the Douglas fir forests in Washington and Oregon, this area includes the famous California redwoods and the Sitka spruce along the coast of Alaska. Forests in the mountain states of the West cover a relatively small area, yet they account for more than 10 percent of the nation’s lumber production. Ponderosa pine is the most important species cut from the forests of this area.
Forests in the South supply about one-third of the lumber, nearly three-fifths of the pulpwood, and almost all the turpentine, pitch, resin, and wood tar produced in the United States. Longleaf, shortleaf, loblolly, and slash pine are the most important commercial trees of the southern coastal plain. Commercially valuable hardwood trees, such as gum, ash, pecan, and oak, grow in the lowlands along the rivers of the South.
The Appalachian Highland and parts of the Great Lakes area have excellent hardwood forests. Hickory, maple, oak, and other hardwoods removed from these forests provide fine woods for the manufacture of furniture and other products.
Beginning in the 1990s the forest products industry underwent a transformation. New environmental requirements, designed to protect wildlife habitat and water resources, were changing forest practices, particularly in the West. The amount of timber cut on federal land declined by 50 percent from 1989 to 1993.
Fishing
The U.S. waters off the coast of North America provide a rich marine harvest, which is about evenly split in commercial value between fish and shellfish. Humans consume approximately 80 percent of the catch as food. The remaining 20 percent goes into the manufacturing of products such as fish oil, fertilizers, and animal food.
In 2007 the United States had a commercial fish catch of 5.3 million metric tons. The value of the catch was an estimated $3.4 billion in 2003. 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. 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.
Mining
As a country of continental proportions, the United States has within its borders substantial mineral deposits. America leads the world in the production of phosphate, an important ingredient in fertilizers, and ranks second in gold, silver, copper, lead, natural gas, and coal. Petroleum production is third in the world, after Russia and Saudi Arabia.
Mining contributes less than 2 percent of annual GDP and employs less than 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 2003 the United States produced 20 percent of the world’s natural gas, 20 percent of its coal, and 11 percent of its crude oil. In the last two decades, 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 (36 percent of U.S. production in 2005), West Virginia (14 percent), and Kentucky (11 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 2005 the United States produced 34 percent of the world’s molybdenum, 26 percent of its phosphate rock, 15 percent of its sulfur, 13 percent of its lead, and 8 percent of its copper. Major deposits of many of these minerals are found in the western states.
Manufacturing and Energy Sector
Manufacturing
The United States leads all nations in the value of its yearly manufacturing output. Manufacturing employs about 12 percent of the nation’s workers and accounts for 14 percent of annual GDP. In 2003 the total value added by manufacturing was $1.9 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 2004 the number of employees in manufacturing declined from 20.7 million to 14.3 million, while the total U.S. nonfarm labor force grew to 134 million people.
One of the most important changes in the pattern of U.S. industry in recent decades has been the growth of manufacturing in regions outside the Northeast and North Central regions. The nation’s industrial core first developed in the Northeast. This area still has the greatest number of industrial firms, but its share of these firms is smaller than in the past. In 1947 about 75 percent of the nation’s manufacturing employees lived in the 21 Northeast and Midwest states that extend from New England to Kansas. By the early 1990s, however, only about one-half of manufacturing employees resided in the same region. Since 1947, the South’s share of the nation’s manufacturing workers increased from 19 to 32 percent, and the West’s share grew from 7 to 18 percent.
In the North, manufacturing is centered in the Middle Atlantic and East North Central states, which accounted for 38 percent of the value added by all manufacturing in the United States in 1996. Located in this area are five of the top seven manufacturing states—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.
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 China, India, Indonesia, Jamaica, Malaysia, the Philippines, and South Korea.
In the 21st century, few products were made entirely within the United States. Although a product may be fabricated in the United States, some component parts were probably 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. See also Globalization.
Principal Products
Ranked by value added by manufacturing, in 2003 the leading categories of U.S. manufactured goods were chemicals, transportation equipment, processed foods, computer and electronic equipment, industrial machinery, and fabricated metal products. The chemical industry accounted for about 14 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.
Machinery accounted for 6.6 percent of the value added by manufacture. Industrial machinery includes engines, farm equipment, various kinds of construction machinery, computers, and refrigeration equipment. California led all states in the annual value added by industrial machinery, followed by Illinois, Ohio, and Michigan.
Factories in the United States build millions of computers, and the United States occupies second place in the world in the production of electronic components (semiconductors, microprocessors, and computer equipment). Electronic equipment accounted for 10.5 percent of the yearly value added by manufacturing, and it was one of the fastest growing manufacturing sectors during the 1990s; production of electronics and electric equipment increased by 77 percent from 1987 to 1994. High-technology research and production facilities have developed in the Silicon Valley of California, south of San Francisco; the area surrounding Boston; the Research Triangle of Raleigh, Chapel Hill, and Durham in North Carolina; and the area around Austin, Texas. In addition, the United States has world leadership in the development and production of computer software. Leading software producers are located in areas around Seattle, Washington; Boston, Massachusetts; and San Francisco, California.
Food processing accounted for about 10.2 percent of the overall annual value added by manufacturing. Food processing is an important industry in several states noted for the production of food crops and livestock, or both. California has a large fruit- and vegetable-processing industry. Meat-packing is important to agriculture in Illinois and dairy processing is a large industry in Wisconsin.
Transportation equipment includes passenger cars, trucks, airplanes, space vehicles, ships and boats, and railroad equipment. This category accounted for 10.1 percent of the yearly value added by manufacturing. Michigan, with its huge automobile industry, is a leading producer of transportation equipment.
The manufacture of fabricated metal and primary metal is concentrated in the nation’s industrial core region. Iron ore from the Lake Superior district, plus that imported from Canada and other countries, and Appalachian coal are the basis for a large iron and steel industry. Pennsylvania, Ohio, Indiana, Illinois, and Michigan are leading states in the value of primary metal output. The fabricated metal industry, which includes the manufacture of cans and other containers, hardware, and metal forgings and stampings, is important in the same states. The primary metals industry of these states provides the basic raw materials, especially steel, that are used in making metal products.
Printing and publishing is a widespread industry, with newspapers published throughout the country. New York, with its book-publishing industry, is the leading state, but California, Illinois, and Pennsylvania also have sizable printing and publishing industries.
The manufacture of paper products is important in several states, particularly those with large timber resources, especially softwood trees used to make most paper. The manufacture of paper and paperboard contributes significantly to the economies of Wisconsin, Alabama, Georgia, Washington, New York, Maine, and Pennsylvania.
Other major U.S. manufactures include textiles, clothing, precision instruments, lumber, furniture, tobacco products, leather goods, and stone, clay, and glass items.
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 41 percent of the total energy consumed in the United States, according to the United States Energy Information Administration (EIA). It supplies nearly all of the energy used to power the nation’s transportation system and heats millions of houses and factories.
In 2004, the latest year for which figures are available, natural gas was the source of 23 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 provided 22 percent of the energy consumed. Its major uses are in the generation of electricity, which uses more than three-fourths of all the coal consumed, and in the manufacture of steel.
Waterpower generates 6 percent of the nation’s energy, and nuclear power supplies 8 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 2007 the nation’s generating plants had a total installed capacity of 1,087,791 megawatts and produced 4.06 trillion kilowatt-hours of electricity. Coal is the most common fuel used by electric power plants, and 57 percent of the nation’s yearly electricity is generated in coal-fired plants. The states producing the most coal-generated electricity are Ohio, Texas, Indiana, Pennsylvania, Illinois, West Virginia, Kentucky, and Georgia.
Natural gas accounts for 9 percent of the electricity produced, and refined petroleum for 2 percent. The states producing the most electricity from natural gas are Texas and California. Refined petroleum is especially important in Florida, New York, and Massachusetts. The leading producers of hydroelectricity are Washington, Oregon, New York, and California. Illinois, Pennsylvania, South Carolina, and California have the largest nuclear power industries.
Petroleum is a key resource for an American lifestyle based on extensive use of private automobiles and trucks for commerce and businesses. Since 1947, when the United States became a net importer of oil, annual domestic production has not been enough to meet the demands of the highly mobile American society.
In 1970 domestic crude-oil production reached a record high of 3.5 billion barrels, but this had to be supplemented by imports amounting to 12 percent of the nation’s overall crude oil supply. Most Americans were unaware of the dependence of the country on foreign petroleum until an oil embargo imposed by some Middle Eastern nations in 1973 and 1974 led to government price ceilings for gasoline and other energy products, which in turn led to shortages. In 1973 the nation imported about one-fourth of its total supply of crude oil. Imports continued to rise until 1977, when about half of the crude and refined oil supply was imported. Imports then declined for a time, largely because energy-conservation measures were introduced and because other domestic energy sources such as coal were used increasingly. As of 2004, however, 58 percent of the petroleum products and crude oil needs of the United States were met by net imports. See also 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. See Greenhouse Effect.
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.
Service Industries
The service sector is extremely diverse. It includes an assortment of private businesses and government agencies that provide a wide spectrum of services to the U.S. public. Services industries can be very different from each other, ranging from health-care providers to vacation resorts to automobile repair shops. Although it would be almost impossible to list every kind of service industry operating in the United States, many of these businesses fall into one of several large service categories.
Banking and Financial Services
In 1995 the U.S. financial market had a total of 628,500 institutions, which employed 7.0 million people. These institutions included investment, commercial, and savings banks; credit unions; mortgage banks; insurance companies; mutual funds; real estate agencies; and various holdings and trusts.
Banks play a central role in any economy since they act as intermediaries in the flow of money. They collect deposits and distribute them as loans, allowing depositors to save for future consumption and allowing borrowers to invest. In 1998 the United States had 10,481 insured banks and savings institutions with a total of 84,123 banking offices. Because of mergers and closures, the number of banks steadily declined in the 1980s and 1990s while the number of bank offices increased. In 2000 the 8,528 commercial banks in the United States controlled 24 percent of the financial industry’s total assets.
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 Citibank and J.P. Morgan Chase & Co., headquartered in New York City; Bank of America, headquartered in Charlotte, North Carolina; and Wells Fargo, headquartered in San Francisco, California.
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 2000 savings institutions’ share of financial assets was roughly 5 percent.
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.
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
Transportation-related businesses are an important part of the service industry. Trucks, railroads, and ships transport goods to markets across the country. Commercial airlines, railroads, bus companies, and taxis move tourists and commuters to their destinations. The U.S. Postal Service and a number of private carriers deliver goods as well as mail to consumers. The U.S. transportation network spreads into all sections of the country, but the web of railroads and highways is much denser in the eastern half of the United States, where it serves the nation’s largest urban, industrial, and population concentrations.
As of 1996 the 10 largest railroad companies in the United States operated 72 percent of tracks. Takeovers and mergers among the major private railroad companies were common during the 1980s and 1990s. Amtrak (the National Railroad Passenger Corporation), a federally subsidized organization, operates almost all the intercity passenger trains in the United States. It carried 20.2 million passengers in 1997. Although rail passenger travel has declined in importance during the 21st 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 75,111-km (46,672-mi) network of limited-access highways that connects the nation’s principal cities. This carefully designed system enables motorists to drive across the country without encountering an intersection or traffic signal. It carries about 20 percent of U.S. motor-vehicle traffic, though it accounts for just over 1 percent of U.S. roads and streets. The system is designed for safe, efficient driving, with gentle curves, easy grades and long sight distances. Entering and exiting the highway system is permitted only at planned interchanges.
Air transport began to compete with other modes of transport in the United States after World War I (1914-1918). The first commercial flights in the United States were made in 1918 and carried small amounts of mail. Passenger service began to gain importance in the late 1920s, but air transport did not become a leading mode of travel until the advent of commercial jet craft after World War II. By the 1990s a growing number of Americans flew for personal and business travel, in part because of the need to cover long distances and in part because they like to get to their destinations quickly. In 1997 airlines in the United States carried 598.1 million passengers, the vast majority of whom were domestic travelers.
By the end of the 20th century, large and small airports across the nation formed a network providing air transportation to individual travelers. The nation had 5,286 public and 14,295 private airports in 2003. The largest airports in the United States by passenger arrivals and departures are Chicago-O’Hare International Airport in Illinois; Hartsfield-Jackson International Airport near Atlanta, Georgia; Dallas-Fort Worth Airport in Texas; and Los Angeles International Airport in California.
The United States has a relatively small commercial shipping fleet. In 1998 only 473 vessels of 1,000 gross tons and larger were registered in the United States. Only 56 percent were in use; most of the remainder formed part of a government-owned military reserve fleet. However, many American ship owners register their vessels in foreign countries such as Liberia and Panama, where crew wages, taxes, and operating costs are lower.
In terms of the number of ships docking, New Orleans, Louisiana, is the busiest port in the nation; each year it handles more than 6,000 vessels. Other leading ports include Los Angeles-Long Beach, California; Houston, Texas; New York, New York; San Francisco-Oakland, California; Miami, Florida; and Philadelphia, Pennsylvania. Crude petroleum accounts for 22 percent of the waterborne tonnage of the United States. Petroleum products make up 18 percent. Coal accounts for 14 percent, and farm products for 14 percent.
The inland waterway network of the United States has three main components—the Mississippi River system, the Great Lakes, and the coastal waterways. Some 66 percent of the annual water freight traffic is on the Mississippi River and its tributaries, 17 percent is on the Great Lakes, and most of the remainder is on the coastal waterways. A major thoroughfare of the coastal waterways is the Intracoastal Waterway, a navigable, toll-free shipping route extending for about 1,740 km (about 1,080 mi) along the Atlantic Coast and for about 1,770 km (about 1,100 mi) along the Gulf of Mexico coast. About 45 percent of the total annual traffic on all coastal waterways travels on the Gulf Intracoastal Waterway, about 30 percent is on the Atlantic Intracoastal Waterway, and about 25 percent is on Pacific Coast waterways.
Most goods in the United States travel by railroad and truck, which compete vigorously for freight transport. In 1996, 38 percent of all United States freight moved by rail and about 27 percent traveled by truck. However, other modes of transportation more easily handle special freight items. An additional 20 percent of all freight, by volume, moved through pipelines, mainly oil and natural gas pipelines originating in Texas and Louisiana with destinations in the Midwest and Northeast. Another 16 percent, mainly bulk commodities like coal, grain, and industrial limestone, moved by barge on inland waters.
Government
Federal, state, and local governments provide a sizeable portion of services delivered in the nation. In 2003 there were 21.3 million government workers. 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 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.
Entertainment
Another leading industry is the entertainment business. Motion picture production has been centered in Hollywood, California, since the early decades of the 20th century, when the budding motion picture industry discovered that the warm climate and sunny skies of southern California provided ideal conditions for film production. Other entertainment industries include theater, which tends to be located in larger urban areas, particularly New York City, and television, with major networks operating out of the New York City area.
Commerce
The 1990s have been years of unrivaled prosperity in the United States, with per capita GDP reaching $45,591.70 by 2007. This high quality of life results partly from a rapid expansion of commerce in the years following World War II.
Domestic Trade
Convenience is the key to consumer markets in the United States, whether it is fast food, movie theaters, clothing, or any of hundreds of different types of consumer goods. Products are being delivered to citizens in a more efficient manner, as industries and business firms have decentralized to more closely fit the distribution of population. Malls have sprung up in suburban areas, making the downtown department store obsolete in many smaller cities. Manufacturers also market their goods directly to customers in factory outlet malls. Prices are often lower in these outlets than in regular retail stores. Customers often travel hundreds of miles to shop at larger factory outlet malls. At the other end of the spectrum, mail order catalogs and Internet sites have made it possible for many consumers to purchase products directly from companies by mail or using personal computers.
Wholesalers and retailers carry on most domestic commerce, or trade, in the United States. Wholesalers buy goods from producers and sell them mainly to retail business firms. Retailers sell goods to the final consumer. Wholesale and retail trade together account for 16 percent of annual GDP of the United States and employ 21 percent of the labor force.
Wholesale establishments conducted aggregate annual sales of $3.2 trillion in 1992. The leading type of wholesale business is the distribution of groceries and related products, which accounts for 16 percent of all wholesale activity. Next in rank are motor-vehicle parts and supplies; petroleum and petroleum products; professional and commercial equipment, and machinery, equipment, and supplies. Wholesalers tend to be located in large urban centers that enable them to distribute goods over wide sections of the nation. The New York City metropolitan area is the country’s leading wholesale center. It serves as the national distribution center for a variety of goods and as the main regional center for the eastern United States. Other leading wholesale centers include Los Angeles, the main center for the western part of the United States; Chicago; San Francisco; Philadelphia; Houston; Dallas; and Atlanta.
In the mid-1990s retail establishments in the United States had aggregate annual sales of $2.2 trillion. Automotive dealers, with 23 percent of the total yearly retail trade, and food stores, with 18 percent, are the leading retailers. The volume of retail sales is directly related to the number of consumers in an area. The four leading states in annual retail sales—California, Texas, Florida, and New York—are also the four most populous states.
Foreign Trade
The United States is the world’s leading trading nation, with total merchandise exports amounting to $1,163 billion, and imports to $2.02 trillion. 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.
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.
Communications
The communications systems in the United States are among the most developed in the world. Television, radio, newspapers, and other publications, provide most of the country’s news and entertainment. On average there are two radios and one television set for every person in the United States. Although the economic output of the communications industry is relatively small, the industry has enormous importance to the political, social, and intellectual activity of the nation. Most communication media in the United States are privately owned and operate independently of government control.
The Federal Communications Commission must license all radio and television broadcasting stations in the United States. In 1997, 1,285 television broadcasters were in operation. All states had television stations, and more than 40 percent of the stations were concentrated in nine states: Texas, California, Florida, New York, Pennsylvania, Ohio, Illinois, Michigan, and North Carolina. A rapidly growing number of U.S. households (estimated at 64 million in 1997) subscribed to cable television. An estimated 98.3 percent of U.S. households had at least one television set. Telephone communication changed as cellular phones allowed people to communicate via telephone while away from their homes and businesses or while traveling. There were more than 120 million cellular phone users in the United States in 2001, according to the Cellular Telecommunications and Internet Association.
There were about 1,500 daily newspapers published in the United States in 2000. That year daily newspapers printed a total of 56 million copies, and on average, each copy was read by at least 2 people. The top daily newspapers in the United States according to circulation were the Wall Street Journal (published in New York City), USA Today (published in Arlington, Virginia), the New York Times, and the Los Angeles Times, each with a circulation in excess of 1 million. Other leading newspapers included the Washington Post, the New York Daily News, the Chicago Tribune, the Detroit Free Press, the San Francisco Chronicle, the Chicago Sun-Times, the Dallas Morning News, the Boston Globe, and the Philadelphia Inquirer.
Nearly 21,300 periodicals were published in 1997. These ranged from specialized journals reaching only a small number of professionals to major newsmagazines such as Time and Newsweek. Other mass publications with vast audiences included the weekly TV Guide and the monthly Reader’s Digest.
Technology
One of the most far-reaching technological advances of the late 20th century took place in the field of computer science. Computers developed from large, cumbersome, and expensive machines to relatively small and affordable devices. The development of the personal computer (PC) in the 1970s made it possible for many individuals to own computers and allowed even small businesses to use computer technology in their operations. The U.S. Bureau of the Census estimates that jobs in the computer industry are growing at the fastest rate of any employment area, with job openings for computer specialists expected to double from 1996 to 2006.
The Internet began in the 1960s as a small network of academic and government computers primarily involved in research for the U.S. military. Originally limited to researchers at a handful of universities and government facilities, the Internet quickly became a worldwide network providing users with information on a range of subjects and allowing them to purchase goods directly from companies via computer. By 2003, 166 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.