U.S. Economy

United States (Economy)
INTRODUCTION

The U.S. economy is immense. In 1998 it included more than 270 million
consumers and 20 million businesses. U.S. consumers purchased more than
$5.5 trillion of goods and services annually, and businesses invested
over a trillion dollars more for factories and equipment. Over 80 percent
of the goods and services purchased by U.S. consumers each year are made
in the United States; the rest are imported from other nations. In
addition to spending by private households and businesses, government
agencies at all levels (federal, state, and local) spend roughly an
additional $1.5 trillion a year. In total, the annual value of all goods
and services produced in the United States, known as the Gross Domestic
Product (GDP), was $9.25 trillion in 1999.

Those levels of production, consumption, and spending make the U.S.
economy by far the largest economy the world has ever known—despite the
fact that some other nations have far more people, land, or other
resources. Through most of the 20th century, U.S. citizens also enjoyed
the highest material standards of living in the world. Some nations have
higher per capita (per person) incomes than the United States. However,
these comparisons are based on international exchange rates, which set
the value of a country’s currency based on a narrow range of goods and
services traded between nations. Most economists agree that the United
States has a higher per capita income based on the total value of goods
and services that households consume. American prosperity has attracted
worldwide attention and imitation. There are several key reasons why the
U.S. economy has been so successful and other reasons why, in the 21st
century, it is possible that some other industrialized nations will
surpass the U.S. standard of living. To understand those historical and
possible future events, it is important first to understand what an
economic system is and how that system affects the way people make
decisions about buying, selling, spending, saving, investing, working,
and taking time for leisure activities.

Capital, savings, and investment are taken up in the fourth section,
which explains how the long-term growth of any economy depends upon the
relationship between investments in capital goods (inventories and the
facilities and equipment used to make products) and the level of saving
in that economy. The next section explains the role money and financial
markets play in the economy. Labor markets, the topic of section six, are
also extremely important in the U.S. economy, because most people earn
their incomes by working for wages and salaries. By the same token, for
most firms, labor is the most costly input used in producing the things
the firms sell.

The role of government in the U.S. economy is the subject of section
seven. The government performs a number of economic roles that private
markets cannot provide. It also offers some public services that elected
officials believe will be in the best interests of the public. The
relationship between the U.S. economy and the world economy is discussed
in section eight. Section nine looks at current trends and issues that
the U.S economy faces at the start of the 21st century. The final section
provides an overview of the kinds of goods and services produced in the
United States.

U.S. ECONOMIC SYSTEM

An economic system refers to the laws and institutions in a nation that
determine who owns economic resources, how people buy and sell those
resources, and how the production process makes use of resources in
providing goods and services. The U.S. economy is made up of individual
people, business and labor organizations, and social institutions. People
have many different economic roles—they function as consumers, workers,
savers, and investors. In the United States, people also vote on public
policies and for the political leaders who set policies that have major
economic effects. Some of the most important organizations in the U.S.
economy are businesses that produce and distribute goods and services to
consumers. Labor unions, which represent some workers in collective
bargaining with employers, are another important kind of economic
organization. So, too, are cooperatives—organizations formed by producers
or consumers who band together to share resources—as well as a wide range
of nonprofit organizations, including many charities and educational
organizations, that provide services to families or groups with special
problems or interests.

For the most part, the United States has a market economy in which
individual producers and consumers determine the kinds of goods and
services produced and the prices of those products. The most basic
economic institution in market economies is the system of markets in
which goods and services are bought and sold. That is where consumers buy
most of the food, clothing, and shelter they use, and any number of
things that they simply want to have or that they enjoy doing. Private
businesses make and sell most of those goods and services. These markets
work by bringing together buyers and sellers who establish market prices
and output levels for thousands of different goods and services.

A guiding principle of the U.S. economy, dating back to the colonial
period, has been that individuals own the goods and services they make
for themselves or purchase to consume. Individuals and private businesses
also control the factors of production. They own buildings and equipment,
and are free to hire workers, and acquire things that businesses use to
produce goods and services. Individuals also own the businesses that are
established in the United States. In other economic systems, some or all
of the factors of production are owned communally or by the government.

For the most part, U.S. producers decide which goods and services to make
and offer to sell, and what prices to charge for those products. Goods
are tangible things—things you can touch—that satisfy wants. Examples of
goods are cars, clothing, food, houses, and toys. Services are activities
that people do for themselves or for other people to satisfy their wants.
Examples of services are cutting hair, polishing shoes, teaching school,
and providing police or fire protection.

Producers decide which goods and services to make and sell, and how much
to ask for those products. At the same time, consumers decide what they
will purchase and how much money they are willing to pay for different
goods and services. The interaction between competing producers, who
attempt to make the highest possible profit, and consumers, who try to
pay as little as possible to acquire what they want, ultimately
determines the price of goods and services.

In a market economy, government plays a limited role in economic decision
making. However, the United States does not have a pure market economy,
and the government plays an important role in the national economy. It
provides services and goods that the market cannot provide effectively,
such as national defense, assistance programs for low-income families,
and interstate highways and airports. The government also provides
incentives to encourage the production and consumption of certain types
of products, and discourage the production and consumption of others. It
sets general guidelines for doing business and makes policy decisions
that affect the economy as a whole. The government also establishes
safety guidelines that regulate consumer products, working conditions,
and environmental protection.

Factors of Production

The factors of production, which in the United States are controlled by
individuals, fall into four major categories: natural resources, labor,
capital, and entrepreneurship.

Natural Resources

Natural resources, which come directly from the land, air, and sea, can
satisfy people’s wants directly (for example, beautiful mountain scenery
or a clear lake used for fishing and swimming), or they can be used to
produce goods and services that satisfy wants (such as a forest used to
make lumber and furniture).

The United States has many natural resources. They include vast areas of
fertile land for growing crops, extensive coastlines with many natural
harbors, and several large navigable rivers and lakes on which large
ships and barges carry products to and from most regions of the nation.
The United States has a generally moderate climate, and an incredible
diversity of landscapes, plants, and wildlife.

Labor

Labor refers to the routine work that people do in their jobs, whether it
is performing manual labor, managing employees, or providing skilled
professional services. Manual labor usually refers to physical work that
requires little formal education or training, such as shoveling dirt or
moving furniture. Managers include those who supervise other workers.
Examples of skilled professionals include doctors, lawyers, and dentists.

Of the 270 million people living in the United States in 1998, nearly 138
million adults were working or actively looking for work. This is the
nation's labor force, which includes those who work for wages and
salaries and those who file government tax forms for income earned
through self-employment. It does not include homemakers or others who
perform unpaid labor in the home, such as raising, caring for, and
educating children; preparing meals and maintaining the home; and caring
for family members who are ill. Nor, of course, does it count those who
do not report income to avoid paying taxes, in some cases because their
work involves illegal activities.

Capital

Capital includes buildings, equipment, and other intermediate products
that businesses use to make other goods or services. For example, an
automobile company builds factories and buys machines to stamp out parts
for cars; those buildings and machines are capital. The value of capital
goods being used by private businesses in the United States in the late
1990s is estimated to be more than $11 trillion. Roughly half of that is
equipment and the other half buildings or other structures. Businesses
have additional capital investments in their inventories of finished
products, raw materials, and partially completed goods.

Entrepreneurship

Entrepreneurship is an ability some people have to accept risks and
combine factors of production in order to produce goods and services.
Entrepreneurs organize the various components necessary to operate a
business. They raise the necessary financial backing, acquire a physical
site for the business, assemble a team of workers, and manage the overall
operation of the enterprise. They accept the risk of losing the money
they spend on the business in the hope that eventually they will earn a
profit. If the business is successful, they receive all or some share of
the profits. If the business fails, they bear some or all of the losses.

Many people mistakenly believe that anyone who manages a large company is
an entrepreneur. However, many managers at large companies simply carry
out decisions made by higher-ranking executives. These managers are not
entrepreneurs because they do not have final control over the company and
they do not make decisions that involve risking the companies resources.
On the other hand, many of the nation’s entrepreneurs run small
businesses, including restaurants, convenience stores, and farms. These
individuals are true entrepreneurs, because entrepreneurship involves not
merely the organization and management of a business, but also an
individual’s willingness to accept risks in order to make a profit.

Throughout its history, the United States has had many notable
entrepreneurs, including 18th-century statesman, inventor, and publisher
Benjamin Franklin, and early-20th-century figures such as inventor Thomas
Edison and automobile producer Henry Ford. More recently, internationally
recognized leaders have emerged in a number of fields: Bill Gates of
Microsoft Corporation and Steve Jobs of Apple Computer in the computer
industry; Sam Walton of Wal-Mart in retail sales; Herb Kelleher and
Rollin King of Southwest Airlines in the commercial airline business; Ray
Kroc of MacDonald’s, Harland Sanders of Kentucky Fried Chicken (KFC), and
Dave Thomas of Wendy’s in fast food; and in motion pictures, Michael
Eisner of the Walt Disney Company as well as a number of entrepreneurs at
smaller independent production studios that developed during the 1980s
and 1990s.

Acquiring the Factors of Production

All four factors of production—natural resources, labor, capital, and
entrepreneurship—are traded in markets where businesses buy these inputs
or productive resources from individuals. These are called factor
markets. Unlike a grocery market, which is a specific physical store
where consumers purchase goods, the markets mentioned above comprise a
wide range of locations, businesses, and individuals involved in the
exchange of the goods and services needed to run a business.

Businesses turn to the factor markets to acquire the means to make goods
and services, which they then try to sell to consumers in product or
output markets. For example, an agricultural firm that grows and sells
wheat can buy or rent land from landowners. The firm may shop for this
natural resource by consulting real estate agents and farmers throughout
the Midwest. This same firm may also hire many kinds of workers. It may
find some of its newly hired workers by recruiting recent graduates of
high schools, colleges, or technical schools. But its market for labor
may also include older workers who have decided to move to a new area, or
to find a new job and employer where they currently live.

Firms often buy new factories and machines from other firms that
specialize in making these kinds of capital goods. That kind of
investment often requires millions of dollars, which is usually financed
by loans from banks or other financial institutions.

Entrepreneurship is perhaps the most difficult resource for a firm to
acquire, but there are many examples of even the largest and most well-
established firms seeking out new presidents and chief executive officers
to lead their companies. Small firms that are just beginning to do
business often succeed or fail based on the entrepreneurial skills of the
people running the business, who in many cases have little or no previous
experience as entrepreneurs.

Markets and the Problem of Scarcity

A basic principle in every economic system—even one as large and wealthy
as the U.S. economy—is that few, if any, individuals ever satisfy all of
their wants for goods and services. That means that when people buy goods
and services in different markets, they will not be able to buy all of
the things they would like to have. In fact, if everyone did have all of
the things they wanted, there would be no reason for anyone to worry
about economic problems. But no nation has ever been able to provide all
of the goods and services that its citizens wanted, and that is true of
the U.S. economy as much as any other.

Scarcity is also the reason why making good economic choices is so
important, because even though it is not possible to satisfy everyone’s
wants, all people are able to satisfy some of their wants. Similarly,
every nation is able to provide some of the things its citizens want. So
the basic problem facing any nation’s economy is how to make sure that
the resources available to the people in the nation are used to satisfy
as many as possible of the wants people care about most.

The U.S. economy, with its system of private ownership, has an extensive
set of markets for final products and for the factors of production. The
economy has been particularly successful in providing material goods and
services to most of its citizens. That is even more striking when results
in the U.S. economy are compared with those of other nations and economic
systems. Nevertheless, most U.S. consumers say they would like to be able
to buy and use more goods and services than they have today. And some
U.S. citizens are calling for significant changes in how the economic
system works, or at least in how the purchasing power and the goods and
services in the system are divided up among different individuals and
families.

Not surprisingly, low-income families would like to receive more income,
and often favor higher taxes on upper-income households. But many upper-
income families complain that government already taxes them too much, and
some argue that government is taking over too many things in the economy
that were, in the past, left up to individuals, families, and private
firms or charities.

These debates take place because of the problem of scarcity. For
individuals and governments, resources that satisfy a particular want
cannot be used to satisfy other wants. Therefore, deciding to satisfy one
want means paying the cost of not satisfying another. Such choices take
place every time the government decides how to spend its tax revenues.

What Are Markets?

Goods and services are traded in markets. Usually a market is a physical
place where buyers and sellers meet to make exchanges, once they have
agreed on a price for the product. One kind of marketplace is a grocery
store, where people go to buy food and household products. However, many
markets are not confined to specific locations. In a broader sense,
markets include all the places and sources where goods and services are
exchanged. For example, the labor market does not exist in a specific
physical building, as does a grocery market. Instead, the term labor
market describes a multitude of individuals offering their labor for sale
as well as all the businesses searching for employees.

Traders do not always have to meet in person to buy and sell. Markets can
operate via technology, such as a telephone line or a computer site. For
example, stocks and other financial securities have long been traded
electronically or by telephone. It is becoming increasingly common in the
United States for many other kinds of goods and services to be sold this
way. For instance, many people today use the Internet—the worldwide
computer-based network of information systems—to buy airline tickets,
make hotel reservations, and rent a car for their vacation. Other people
buy and sell items ranging from books, clothing, and airline tickets to
baseball cards and other rare collectibles over the Internet. Although
these Internet buyers and sellers may never meet face to face the way
buyers and sellers do in more traditional markets, these markets share
certain basic features.

How a Single Market Works

Buyers hope to buy at low prices and will purchase more units of a
product at lower prices than they do at higher prices. Sellers are just
the opposite. They hope to sell at high prices, and typically they will
be willing to produce and sell more units of a product at higher prices
than at lower prices.

The price for a product is determined in the market if prices are allowed
to rise and fall, and are not legally required to be above some minimum
price floor or below some maximum price ceiling. When a product, for
example, a personal computer, reaches the market, consumers learn what
producers want to charge for it and producers learn what consumers are
willing to pay. The interaction of producers and consumers quickly
establishes what the market price for the computer will actually be. Some
people who were considering buying a computer decide that the price is
higher than they are willing to pay. And some producers may determine
that consumers are not willing to pay a price high enough for them
profitably to produce and sell this computer.

But all of the buyers who are willing and able to pay the market price
get the computer, and all of the sellers willing and able to produce it
for this price find buyers. If more consumers want to buy a computer at a
specific market price than there are suppliers are willing to sell at
that price—or in other words, if the quantity demanded is greater than
the quantity supplied—the price for the computer increases. When
producers try to sell more of their computers at a price higher than
consumers are willing to buy, the quantity supplied exceeds the quantity
demanded and the price falls.

The price stops rising or falling at the price where the amount consumers
are willing and able to buy is just equal to the amount sellers are
willing and able to produce and sell. This is called the market clearing
price. Market clearing prices for many goods and services change
frequently, for reasons that will be discussed below. But some market
prices are stable for long periods of time, such as the prices of candy
bars and sodas sold in vending machines, and the prices of pizzas and
hamburgers. Most buyers of these products have come to know the general
price they will have to pay for these items. Sellers know what prices
they can charge, given what consumers will pay and considering the
competition they face from other sellers of identical, or very similar,
products.

A System of Markets for All Goods and Services

How markets determine price is simple enough to understand for a single
good or service in a single location. But consider what happens when
there are markets for nearly all of the goods and services produced and
consumed in an economy, across the entire country. In that context, this
reasonably simple process of setting market prices allows an economic
system as large and complex as the U.S. economy to operate with great
efficiency and a high degree of freedom for consumers and producers.

Efficiency here means producing what consumers want to buy, at prices
that are as low as they can be for producers to stay in business. And it
turns out this efficiency is directly linked to the freedom that buyers
and sellers have in a market economy. No central authority has to decide
how many shirts or cars or sandwiches to produce each day, or where to
produce them, or what price to charge for them. Instead, consumers spend
their money for the products that give them the most satisfaction, and
they try to find the best deal they can in terms of price, quality,
convenience, assurances that defective products will be replaced or
repaired, or other considerations.

What consumers are willing and able to buy tells producers what they
should produce, if they hope to make a profit. Usually consumers have
many options to choose from, because more than one producer offers the
same or reasonably similar products (such as two or more kinds of cars,
colas, and carpets). Producers then compete energetically for the dollars
that consumers spend.

Competition among producers determines the best ways to produce a good or
service. For example, in the early 1900s automobiles were made largely by
hand, one at a time. But once Henry Ford discovered how to lower the cost
of producing cars by using assembly lines, other car makers had to adopt
the same production methods or be driven out of business (as many were).

Competition also determines what features and quality standards go into
products. And competition holds down the costs of production because
producers know that consumers compare their prices to the prices charged
by other firms and for other products they might buy. In markets where a
large number of producers compete, inefficient producers will be driven
out of the market.

For example, at one time most towns and cities had independently owned
cafes and drive-in restaurants that sold hamburgers, french fries, and
soft drinks. Some of these businesses are still operating, but many
closed down after larger fast-food chains began opening local franchises
all around the nation, with well-known product standards and relatively
low prices. The increased competition led to prices that were too low for
many of the old cafes and drive-ins to make a profit. The private cafes
that did survive were able to meet that level of efficiency, or they
managed to make their products different enough from the national chains
to keep their customers.

Prices for goods and services can only fall so far, however. Even the
most efficient producers have to pay for the natural resources, labor,
capital, and entrepreneurship they use to make and sell products. The
market price cannot stay below the level of those costs for long without
driving all of the producers out of this market. Therefore, if consumers
want to buy some good or service not just today but also in the future,
they have to pay a price at least high enough to cover the costs of
producing it, including enough profit to make it worthwhile for sellers
to stay in that market.

Once market prices for various goods and services are set, consumers are
free to choose what to buy, and producers are free to choose what to
produce and sell. They both follow their self-interest and do what makes
them as well off as they can be. When all buyers and sellers do that in
an economic system of competitive markets, the overall economy will also
be very efficient and responsive to individual preferences.

This economic process is extremely decentralized. For example, it is
likely that no one person or government agency knows how many corned beef
sandwiches are sold in any large U.S. city on any given day. Individual
sellers decide how many sandwiches they are likely to sell and arrange to
have enough meat and bread available to meet the demand from their
customers.

Consumers usually do not make up their mind about what to eat for lunch
or dinner until they walk into the restaurant, grocery store, or sandwich
shop. But they know they can go to several different places and choose
many different things to eat and drink, while individual sellers know
about how much they are likely to sell on an average business day.

Other businesses sell bread and meat and drinks to the restaurants and
grocers, but they do not really know how many different sandwiches the
different food stores are selling either. They only know how much bread
and meat they need to have on hand to satisfy the orders they get from
their customers.

Each buyer and seller knows his or her small part of the market very well
and makes choices carefully to avoid wasting money and other resources.
When everyone acts this carefully while facing competition from other
consumers or producers, the overall system uses its scarce resources very
efficiently. Efficiency implies two things here: taking into account the
preferences and alternative choices that individual buyers and sellers
face, and producing goods and services at the lowest possible cost.

How and Why Market Prices Change

Another advantage of any competitive market system is a high level of
flexibility and speed in responding to changing economic conditions. In
economies where government agencies and central planners set prices, it
often takes much longer to adjust prices to new conditions. In the last
decades of the 20th century, the U.S. market economy has made these
adjustments very quickly, even compared with other market economies in
Western Europe, Canada, and Japan.

Market prices change whenever something causes a change in demand (the
amount people are willing to buy at different prices) or a change in
supply (the amount producers are willing and able to make and sell at
different prices). see Supply and Demand. Because these changes can occur
rapidly, with little or no advance warning, it is important for both
consumers and producers to understand what can cause prices to rise and
fall. Those who anticipate price changes correctly can often gain
financially from their foresight. Those who do not understand why prices
have changed are likely to feel bewildered and frustrated, and find it
more difficult to know how to respond to changing prices. Market
economies are, in fact, sometimes called price systems. It is important
to understand why prices rise and fall to understand how a market system
works.

Changes in Demand

Demand for most products changes whenever there is a significant change
in the level of consumers’ income. In the United States, incomes have
risen substantially over the past 200 years. As that happened, the demand
for most goods and services also increased. There are, however, a few
products that people buy less of as income falls. Examples of these
inferior goods include low quality foods and fabrics.

Demand for a product also changes when the price of a substitute product
changes. For example, if the price for one brand of blue jeans sharply
increases while other brands do not, many consumers will switch to the
other brands, so the demand for those brands will increase. Conversely,
if the price for beef drops, then many people will buy less pork and
chicken.

Some products are complements rather than substitutes. Complements are
products that are consumed together, for example cameras and film, or
tennis balls and tennis rackets. When the price of a complementary good
rises, the demand for a product falls. For example, if the price of
cameras rises, the demand for film will fall. On the other hand, if the
price of a complementary good falls, the demand for a product will rise.
If the price of tennis rackets falls, for example, more people will buy
rackets and the demand for tennis balls will increase.

Demand can also increase or decrease as a product goes in or out of
style. When famous athletes or movie stars create a popular new look in
clothing or tennis shoes, demand soars. When something goes out of style,
it soon disappears from stores, and eventually from people’s closets,
too.

If people expect the price of something to go up in the future, they
start to buy more of the product now, which increases demand. If they
believe the price is going to fall in the future, they wait to buy and
hope they were right. Sometimes these choices involve very serious
decisions and large amounts of money. For example, people who buy stocks
on the stock market are hoping that prices will rise, while at least some
of the people selling those stocks expect the prices to fall. But not all
economic decisions are this serious. For example, in the 1970s there was
a brief episode when toilet paper disappeared from the shelves of grocery
stores, because people were afraid that there were going to be shortages
and rising prices. It turns out that some of these unfounded fears were
based on remarks made by a comedian on a late-night talk show.

The final factor that affects the demand for most goods and services is
the number of consumers in the market for a product. In cities where
population is rising rapidly, the demand for houses, food, clothing, and
entertainment increases dramatically. In areas where population is
falling—as it has in many small towns where farm populations are
shrinking—demand for these goods and services falls.

Changes in Supply

The supply of most products is also affected by a number of factors. Most
important is the cost of producing products. If the price of natural
resources, labor, capital, or entrepreneurship rises, sellers will make
less profit and will not be as motivated to produce as many units as they
were before the cost of production increased. On the other hand, when
production costs fall, the amount producers are willing and able to sell
increases.

Technological change also affects supply. A new invention or discovery
can allow producers to make something that could not be made before. It
could also mean that producers can make more of a product using the same
or fewer inputs. The most dramatic example of technological change in the
U.S. economy over the past few decades has been in the computer industry.
In the 1990s, small computers that people carry to and from work each day
were more powerful and many times less expensive than computers that
filled entire rooms just 20 to 30 years earlier.

Opportunities to make profits by producing different goods and services
also affect the supply of any individual product. Because many producers
are willing to move their resources to completely different markets,
profits in one part of the economy can affect the supply of almost any
other product. For example, if someone running a barbershop decided to
sign a contract to provide and operate the machines that clean runways at
a large airport, this would decrease the supply of haircutting services
and increase the supply of runway sweeping services.

When suppliers believe the price of the good or service they provide is
going to rise in the future, they often wait to sell their product,
reducing the current supply of the product. On the other hand, if they
believe that the price is going to fall in the future, they try to sell
more today, increasing the current supply. We see this behavior by large
and small sellers. Examples include individuals who are thinking about
selling a house or car, corn and wheat farmers deciding whether to sell
or store their crops, and corporations selling manufactured products or
reserves of natural resources.

Finally, the number of sellers in a market can also affect the level of
supply. Generally, markets with a larger number of sellers are more
competitive and have a greater supply of the product to be sold than
markets with fewer sellers. But in some cases, the technology of
producing a product makes it more efficient to produce large quantities
at just a few production sites, or perhaps even at just one. For example,
it would not make sense to have two or more water and sewage companies
running pipes to every house and business in a city. And automobiles can
be produced at a much lower cost in large plants than in small ones,
because large plants can take greater advantage of assembly-line
production methods.

All these different factors can lead to changes in what consumers demand
and what producers supply. As a result, on any given day prices for some
things will be rising and those for others will be falling. This creates
opportunities for some individuals and firms, and problems for others.
For example, firms producing goods for which the demand and the price are
falling may have to lay off workers or even go out of business. But for
the economy as a whole, allowing prices to rise and fall quickly in
response to changes in any of the market forces that affect supply and
demand offers important advantages. It provides an extremely flexible and
decentralized system for getting goods and services produced and
delivered to households while responding to a vast number of
unpredictable changes.

Creative Destruction

Taking advantage of new opportunities while curtailing production of
things that are no longer in demand or no longer competitive was
described as the process of creative destruction by 20th century Austrian-
American economist Joseph Schumpeter. For example, Schumpeter discussed
how the United States, Britain, and other market economies helped many
new businesses to grow by building systems of canals (such as the Erie
Canal) during the mid-19th century. But then the canal systems were
replaced or “destroyed” by the railroads, which in turn saw their role
diminished with the rise of national systems of highways and airports.
The same thing happened in the communications industry in the United
States. The Pony Express, which carried mail between Missouri and
California in the early 1860s, went out of business with the completion
of telegraph lines to California. In the 20th century, the telegraph was
replaced by the telephone. Time and time again, one decade’s innovation
is partially replaced or even destroyed by the next round of
technological change.

In the modern world, prices change not only as a result of things that
happen in one country, but increasingly because of changes that happen in
other countries, too. International change affects production patterns,
wages, and jobs in the U.S. economy. Sometimes these changes are
triggered by something as simple as weather conditions someplace else in
the world that affect the production of grain, coffee, sugar, or other
crops. Sometimes it reflects political or financial upheavals in Europe,
Asia, or other parts of the world. There have been several examples of
such events in the U.S. economy in the 1990s. Higher coffee prices
occurred after poor harvests of coffee beans in South America, and U.S.
banks lost large sums of money following financial and political crises
in places such as Indonesia and Russia.

The ability to respond quickly to an increasingly volatile economic and
political environment is, in many ways, one of the greatest strengths of
the U.S. economic system. But these changes can result in hardships for
some people or even some large segments of the economy. For example,
importing clothing produced in other nations has benefited U.S. consumers
by keeping clothing prices lower. In addition, it has been profitable for
the firms that import and sell this clothing. However, it has also
reduced the number of jobs available in clothing manufacturing for U.S.
workers.

Many people think the most important general issue facing the U.S.
economy today is how to balance the benefits of quickly adapting to
changing economic conditions against the costs of abandoning the old
ways. It is vital for the economy to adapt quickly to changing conditions
and to focus on producing goods and services that will meet the most
recent demands of the market place. However, when businesses close
because their products no longer meet the demands of the market, it is
important to make retraining or new jobs available to workers who lost
their means of making a living.

PRODUCTION OF GOODS AND SERVICES

Before goods and services can be distributed to households and consumed,
they must be produced by someone, or by some business or organization. In
the United States and other market economies, privately owned firms
produce most goods and services using a variety of techniques. One of the
most important is specialization, in which different firms make different
kinds of products and individual workers perform specific jobs within a
company.

Successful firms earn profits for their owners, who accept the risk of
losing money if the products the firms try to sell are not purchased by
consumers at prices high enough to cover the costs of production. In the
modern economy, most firms and workers have found that to be competitive
with other firms and workers they must become very good at producing
certain kinds of goods and services.

Most businesses in the United States also operate under one of three
different legal forms: corporations, partnerships, or sole
proprietorships. Each of these forms has certain advantages and
disadvantages. Because of that, these three types of business
organizations often operate in different kinds of markets. For example,
most firms with large amounts of money invested in factories and
equipment are organized as corporations.

Specialization and the Division of Labor

In earlier centuries, especially in frontier areas, families in the
United States were much more self-sufficient, producing for themselves
most of the goods and services they consumed. But as the U.S. population
and economy grew, it became easier for people to buy more and more things
in the marketplace. Once that happened, people faced a choice they still
face today: In terms of time, money, and other things that they could do,
is it less expensive to make something themselves or to let someone else
produce it and buy it from them?

Over the years, most people and businesses realized that they could make
better use of their time and resources by concentrating on one particular
kind of work, rather than trying to produce for themselves all the items
they want to consume. Most people now work in jobs where they do one kind
of work; they are carpenters, bankers, cooks, mechanics, and so forth.
Likewise, most businesses produce only certain kinds of goods or
services, such as cars, tacos, or gardening services. This feature of
production is known as specialization. A high degree of specialization is
a key part of the economic system in the United States and all other
industrialized economies. When businesses specialize, they focus on
providing a particular product or type of product. For instance, some
large companies produce only automobiles and trucks, or even special
parts of cars and trucks, such as tires.

At almost all businesses, when goods and services are produced, labor is
divided among workers, with different employees responsible for
completing different tasks. This is known as division of labor. For
example, the individual parts of cars and televisions are made by many
different workers and then put together in an assembly line. Other well-
known examples of this specialization and division of labor are seen in
the production of computers and electrical appliances. But even kitchens
in large restaurants have different chefs for different items, and
professional workers such as doctors and dentists have also become more
specialized during the past century.

Advantages of Specialization

By specializing in what they produce, workers become more expert at a
particular part of the production process. As a result, they become more
efficient in these jobs, which lowers the costs of production.
Specialization also makes it possible to develop tools and machines that
help workers do highly specialized tasks. Carpenters use many tools that
plumbers and painters do not. Commercial bakeries have much larger ovens
and mixers than those used by people who only bake bread and pies once a
year. And unlike a household kitchen, a commercial bakery has machines to
slice and package bread. All of these tools and machines help workers and
businesses produce more efficiently, and lower the cost of producing
goods and services.

The advantages of specialization have led to the creation of many very
large production facilities in the United States and other industrialized
nations. This trend is especially prevalent in the manufacturing sector.
For example, many automobile factories produce thousands of cars each
day, and some shipyards employ more than 10,000 workers. One open-pit
mine in the western United States has dug a crater so large that it can
be seen from space.

When the market for a product is very large, and a company can sell
enough goods or services in that market to support a very large
production facility, it will often choose to produce on a large scale to
take advantage of specialization and division of labor. As long as
producing more in larger facilities lowers the average costs of
production, the producer enjoys what are known as economies of scale.

But bigger is not always better, and eventually almost all producers
encounter diseconomies of scale in which larger plants or production
sites become less efficient and more costly to operate. Usually that
happens because monitoring and managing increasingly larger production
facilities becomes more difficult. That is why most large manufacturers
have more than one factory to make their products, instead of one massive
facility where they make everything they produce. In recent years, many
steel companies have found it more efficient to build and operate smaller
steel mills than they once operated.

Specialization and International Trade

Over the past few decades, international trade has led to greater
specialization and competition among producers in the United States and
throughout the world. By selling worldwide, companies in the United
States and in other countries can reach many more customers.
Specialization is ultimately limited by the size of the market for a good
or service. In other words, larger markets always allow for greater
levels of specialization. For example, in small towns with few customers
to serve, there is often only one clothing store that carries a small
selection of many different kinds of clothing. In large cities with a
million or more potential customers, there are much larger clothing
stores with many more choices of items and styles, and even some stores
that sell only hats, gloves, or some other particular kind of clothing.

International trade is a dramatic way of expanding the size of a firm’s
market. In markets where transportation costs are low compared with the
selling price of a product, it has become possible for producers to
compete globally to take full advantage of highly specialized production.
But international trade also means that businesses must compete more
efficiently against firms from all around the world. That competition
also makes them try to take advantage of greater specialization and the
division of labor.

In many cases, products are produced and sold by firms from two or more
countries that have large production and employment levels in the same
industry. Often, however, these firms still specialize in the kinds of
products they produce. For example, though many small cars and small
pickup trucks are made in Japan and sent to the United States, large
pickups and four-wheel drive sport utility vehicles are often exported
from the United States to Japan and other nations. Similarly, the United
States exports large commercial passenger jets to most countries, but
imports many small jets from Canada, Brazil, and other nations. While
this may seem strange at first glance, it allows greater specialization
in production for particular kinds of products.

Transportation costs can also help to explain the pattern of
international production and trade. It often makes sense to produce goods
close to the markets where they will be sold, or close to where the
resources used in the production process are found or made. In recent
years, the availability of a skilled and hard-working labor force has
become more important to producers in many different industries, so new
factories are often located in areas with large numbers of well-trained
workers and good schools that provide a future supply of well-educated
workers.

Production Patterns: Past, Present, and Future

Several dramatic changes in production patterns occurred in the United
States during the 20th century. First, most employment shifted from
farming in rural areas to industrial jobs in cities and suburbs. Then,
during the second half of the century, production and employment patterns
changed again as a result of technological advances, increased levels of
world trade, and a rapid increase in the demand for services.

Technological changes in the transportation, communications, and computer
industries created entirely new kinds of jobs and businesses, and altered
the kinds of skills workers were expected to have in many others. World
trade led to increased specialization and competition, as businesses
adapted to meet the demands of international competition.

Perhaps the greatest change in the U.S. economy came with the nation’s
growing prosperity in the years following World War II (1939-1945). This
prosperity resulted in a population with more money to spend on services
and leisure activities. More people began dining out at restaurants,
taking vacations to far-off locations, and going to movies and other
forms of entertainment. As family incomes increased, a wealthier
population became more willing to pay others for services.

As a result of these developments, the closing decades of the 20th
century saw a dramatic increase in service industries in the United
States. In 1940 about 33 percent of U.S. employees worked in
manufacturing, and about 49 percent worked in service-producing
industries. By the late 1990s, only 26 percent worked in goods-producing
industries, and 74 percent worked in service-producing industries. This
change was driven by powerful market forces, including technological
change and increased levels of world trade, competition, and income.

Some observers worried that this growth of employment in service-
producing industries would result in declining living standards for most
U.S. workers, but in fact most of this growth has occurred in industries
where job skill requirements and wages have risen or at least remained
high. That is less surprising when you consider that this employment
includes business and repair services, entertainment and recreation
occupations, and professional and related services (including health
care, education, and legal services). United States consumers and
families are, on average, financially better off today than they were 50
or 100 years ago, and they have more leisure time, which is one of the
reasons why the demand for services has increased so rapidly.

During the 20th century, businesses and their workers had to adjust to
many changes in the kinds of goods and services people demanded. These
changes naturally led to changes in where jobs were available, and in
what kinds of education, training, and skills employees were expected to
have. As the base of employment in the United States has changed from
predominantly agriculture to manufacturing to services, individuals,
firms, and communities have faced often-difficult adjustments. Many
workers lost jobs in traditional occupations and had to seek employment
in jobs that required completely different sets of skills. Standards of
living declined in some communities whose economies centered on farming
or around large factories that shut down. In recent decades, populations
have decreased in some states where agriculture provides a significant
number of jobs. While high-technology industries in places such as
California's Silicon Valley were booming and attracting larger
populations, some textile and clothing factories in Southern and Midwest
states were closing their doors.

Public Policies to “Protect” Firms and Workers

Historically in the United States, the government has rarely stepped in
to protect individual businesses from changing levels of demand or
competition. There have been some notable exceptions, including the
federal government’s guarantee of $1.5 billion in loans to the Chrysler
Corporation, the nation’s third-largest automobile manufacturer, when it
faced bankruptcy in 1980.

Although direct financial assistance to corporations has been rare, the
government has provided subsidies or partial protection from
international competition to a large number of industries. Economic
analysis of these programs rarely finds such subsidies and protection to
be a good idea for the nation as a whole, though naturally the companies
and workers who receive the support are better off. But usually these
programs result in higher prices for consumers, higher taxes, and they
hurt other U.S. businesses and workers.

For example, in the 1980s the U.S. government negotiated limits on
Japanese car imports, and the price of new Japanese cars sold in the
United States increased by an average of $2,000. The price of new U.S.
cars also rose on average by about $1,000. Although the import limits did
save some jobs in the U.S. automobile industry, the total cost of saving
the jobs was several times higher than what workers earned from these
jobs. When fewer dollars are sent to Japan to buy new automobiles, the
Japanese companies and consumers also have fewer dollars to spend on U.S.
exports to Japan, such as grain, music cassettes and CDs, and commercial
passenger jets. So the protection from Japanese car imports hurt firms
and workers in U.S. export industries. Still other U.S. firms and workers
were hurt because some U.S. consumers spent more for cars and had less to
spend on other goods and services.

It is simply not possible to subsidize and protect everyone in the U.S.
economy from changes in consumer demands and technology, or from
international trade and competition. And while most people agree that the
government should subsidize the production of certain types of goods
required for national defense, such as electronic navigation and
surveillance systems, economists warn against the futility of trying to
protect large numbers of firms and workers from change and competition.
Typically such support cannot be sustained over the long run, when the
cost of protection and subsidies begins to mount up, except in cases
where producers and workers represent a strong special interest group
with enough political clout to maintain their special protection or
subsidies.

When the special protection or support is removed, the adjustments that
producers and workers often have to make then can be much more severe
than they would have been when the government programs were first
adopted. That has happened when price support programs for milk and other
agricultural products were phased out, and when policies that subsidized
U.S. oil production and limited imports of oil were dropped in the 1970s,
during the worldwide oil shortage.

For these reasons, if public assistance is provided to a particular
industry, economists are likely to favor only temporary payments to cover
some of the costs of relocation and retraining of workers. That policy
limits the cost of such assistance and leaves workers and firms free to
move their resources into whatever opportunities they believe will work
best for them.

Most producers in the United States and other market economies must face
competition every day. If they are successful, they stand to earn large
returns. But they also risk the possibility of failure and large losses.
The lure of profits and the risk of losses are both part of what makes
production in a market economy efficient and responsive to consumer
demands.

CORPORATIONS AND OTHER TYPES OF BUSINESSES

Three major types of firms carry out the production of goods and services
in the U.S. economy: sole proprietorships, partnerships, and
corporations. In 1995 the U.S. economy included 16.4 million
proprietorships, excluding farms; 1.6 million partnerships; and about 4.3
million corporations. The corporations, however, produce far more goods
and services than the proprietorships and partnerships combined.

Proprietorships and Partnerships

Sole proprietorships are typically owned and operated by one person or
family. The owner is personally responsible for all debts incurred by the
business, but the owner gets to keep any profits the firm earns, after
paying taxes. The owner’s liability or responsibility for paying debts
incurred by the business is considered unlimited. That is, any individual
or organization that is owed money by the business can claim all of the
business owner’s assets (such as personal savings and belongings), except
those protected under bankruptcy laws.

Normally when the person who owns or operates a proprietorship retires or
dies, the business is either sold to someone else, or simply closes down
after any creditors are paid. Many small retail businesses are operated
as sole proprietorships, often by people who also work part-time or even
full-time in other jobs. Some farms are operated as sole proprietorships,
though today corporations own many of the nation’s farms.

Partnerships are like sole proprietorships except that there are two or
more owners who have agreed to divide, in some proportion, the risks
taken and the profits earned by the firm. Legally, the partners still
face unlimited liability and may have their personal property and savings
claimed to pay off the business’s debts. There are fewer partnerships
than corporations or sole proprietorships in the United States, but
historically partnerships were widely used by certain professionals, such
as lawyers, architects, doctors, and dentists. During the 1980s and
1990s, however, the number of partnerships in the U.S. economy has grown
far more slowly than the number of sole proprietorships and corporations.
Even many of the professions that once operated predominantly as
partnerships have found it important to take advantage of the special
features of corporations.

Corporations

In the United States a corporation is chartered by one of the 50 states
as a legal body. That means it is, in law, a separate entity from its
owners, who own shares of stock in the corporation. In the United States,
corporate names often end with the abbreviation Inc., which stands for
incorporated and refers to the idea that the business is a separate legal
body.

Limited Liability

The key feature of corporations is limited liability. Unlike
proprietorships and partnerships, the owners of a corporation are not
personally responsible for any debts of the business. The only thing
stockholders risk by investing in a corporation is what they have paid
for their ownership shares, or stocks. Those who are owed money by the
corporation cannot claim stockholders’ savings and other personal assets,
even if the corporation goes into bankruptcy. Instead, the corporation is
a separate legal entity, with the right to enter into contracts, to sue
or be sued, and to continue to operate as long as it is profitable, which
could be hundreds of years.

When the stockholders who own the corporation die, their stock is part of
their estate and will be inherited by new owners. The corporation can go
on doing business and usually will, unless the corporation is a small,
closely held firm that is operated by one or two major stockholders. The
largest U.S. corporations often have millions of stockholders, with no
one person owning as much as 1 percent of the business. Limited liability
and the possibility of operating for hundreds of years make corporations
an attractive business structure, especially for large-scale operations
where millions or even billions of dollars may be at risk.

When a new corporation is formed, a legal document called a prospectus is
prepared to describe what the business will do, as well as who the
directors of the corporation and its major investors will be. Those who
buy this initial stock offering become the first owners of the
corporation, and their investments provide the funds that allow the
corporation to begin doing business.

Separation of Ownership and Control

The advantages of limited liability and of an unlimited number of years
to operate have made corporations the dominant form of business for large-
scale enterprises in the United States. However, there is one major
drawback to this form of business. With sole proprietorships, the owners
of the business are usually the same people who manage and operate the
business. But in large corporations, corporate officers manage the
business on behalf of the stockholders. This separation of management and
ownership creates a potential conflict of interest. In particular,
managers may care about their salaries, fringe benefits, or the size of
their offices and support staffs, or perhaps even the overall size of the
business they are running, more than they care about the stockholders’
profits.

The top managers of a corporation are appointed or dismissed by a
corporation’s board of directors, which represents stockholders’
interests. However, in practice, the board of directors is often made up
of people who were nominated by the top managers of the company. Members
of the board of directors are elected by a majority of voting
stockholders, but most stockholders vote for the nominees recommended by
the current board members. Stockholders can also vote by proxy—a process
in which they authorize someone else, usually the current board, to
decide how to vote for them.

There are, however, two strong forces that encourage the managers of a
corporation to act in stockholders’ interests. One is competition. Direct
competition from other firms that sell in the same markets forces a
corporation’s managers to make sound business decisions if they want the
business to remain competitive and profitable. The second is the threat
that if the corporation does not use its resources efficiently, it will
be taken over by a more efficient company that wants control of those
resources. If a corporation becomes financially unsound or is taken over
by a competing company, the top managers of the firm face the prospect of
being replaced. As a result, corporate managers will often act in the
best interests of a corporation’s stockholders in order to preserve their
own jobs and incomes.

In practice, the most common way for a takeover to occur is for one
company to purchase the stock of another company, or for the two
companies to merge by legal agreement under some new management
structure. Stock purchases are more common in what are called hostile
takeovers, where the company that is being taken over is fighting to
remain independent. Mergers are more common in friendly takeovers, where
two companies mutually agree that it makes sense for the companies to
combine. In 1996 there were over $556.3 billion worth of mergers and
acquisitions in the U.S. economy. Examples of mergers include the
purchase of Lotus Development Corporation, a computer software company,
by computer manufacturer International Business Machines Corporation
(IBM) and the acquisition of Miramax Films by entertainment and media
giant Walt Disney Company.

Takeovers by other firms became commonplace in the closing decades of the
20th century, and some research indicates that these takeovers made firms
operate more efficiently and profitably. Those outcomes have been good
news for shareholders and for consumers. In the long run, takeovers can
help protect a firm’s workers, too, because their jobs will be more
secure if the firm is operating efficiently. But initially takeovers
often result in job losses, which force many workers to relocate,
retrain, or in some cases retire sooner than they had planned. Such
workforce reductions happen because if a firm was not operating
efficiently, it was probably either operating in markets where it could
not compete effectively, or it was using too many workers and other
inputs to produce the goods and services it was selling. Sometimes
corporate mergers can result in job losses because management combines
and streamlines departments within the newly merged companies. Although
this streamlining leads to greater efficiency, it often results in fewer
jobs. In many cases, some workers are likely to be laid off and face a
period of unemployment until they can find work with another firm.

How Corporations Raise Funds for Investment

By investing in new issues of a company’s stock, shareholders provide the
funds for a company to begin new or expanded operations. However, most
stock sales do not involve new issues of stock. Instead, when someone who
owns stock decides to sell some or all of their shares, that stock is
typically traded on one of the national stock exchanges, which are
specialized markets for buying and selling stocks. In those transactions,
the person who sells the stock—not the corporation whose stock is
traded—receives the funds from that sale.

An existing corporation that wants to secure funds to expand its
operations has three options. It can issue new shares of stock, using the
process described earlier. That option will reduce the share of the
business that current stockholders own, so a majority of the current
stockholders have to approve the issue of new shares of stock. New issues
are often approved because if the expansion proves to be profitable, the
current stockholders are likely to benefit from higher stock prices and
increased dividends. Dividends are corporate profits that some companies
periodically pay out to shareholders.

The second way for a corporation to secure funds is by borrowing money
from banks, from other financial institutions, or from individuals. To do
this the corporation often issues bonds, which are legal obligations to
repay the amount of money borrowed, plus interest, at a designated time.
If a corporation goes out of business, it is legally required to pay off
any bonds it has issued before any money is returned to stockholders.
That means that stocks are riskier investments than bonds. On the other
hand, all a bondholder will ever receive is the amount of money specified
in the bond. Stockholders can enjoy much larger returns, if the
corporation is profitable.

The final way for a corporation to pay for new investments is by
reinvesting some of the profits it has earned. After paying taxes,
profits are either paid out to stockholders as dividends or held as
retained earnings to use in running and expanding the business. Those
retained earnings come from the profits that belong to the stockholders,
so reinvesting some of those profits increases the value of what the
stockholders own and have risked in the business, which is known as
stockholders’ equity. On the other hand, if the corporation incurs
losses, the value of what the stockholders own in the business goes down,
so stockholders’ equity decreases.

Entrepreneurs and Profits

Entrepreneurs raise money to invest in new enterprises that produce goods
and services for consumers to buy—if consumers want these products more
than other things they can buy. Entrepreneurs often make decisions on
which businesses to pursue based on consumer demands. Making decisions to
move resources into more profitable markets, and accepting the risk of
losses if they make bad decisions—or fail to produce products that stand
the test of competition—is the key role of entrepreneurs in the U.S.
economy.

Profits are the financial incentives that lead business owners to risk
their resources making goods and services for consumers to buy. But there
are no guarantees that consumers will pay prices high enough to cover a
firm’s costs of production, so there is an inherent risk that a firm will
lose money and not make profits. Even during good years for most
businesses, about 70,000 businesses fail in the United States. In years
when business conditions are poor, the number approaches 100,000 failures
a year. And even among the largest 500 U.S. industrial corporations, a
few of these firms lose money in any given year.

Entrepreneurs invest money in firms with the expectation of making a
profit. Therefore, if the profits a company earns are not high enough,
entrepreneurs will not continue to invest in that firm. Instead, they
will invest in other companies that they hope will be more profitable. Or
if they want to reduce their risk, they can put their money into savings
accounts where banks guarantee a minimum return. They can also invest in
other kinds of financial securities (such as government or corporate
bonds) that are riskier than savings accounts, but less risky than
investments in most businesses. Generally, the riskier the investment,
the higher the return investors will require to invest their money.

Calculating Profits

The dollar value of profits earned by U.S. businesses—about $700 billion
a year in the late 1990s—is a great deal of money. However, it is
important to see how profits compare with the money that business owners
have risked in the business. Profits are also often compared to the level
of sales for individual firms, or for all firms in the U.S. economy.

Accountants calculate profits by starting with the revenue a firm
received from selling goods or services. The accountants then subtract
the firm’s expenses for all of the material, labor, and other inputs used
to produce the product. The resulting number is the dollar level of
profits. To evaluate whether that figure is high or low, it must be
compared to some measure of the size of the firm. Obviously, $1 million
would be an incredibly large amount of profits for a very small firm, and
not much profit at all for one of the largest corporations in the
country, such as telecommunications giant AT&T Corp. or automobile
manufacturer General Motors (GM).

To take into consideration the size of the firm, profits are calculated
as a percentage of several different aspects of the business, including
the firm’s level of sales, employment, and stockholders’ equity. Various
individuals will use one of these different methods to evaluate a
company’s performance, depending on what they want to know about how the
firm operates. For example, an efficiency expert might examine the firm’s
profits as a percentage of employment to determine how much profit is
generated by the average worker in that firm. On the other hand,
potential investors and a company’s chief executive would be more
interested in profit as a percentage of stockholder equity, which allows
them to gauge what kind of return to expect on their investments. A sales
executive in the same firm might be more interested in learning about the
company’s profit as a percentage of sales in order to compare its
performance to the performances of competing firms in the same industry.

Using these different accounting methods often results in different
profit percent figures for the same company. For example, suppose a firm
earned a yearly profit of $1 million, with sales of $20 million. That
represents a 5-percent rate of profit as a return on sales. But if
stockholders’ equity in the corporation is $10 million, profits as a
percent of stockholders’ equity will be 10 percent.

Return on Sales

Year after year, U.S. manufacturing firms average profits of about 5
percent of sales. Many business owners with profits at this level or
lower like to say that they earn only about what people can earn on the
interest from their savings accounts. That sounds low, especially
considering that the federal government insures many savings accounts, so
that most people with deposits at a bank run no risk of losing their
savings if the bank goes out of business. And in fact, given the risks
inherent in almost all businesses, few stockholders would be satisfied
with a return on their investment that was this low.

Although it is true that on average, U.S. manufacturing firms only make
about a 5-percent return on sales, that figure has little to do with the
risks these businesses take. To see why, consider a specific example.

Most grocery stores earn a return on sales of only 1 to 2 percent, while
some other kinds of firms typically earn more than the 5-percent average
profit on sales. But selling more or less does not really increase what
the owners of a grocery store (or most other businesses) are risking.
Each time a grocery store sells $100 worth of canned spinach, it keeps
about one or two dollars as profit, and uses the rest of the money to put
more cans of spinach on the shelves for consumers to buy. At the end of
the year, the grocery store may have sold thousands of dollars worth of
canned spinach, but it never really risked those thousands of dollars. At
any given time, it only risked what it spent for the cans that were at
the store. When some cans were sold, the store bought new cans to put on
the shelves, and it turned over its inventory of canned spinach many
times during the year.

But the total value of these sales at the end of the year says little or
nothing about the actual level of risk that the grocery store owners
accepted at any point during the year. And in fact, the grocery industry
is a relatively low-risk business, because people buy food in good times
and bad. Providing goods or services where production or consumer demand
is more variable—such as exploring for oil and uranium, or making movies
and high fashion clothing—is far riskier.

Return on Equity

What stockholders risk—the amount they stand to lose if a business incurs
losses and shuts down—is the money they have invested in the business,
their equity. These are the funds stockholders provide for the firm
whenever it offers a new issue of stock, or when the firm keeps some of
the profits it earns to use in the business as retained earnings, rather
than paying those profits out to stockholders as dividends.

Profits as a return on stockholders’ equity for U.S. corporations usually
average from 12 to 16 percent, for larger and smaller corporations alike.
That is more than people can earn on savings accounts, or on long-term
government and corporate bonds. That is not surprising, however, because
stockholders usually accept more risk by investing in companies than
people do when they put money in savings accounts or buy bonds. The
higher average yield for corporate profits is required to make up for the
fact that there are likely to be some years when returns are lower, or
perhaps even some when a company loses money.

At least part of any firm’s profits are required for it to continue to do
business. Business owners could put their funds into savings accounts and
earn a guaranteed level of return, or put them in government bonds that
carry hardly any risk of default. If a business does not earn a rate of
return in a particular market at least as high as a savings account or
government bonds, its owners will decide to get out of that market and
use the resources elsewhere—unless they expect higher levels of profits
in the future.

Over time, high profits in some businesses or industries are a signal to
other producers to put more resources into those markets. Low profits, or
losses, are a signal to move resources out of a market into something
that provides a better return for the level of risk involved. That is a
key part of how markets work and respond to changing demand and supply
conditions. Markets worked exactly that way in the U.S. economy when
people left the blacksmith business to start making automobiles at the
beginning of the 20th century. They worked the same way at the end of the
century, when many companies stopped making typewriters and started
making computers and printers.

CAPITAL, SAVINGS, AND INVESTMENT

In the United States and in other market economies, financial firms and
markets channel savings into capital investments. Financial markets, and
the economy as a whole, work much better when the value of the dollar is
stable, experiencing neither rapid inflation nor deflation. In the United
States, the Federal Reserve System functions as the central banking
institution. It has the primary responsibility to keep the right amount
of money circulating in the economy.

Investments are one of the most important ways that economies are able to
grow over time. Investments allow businesses to purchase factories,
machines, and other capital goods, which in turn increase the production
of goods and services and thus the standard of living of those who live
in the economy. That is especially true when capital goods incorporate
recently developed technologies that allow new goods and services to be
produced, or existing goods and services to be produced more efficiently
with fewer resources.

Investing in capital goods has a cost, however. For investment to take
place, some resources that could have been used to produce goods and
services for consumption today must be used, instead, to make the capital
goods. People must save and reduce their current consumption to allow
this investment to take place. In the U.S. economy, these are usually not
the same people or organizations that use those funds to buy capital
goods. Banks and other financial institutions in the economy play a key
role by providing incentives for some people to save, and then lend those
funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings
institutions pay interest to people who deposit funds with the
institution, and borrowers pay interest on their loans. Like any other
price in a market economy, supply and demand determine the interest rate.
The demand for money depends on how much money people and organizations
want to have to meet their everyday expenses, how much they want to save
to protect themselves against times when their income may fall or their
expenses may rise, and how much they want to borrow to invest. The supply
of money is largely controlled by a nation’s central bank—which in the
United States is the Federal Reserve System. The Federal Reserve
increases or decreases the money supply to try to keep the right amount
of money in the economy. Too much money leads to inflation. Too little
results in high interest rates that make it more expensive to invest and
may lead to a slowdown in the national economy, with rising levels of
unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must
build large production facilities that can cost hundreds of millions of
dollars. The firms that build these plants raise some funds with new
issues of stock, as described above. But firms also borrow huge sums of
money every year to undertake these capital investments. When they do
that, they compete with government agencies that are borrowing money to
finance construction projects and other public spending programs, and
with households that are borrowing money to finance the purchase of
housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this
borrowing to take place, banks and other lenders must have funds to lend
out. They obtain these funds from people or organizations that are
willing to deposit money in accounts at the bank, including savings
accounts. If everyone spent all of the income they earned each year,
there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses,
and government—only households are net savers. In other words, households
save more money than they borrow. Conversely, businesses and government
are net borrowers. A few businesses may save more than they invest in
business ventures. However, overall, businesses in the United States,
like businesses in virtually all countries, invest far more than they
save. Many companies borrow funds to finance their investments. And while
some local and state governments occasionally run budget surpluses,
overall the government sector is also a large net borrower in the U.S.
economy. The government borrows money by issuing various forms of bonds.
Like corporate bonds, government bonds are contractual obligations to
repay what is borrowed, plus some specified rate of interest, at a
specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against
bad times, as when wage earners or others in the household become sick,
injured, or disabled; to pay for large expenditures such as houses, cars,
and vacations; to set aside money for retirement; or to invest. Banks and
other financial institutions compete for households’ savings deposits by
paying interest to the savers. Then banks lend those funds out to
borrowers at a higher rate of interest than they pay to savers. The
difference between the interest rates charged to borrowers and paid to
savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and
firms that are creditworthy—meaning they will be able to repay the loans.
The creditworthiness of the borrower is one reason why some kinds of
loans have higher rates of interest than others do. Short-term loans made
to people or businesses with a long history of stable income and
employment, and who have assets that can be pledged as collateral that
will become the bank’s property if a loan is not repaid, will receive the
lowest interest rates. For example, well-established firms such as AT&T
often pay what is called the bank’s prime rate—the lowest available rate
for business loans—when they borrow money. New, start-up companies pay
higher rates because there is a greater risk they will default on the
loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and
other lenders charge different rates of interest. Mortgage loans are
backed by the collateral of the property the loan was used to purchase.
If someone does not pay his or her mortgage, the bank has the right to
sell the property that was pledged as collateral and to collect the
proceeds as payment for what it is owed. That means the bank’s risks are
lower, so interest rates on these loans are typically lower, too. The
money that is loaned to people who do not pay off the balances on their
credit cards every month represents a greater risk to banks, because no
collateral is provided. Because the bank does not hold any title to the
consumer’s property for these loans, it charges a higher interest rate
than it charges on mortgages. The higher rate allows the bank to collect
enough money overall so that it can cover its losses when some of these
riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of
business. The effects of bank failures on depositors and the overall
economy can be very severe, especially if many banks fail at the same
time and the deposits are not insured. In the United States, the most
famous example of this kind of financial disaster occurred during the
Great Depression of the 1930s, when a large number of banks failed. Many
other businesses also closed and many people lost both their jobs and
savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not
want to lose money or go out of business, and they try to avoid making
loans to individuals and businesses who will be unable to repay them. In
addition, a number of safeguards protect U.S. financial institutions and
their customers against failures. The Federal Deposit Insurance
Corporation (FDIC) insures most bank and savings and loan deposits up to
$100,000. Government examiners conduct regular inspections of banks and
other financial institutions to try to ensure that these firms are
operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is
the low household savings rate in this country, compared to that of many
other industrialized nations. People who live in the United States save
less of their annual income than people who live in many other
industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and
several factors are often discussed. U.S. citizens may simply choose to
enjoy more of their income in the form of current consumption than people
in nations where living standards have historically been lower. But other
considerations may also be important. There are significant differences
among nations in how savings, dividends, investment income, housing
expenditures, and retirement programs are taxed and financed. These
differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts
as much as they do other forms of income, and some countries do not tax
at least part of the income people earn on savings accounts at all. In
the United States, such favorable tax treatment does not apply to regular
savings accounts. The government does offer more limited advantages on
special retirement accounts, but such accounts have many restrictions on
how much people can deposit or withdraw before retirement without facing
tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they
pay on mortgages for the homes they live in. That encourages people to
spend more on housing than they otherwise would. As a result, some funds
that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the
Social Security system, the government program that provides some
retirement income to most older people. The money that workers pay into
the Social Security system does not go into individual savings accounts
for those workers. Instead, it is used to make Social Security payments
to current retirees. No savings are created under this system unless it
happens that the total amount being paid into the system is greater than
the current payments to retirees. Even when that has happened in the
past, the federal government often used the surplus to pay for some of
its other expenditures. Individuals are also likely to save less for
their own retirement because they expect to receive Social Security
benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with
fewer dollars available as savings to banks and other financial
institutions, interest rates are higher for both savers and borrowers
than they would otherwise be. That makes it more costly to finance
investment in factories, equipment, and other goods, which slows growth
in national output and income levels. Second, the higher U.S. interest
rates attract funds from savers and investors in other nations. As we
will see below, such foreign investments can have several effects on the
U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more
investments in capital goods, but it also creates concerns. For example,
in order for foreigners to invest in U.S. savings accounts and U.S.
government or corporate bonds, they must have dollars. As they demand
dollars for these investments, the price of the dollar in terms of other
nations’ currencies rises. When the price of the dollar is rising, people
in other countries who want to buy U.S. exports will have to pay more for
them. That means they will buy fewer goods and services produced in the
United States, which will hurt U.S. export industries. This happened in
the early 1980s, when U.S. companies such as Caterpillar, which makes
large engines and industrial equipment, saw the sales of their products
to their international customers plummet. The higher value of the dollar
also makes it cheaper for U.S. citizens to import products from other
nations. Imports will rise, leading to a larger deficit (or smaller
surplus) in the U.S. balance of trade, the amount of exports compared to
imports.

Foreign investment has other effects on the U.S. economy. Eventually the
money borrowed must be repaid. How those repayments will affect the U.S.
economy will depend on how the borrowed money is invested. If the money
borrowed from foreign individuals and companies is put into capital
projects that increase levels of output and income in the United States,
repayments can be made without any decrease in U.S. living standards.
Otherwise, U.S. living standards will decline as goods and services are
sent overseas to repay the loans. The concern is that instead of using
foreign funds for additional investments in capital goods, today these
funds are simply making it possible for U.S. consumers and government
agencies to spend more on consumption goods and social services, which
will not increase output and living standards.

In the early history of the United States, many U.S. capital projects
were financed by people in Britain, France, and other nations that were
then the wealthiest countries in the world. These loans helped the
fledgling U.S. economy to grow and were paid off without lowering the
U.S. standard of living. It is not clear that current U.S. borrowing from
foreign nations will turn out as well and will be used to invest in
capital projects, now that the United States, with the largest and
wealthiest economy in the world, faces a low national savings rate.

MONEY AND FINANCIAL MARKETS

A Money and the Value of Money

Money is anything generally accepted as final payment for goods and
services. Throughout history many things have been used around the world
as money, including gold, silver, tobacco, cattle, and rare feathers or
animal skins. In the U.S. economy today, there are three basic forms of
money: currency (dollar bills), coins, and checks drawn on deposits at
banks and other financial firms that offer checking services. Most of the
time, when households, businesses, and government agencies pay their
bills they use checks, but for smaller purchases they also use currency
or coins.

People can change the type of the money they hold by withdrawing funds
from their checking account to receive currency or coins, or by
depositing currency and coins in their checking accounts. But the money
that people have in their checking accounts is really just the balance in
that account, and most of those balances are never converted to currency
or coins. Most people deposit their paychecks and then write checks to
pay most of their bills. They only convert a small part of their pay to
currency and coins. Strange as it seems, therefore, most money in the
U.S. economy is just the dollar amount written on checks or showing in
checking account balances. Sometimes, economists also count money in
savings accounts in broader measures of the U.S. money supply, because it
is easy and inexpensive to move money from savings accounts to checking
accounts.

Most people are surprised to learn that when banks make loans, the loans
create new money in the economy. As we’ve seen, banks earn profits by
lending out some of the money that people have deposited. A bank can make
loans safely because on most days, the amount some customers are
depositing in the bank is about the same amount that other customers are
withdrawing. A bank with many customers holding a lot of deposits can
lend out a lot of money and earn interest on those loans. But of course
when that happens, the bank does not subtract the amount it has loaned
out from the accounts of the people who deposited funds in savings and
checking accounts. Instead, these depositors still have the money in
their accounts, but now the people and firms to whom the bank has loaned
money also have that money in their accounts to spend. That means the
total amount of money in the economy has increased. This process is
called fractional reserve banking, because after making loans the bank
retains only a fraction of its deposits as reserves. The bank really
could not pay all of its depositors without calling in the loans it has
made. It also means that money is created when banks make loans but
destroyed when loans are paid off.

At one time the dollar, like most other national currencies, was backed
by a specified quantity of gold or silver held by the federal government.
At that time, people could redeem their dollars for gold or silver. But
in practice paper currency is much easier to carry around than large
amounts of gold or silver. Therefore, most people have preferred to hold
paper money or checking balances, as long as paper currency and checks
are accepted as payment for goods and services and maintain their value
in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold
and guard large quantities of gold or silver. As foreign trade grew,
governments found it especially difficult to transfer gold and silver to
other countries that decided to redeem paper money acquired through
international trade. They, too, changed to using paper currencies and
writing checks against deposits in accounts. In 1971 the United States
suspended the international payment of gold for U.S. currency. This
action effectively ended the gold standard, the name for this official
link between the dollar and the price of gold. Since then, there has been
no official link between the dollar and a set price for gold, or to the
amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods
and services a dollar can purchase. That purchasing power depends
primarily on the relationship between the number of dollars people are
holding as currency and in their checking and savings accounts, and the
quantity of goods and services that are produced in the economy each
year. If the number of dollars increases much more rapidly than the
quantity of goods and services produced each year, or if people start
spending the dollars they hold more rapidly, the result is likely to be
inflation. Inflation is an increase in the average price of all goods and
services. In other words, it is a decrease in the value of what each
dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply
of money. Consequently, organizations that control how much money is
issued in an economy play a major role in how the economy performs, in
terms of prices, output and employment levels, and economic growth. In
the United States, that organization is the nation’s central bank, the
Federal Reserve System. The system’s name comes from the fact that the
Federal Reserve has the legal authority to make banks hold some of their
deposits as reserves, which means the banks cannot lend out those
deposits. These reserve funds are held in the Federal Reserve Bank. The
Federal Reserve also acts as the banker for the federal government, but
the government does not own the Federal Reserve. It is actually owned by
the nation’s banks, which by law must join the Federal Reserve System and
observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not
commercial banks. They do not accept savings deposits from or provide
loans to individuals or businesses. Instead, the Federal Reserve
functions as a central bank for other banks and for the federal
government. In that role the Federal Reserve System performs several
important functions in the national economy. First, the branches of the
Federal Reserve distribute paper currency in their regions. Dollar bills
are actually Federal Reserve notes. You can look at a dollar bill of any
denomination and see the number for the regional Federal Reserve Bank
where the bill was originally issued. But of course the dollar is a
national currency, so a bill issued by any regional Federal Reserve Bank
is good anyplace in the country. The distribution of currency occurs as
commercial banks convert some of their reserve balances at the Federal
Reserve System into currency, and then provide that currency to bank
depositors who decide to hold some of their money balances as currency
rather than deposits in checking accounts. The U.S. Treasury prints new
currency for the Federal Reserve System. The bills are introduced into
circulation when commercial banks use their reserves to buy currency from
the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that
are deposited by a bank in one part of the country, but were written by
someone who has a checking account with a bank in another part of the
country. Millions of checks are processed this way every business day.
Third, the regional Federal Reserve Banks collect and analyze data on the
economic performance of their regions, and provide that information and
their analysis of it to the national Federal Reserve System. Each of the
12 regions served by the Federal Reserve banks has its own economic
characteristics. Some of these regional economies are concerned more with
agricultural issues than others; some with different types of
manufacturing and industries; some with international trade; and some
with financial markets and firms. After reviewing the reports from all
different parts of the country, the national Federal Reserve System then
adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is
controlling the nation’s money supply and the overall availability of
credit in the economy. If the Federal Reserve System wants to put more
money in the economy, it does not ask the Treasury to print more dollar
bills. Remember, much more money is held in checking and savings accounts
than as currency, and it is through those deposit accounts that the
Federal Reserve System most directly controls the money supply. The
Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits
as reserves at the Federal Reserve System. A lower reserve requirement
allows banks to make more loans and earn more money from the interest
paid on those loans. Banks making more loans increase the money supply.
Conversely, a higher reserve requirement reduces the amount of loans
banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the
economy is by lowering the rate it charges banks when they borrow money
from the Federal Reserve System. This particular interest rate is known
as the discount rate. When the discount rate goes down, it is more likely
that banks will borrow money from the Federal Reserve System, to cover
their reserve requirements and support more loans to borrowers. Once
again, those loans will increase the nation’s money supply. Therefore, a
decrease in the discount rate can increase the money supply, while an
increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve,
so changes in the discount rate are more important as a signal of whether
the Federal Reserve wants to increase or decrease the money supply. For
example, raising the discount rate may alert banks that the Federal
Reserve might take other actions, such as increasing the reserve
requirement. That signal can lead banks to reduce the amount of loans
they are making.

The third way the Federal Reserve System can adjust the supply of money
and the availability of credit in the economy is through its open market
operations—the buying or selling of government bonds. Open market
operations are actually the tool that the Federal Reserve uses most often
to change the money supply. These open-market operations take place in
the market for government securities. The U.S. government borrows money
by issuing bonds that are regularly auctioned on the bond market in New
York. The Federal Reserve System is one of the largest purchasers of
those bonds, and the bank changes the amount of money in the economy when
it buys or sells bonds.

Government bonds are not money, because they are not generally accepted
as final payment for goods and services. (Just try paying for a hamburger
with a government savings bond.) But when the Federal Reserve System pays
for a federal government bond with a check, that check is new
money—specifically, it represents a loan to the government. This loan
creates a higher balance in the government’s own checking account after
the funds have been transferred from the privately owned Federal Reserve
Bank to the government. That new money is put into the economy as soon as
the government spends the funds. On the other hand, if the Federal
Reserve sells government bonds, it collects money that is taken out of
circulation, since the bonds that the Federal Reserve sells to banks,
firms, or households cannot be used as money until they are redeemed at a
later date.

The Wall Street Journal and other financial media regularly report on
purchases of bonds made by the Federal Reserve and other buyers at
auctions of U.S. government bonds. The Federal Reserve System itself also
publishes a record of its buying and selling in the bond market. In
practice, since the U.S. economy is growing and the money supply must
grow with it to keep prices stable, the Federal Reserve is almost always
buying bonds, not selling them. What changes over time is how fast the
Federal Reserve wants the money supply to grow, and how many dollars
worth of bonds it purchases from month to month.

To summarize the Federal Reserve System’s tools of monetary policy: It
can increase the supply of money and the availability of credit by
lowering the percentage of deposits that banks must hold as reserves at
the Federal Reserve System, by lowering the discount rate, or by
purchasing government bonds through open market operations. The Federal
Reserve System can decrease the supply of money and the availability of
credit by raising reserve ratios, raising the discount rate, or by
selling government bonds.

The Federal Reserve System increases the money supply when it wants to
encourage more spending in the economy, and especially when it is
concerned about high levels of unemployment. Increasing the money supply
usually decreases interest rates—which are the price of money paid by
those who borrow funds to those who save and lend them. Lower interest
rates encourage more investment spending by businesses, and more spending
by households for houses, automobiles, and other “big ticket” items that
are often financed by borrowing money. That additional spending increases
national levels of production, employment, and income. However, the
Federal Reserve Bank must be very careful when increasing the money
supply. If it does so when the economy is already operating close to full
employment, the additional spending will increase only prices, not output
and employment.

Effect of Monetary Policies on the U.S. Economy

The monetary policies adopted by the Federal Reserve System can have
dramatic effects on the national economy and, in particular, on financial
markets. Most directly, of course, when the Federal Reserve System
increases the money supply and expands the availability of credit, then
the interest rate, which determines the amount of money that borrowers
pay for loans, is likely to decrease. Lower interest rates, in turn, will
encourage businesses to borrow more money to invest in capital goods, and
will stimulate households to borrow more money to purchase housing,
automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money
supply. If the supply of money and credit grows much faster than the
production of goods and services in the economy, then prices will
increase, and the rate of inflation will rise. Inflation is a serious
problem for those who live on fixed incomes, since the income of those
individuals remains constant while the amount of goods and services they
can purchase with their income decreases. Inflation may also hurt banks
and other financial institutions that lend money, as well as savers. In a
period of unanticipated inflation, as the value of money decreases in
terms of what it will purchase, loans are repaid with dollars that are
worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to
protect themselves by demanding higher interest rates on loans and
savings accounts. This will be especially true on long-term loans and
savings deposits, if the higher inflation is considered likely to
continue for many years. But higher interest rates create problems for
borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then
interest rates are again likely to rise, leading to decreased spending
for capital investments and consumer durable goods (products designed for
long-term use, such as television sets, refrigerators, and personal
computers). Such decreased spending will hurt many businesses and may
lead to a recession, an economic slowdown in which the national output of
goods and services falls. When that happens, wages and salaries paid to
individual workers will fall or grow more slowly, and some workers will
be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the
Federal Reserve’s actions with monetary policy very closely. There are
regular reports in the media about policy changes made by the Federal
Reserve System, and even about statements made by Federal Reserve
officials that may indicate that the Federal Reserve is going to change
the supply of money and interest rates. The chairman of the Federal
Reserve System is widely considered to be one of the most influential
people in the world because what the Federal Reserve does so dramatically
affects the U.S. and world economies, especially financial markets.

LABOR AND LABOR MARKETS

Labor includes work done for employers and work done in a person’s own
household, but labor markets deal only with work that is done for some
form of financial compensation. Labor markets include all the means by
which workers find jobs and by which employers locate workers to staff
their businesses. A number of factors influence labor and labor markets
in the United States, including immigration, discrimination, labor
unions, unemployment, and income inequality between the rich and poor.

The official definition of the U.S. labor force includes people who are
at least 16 years old and either working, waiting to be recalled from a
layoff, or actively looking for work within the past 30 days. In 1998 the
U.S. labor force included nearly 138 million people, most of them working
in full-time or part-time jobs.

Most people in the United States receive their income as wages and
salaries paid by firms that have hired individuals to work as their
employees. Those wages and salaries are the prices they receive for the
labor services they provide to their employers. Like other prices, wages
and salaries are determined primarily by market forces.

Labor Supply and Demand

The wages and salaries that U.S. workers earn vary from occupation to
occupation, across geographic regions, and according to workers’ levels
of education, training, experience, and skill. As with goods and services
purchased by consumers, labor is traded in markets that reflect both
supply and demand. In general, higher wages and salaries are paid in
occupations where labor is more scarce—that is, in jobs where the demand
for workers is relatively high and the supply of workers with the
qualifications and ability to do that work is relatively low. The demand
for workers in particular occupations depends largely on how much the
work they do adds to a firm’s revenues. In other words, workers who
create more products or higher-priced products will be worth more to
employers than workers who make fewer or less valuable products. The
supply of workers in any occupation is affected by the amount of time and
effort required to enter that occupation compared to other things workers
might do.

Workers seeking higher wages often learn skills that will increase the
likelihood of finding a higher-paying job. The knowledge, skills, and
experience a worker has acquired are the worker’s human capital.
Education and training can clearly increase workers’ human capital and
productivity, which makes them more valuable to employers. In general,
more educated individuals make more money at their jobs. However, a
greater level of education does not always guarantee higher wages.
Certain professions that demand a high level of education, such as
teaching elementary and secondary school, are not high-paying. Such
situations arise when the number of people with the training to do that
job is relatively large compared with the number of people that employers
want to hire. Of course this situation can change over time if, for
example, fewer young people choose to train for the profession.

Supply and demand factors change in labor markets, just as they do in
markets for goods and services. As a result, occupations that paid high
wages and salaries in the past sometimes become outdated, while entirely
new occupations are created as a result of technological change or
changes in the goods and services consumers demand. For example,
blacksmiths were once among the most skilled workers in the United
States; today, computer programmers and software developers are in great
demand.

The process of creative destruction carries over from product markets to
labor markets because the demand for particular goods and services
creates a demand for the labor to produce them. Conversely, when the
demand for particular goods or services decreases, the demand for labor
to produce them will also fall. Similarly, when new technologies create
new products or new ways of producing existing products, some workers
will have new job opportunities, but other workers might have to retrain,
relocate, or take new jobs.

Factors Affecting Labor Markets

Changes in society and in the makeup of the population also affect labor
markets. For example, starting in the 1960s it became more common for
married women to work outside the home. Unprecedented numbers of
women—many with little previous job experience and training—entered the
labor markets for the first time during the 1970s. As a result, wages for
entry-level jobs were pushed down and did not rise as rapidly as they had
in the past. This decline in entry-level wages was further fueled by huge
numbers of teens who were also entering the labor market for the first
time. These young people were the children of the baby boom of 1946 to
1964, a period in which the birth rate increased dramatically in the
United States. So, two changes—one affecting women’s roles in the labor
market, the other in the makeup of the age of the workforce—combined to
affect the labor market.

The baby boomers’ effects have continued to reverberate through the U.S.
economy. For example, starting salaries for people with college degrees
became depressed when large numbers of baby boomers started graduating
from college. And as workers born during the boom have aged, the work
force in the United States has grown progressively older, with the
percentage of workers under the age of 25 falling from 20.3 percent in
1980 to 14.3 percent in 1997.

By the 1990s, the women and baby boomers who first entered the job market
in the 1970s had acquired more experience and training. Therefore, the
aging of the labor force was not affecting entry-level jobs as it once
did, and starting salaries for college graduates were rising rapidly
again. There will be, however, other kinds of labor market and public
policy issues to face when the baby boomers begin to retire in the early
decades of the 21st century.

Immigration

Labor markets in the United States have also been significantly affected
by the immigration of families and workers from other nations. Most
families and workers in the United States can trace their heritage to
immigrants. In fact, before the 20th century, while the United States was
trying to settle its frontiers, it allowed essentially unlimited
immigration. see Immigration: A Nation of Immigrants. In these periods
the U.S. economy had more land and other natural resources than it was
able to use, because labor was so scarce. Immigration served as one of
the main remedies for this shortage of labor.

Generally, immigration raises national output and income levels. These
changes occur because immigration increases the number of workers in the
economy, which allows employers to produce more goods and services.
Capital resources in the economy may also become more valuable as
immigration increases. The number of workers available to work with
machines and tools increases, as does the number of consumers who want to
buy goods and services. However, wages for jobs that are filled by large
numbers of immigrants may decrease. This wage decline stems from greater
competition for these jobs and from the fact that many immigrants are
willing to work for lower wages than other U.S. workers.

Immigration into the United States is now regulated by a system of quotas
that limits the number of immigrants who can legally enter the country
each year. In 1964 Congress changed immigration policies to give
preference to those with families already in the United States, to
refugees facing political persecution, and to individuals with other
humanitarian concerns. Before that time, more weight had been placed on
immigrants’ labor-market skills. Although this change in policy helped
reunite families, it also increased the supply of unskilled labor in the
nation, especially in the states of California, Florida, and New York. In
1990 Congress modified the immigration legislation to set a separate
annual quota for immigrants with job skills needed in the United States.
But people with family members who are already U.S. citizens remain the
largest category of immigrants, and U.S. immigration law still puts less
focus on job skills than do immigration laws in many other market
economies, including Canada and many of the nations of Western Europe.

Discrimination

Women and many minorities have long faced discrimination in U.S. labor
markets. Employed women earn less, on average, than men with similar
levels of education. In part this wage disparity reflects different
educational choices that women and men have made. In the past, women have
been less likely to study engineering, sciences, and other technical
fields that generally pay more. In part, the wage differences result from
women leaving the job market for a period of years to raise children.
Another reason for the disparity in wages between men and women is that
there is still a considerable degree of occupational segregation between
males and females—for example, nurses are much more likely to be females
and dentists males. But even after allowing for those factors, studies
have generally found that, on average, women earn roughly 10 percent less
than men even in comparable jobs, with equal levels of education,
training, and experience.

Analysis of wage discrimination against black Americans leads to similar
conclusions. Specifically, after controlling for differences in age,
education, hours worked, experience, occupation, and region of the
country, wages for black men are roughly 10 percent lower than for white
men, though occupational segregation appears to be less common by race
than by gender. Issues other than wage discrimination are also important
to note for black workers. In particular, unemployment rates for black
workers are about twice as high as they are for white workers. Partly
because of that, a much lower percentage of the U.S. black population is
employed than the white population.

Hispanic workers generally receive wages about 5 percent lower than white
workers, after adjusting for differences in education, training,
experience, and other characteristics that affect workers’ productivity.
Some studies suggest that differences in the ability to speak English are
particularly important in understanding wage differences for Hispanic
workers.

The differences between the earnings of white males and earnings of
females and minorities slowly decreased in the closing decades of the
20th century. Some laws and regulations prohibiting discrimination seem
to have helped in this process. A large part of those gains occurred
shortly after the adoption of the 1964 Civil Rights Act, which among
other things, outlawed discrimination by employers and unions. Many
economists worry that the discrimination that remains may be more
difficult to identify and eliminate through legislation.

Discrimination in competitive labor markets is economically inefficient
as well as unfair. When workers are not paid based on the value of what
they add to employers’ production and profit levels, society loses
opportunities to use labor resources in their most valuable ways. As a
result, fewer goods and services are produced. If employers discriminate
against certain groups of workers, they will pay for that behavior in
competitive markets by earning lower profits. Similarly, if workers
refuse to work with (or for) coworkers of a different gender, race, or
ethnic background, they will have to accept lower wages in competitive
markets because their discrimination makes it more costly for employers
to run their businesses. And if customers refuse to be served by workers
of a certain gender, race, or ethnicity in certain kinds of jobs, they
will have to pay higher prices in competitive markets because their
discrimination raises the costs of providing these goods and services.

Those who are discriminated against receive lower wages and often
experience other forms of economic hardship, such as more frequent and
longer periods of unemployment. Beyond that, the lower wage rates and
restricted career opportunities they face will naturally affect their
decisions about how much education and training to acquire and what kinds
of careers to pursue. For that reason, some of the costs of
discrimination are paid over very long periods of time, sometimes for a
worker’s entire life.

It is clear that there is still discrimination in the U.S. economy. What
is not always so clear is how much that discrimination costs the economy
as a whole, and that it costs not only those who are discriminated
against, but also those who practice discrimination.

Unions

Many U.S. workers belong to unions or to professional associations (such
as the National Education Association for teachers) that act like unions.
These unions and associations represent groups of workers in collective
bargaining with employers to agree on contracts. During this bargaining,
workers and employers establish wages and fringe benefits, such as health
care and pension benefits, for different types of jobs. They also set
grievance procedures to resolve labor disputes during the life of the
contract and often address many other issues, such as procedures for job
transfers and promotions of workers.

Many studies indicate that wages for union workers in the United States
are 10 to 15 percent higher than for nonunion workers in similar jobs and
that fringe benefits for union workers also tend to be higher. That
compensation difference is an important consideration both for workers
thinking about joining unions, and for employers who are concerned about
paying higher wages and benefits than their competitors. In some cases,
it appears that the higher wages and benefits are paid because union
workers are more productive than nonunion workers are. But in other cases
unions have been found to decrease productivity, sometimes by limiting
the kinds of work that certain employees can do, or by requiring more
workers in some jobs than employers would otherwise hire. Economists have
not reached definite conclusions on some of these issues, but it is
evident that there are many other broad effects of unions on the economy.

Unions and collective bargaining in the United States are markedly
different from such organizations and procedures in other industrialized
nations. U.S. unions generally practice what is often described as
business unionism, which focuses mainly on the direct economic interests
of their members. In contrast, unions in Europe and South America focus
more on influencing national policy agendas and political parties.

The different focus by U.S. unions partly reflects the special history of
unions in the United States, where the first sustained successes were
achieved by craft unions representing skilled workers such as carpenters,
printers, and plumbers. These skilled workers had more bargaining power
and were more difficult for employers to replace or do without than
workers with less training. Unions representing these skilled workers
were also able to provide special services to employers that allowed both
the unions and employers to operate more efficiently. For example, craft
unions in large cities often ran apprenticeship programs to train young
workers in these occupations. And many craft unions operated hiring halls
that employers could call to find trained workers on short notice or for
short periods of time.

Most of these craft unions were members of the American Federation of
Labor (AFL), founded in 1886. The strong bargaining position of these
skilled workers, and the fact that these workers typically earned much
higher wages than most other workers, led the AFL unions to focus on
wages and other financial benefits for their members. Samuel Gompers, the
president of the AFL for nearly all of its first 38 years, once
summarized his philosophy of unions by saying, “What do we want? More.
When do we want it? Now.”

By contrast, industrial unions—which represent all of the workers at a
firm or work site, regardless of their function or trade—were generally
not successful in the United States before Congress passed the National
Labor Relations Act of 1935. This law, also known as the Wagner Act after
its sponsor, Senator Robert F. Wagner of New York, changed the way that
unions are recognized as bargaining agents for workers by employers, and
made it easier for unions representing all workers to win that
recognition. The Wagner Act largely put an end to the violent strikes
that often occurred when unions were trying to be recognized as the
bargaining agent for employees at some firm or work site. The act
established clear procedures for calling and holding elections in which
the workers decide whether they want to be represented by a union, and if
so by which union. The Wagner Act also established a government agency
known as the National Labor Relations Board (NLRB) to hear charges of
unfair labor practices. Either employees or employers may file charges of
unfair labor practices with the NLRB.

After the Wagner Act was passed, the number of workers who belonged to
unions increased rapidly. This trend continued through World War II (1939-
1945), when unions successfully negotiated more fringe benefits for their
members. These fringe benefits were partly a result of wage and price
controls established during the war, which made large wage increases
impossible. In the 1950s union strength continued to grow, and the
national association of industrial unions, known as the Congress of
Industrial Organization (CIO) merged with the AFL.

Since the late 1970s, total union membership has fallen. The percentage
of the U.S. labor force that belongs to unions has decreased dramatically
in the last half of the 20th century, from more than 25 percent in the
mid-1950s to 14 percent in 1997. A number of reasons explain the decline
in union representation of the U.S. labor force. First, unions are
traditionally strong in manufacturing industries, but since the 1950s
manufacturing has accounted for a smaller percentage of overall
employment in the U.S. economy. Employment has grown more rapidly in the
service sector, particularly in professional services and white-collar
jobs. Unions have not had as much success in acquiring new members in the
service sector, with the exception of government employees.

Union membership has also declined as the government established laws and
regulations that mandate for all workers many of the benefits and
guarantees that unions had achieved for their members. These mandates
include minimum wage, workplace safety, higher pay rates for overtime,
and oversight of the management of pension funds if employers fund or
partially fund pensions.

Third, many U.S. firms have become more aggressive in opposing the
recognition of unions as bargaining agents for their employees, and in
dealing with confrontations involving existing unions. For example, it is
increasingly common for firms to hire permanent replacement workers if
strikes occur at a firm or work site.

Finally, workers with college degrees held a larger percentage of jobs in
the U.S. economy in the late 1990s than in earlier decades. These workers
are more likely to be in jobs with some level of managerial
responsibilities, and less likely to think of themselves as potential
union members.

Unions, however, continue to play many valuable roles in representing
their members on economic issues. Equally or perhaps more importantly,
unions provide workers with a stronger voice in how work is done and how
workers are treated. This is particularly true in jobs where it is
difficult to identify clearly how much an individual worker contributes
to total output in the production process. During the 1990s, many U.S.
manufacturing firms adopted team production methods, in which small
groups of workers function as a team. Any member of the team can suggest
ideas for different ways of doing jobs. But management is likely to
consider more carefully those that are recommended by the union or have
union support. Workers may also be more willing to present ideas for job
improvements to union representatives than to managers. In some cases,
workers feel that the union would consider how the changes can be made
without reducing jobs, wages, or other benefits.

Unemployment

A persistent problem for the U.S. economy and some of its workers is
unemployment—not being able to find a job despite actively looking for
work for at least 30 consecutive days. There are three major kinds of
unemployment: frictional, cyclical, and structural. Each type of
unemployment has different causes and consequences, and so public
policies designed to reduce each type of unemployment must be different,
too.

Frictional unemployment occurs as a result of labor mobility, when
workers change jobs or wait to begin a new job. Labor mobility is, in
general, a good thing for workers and the economy overall. It allows
workers to look for the best available job for which they are qualified
and lets employers find the best-qualified people for their job openings.
Because this searching and matching by employees and employers takes
time, on any given day in a market economy there will be some workers who
are looking for a new job, or waiting to begin a job. Even when
economists describe the economy as being at full employment there will be
some frictional unemployment (as much as 5 to 6 percent of the labor
force in some years). This kind of unemployment is generally not a major
economic problem.

Cyclical unemployment occurs when the economy goes into a recession. The
basic causes of cyclical unemployment are decreases in the levels of
consumption, investment, or government spending in the economy, or a
decrease in the demand for goods and services exported to other
countries. As national spending and production levels fall, some
employers begin to lay off workers. Cyclical unemployment varies greatly
according to the health of the economy. Some of the highest unemployment
rates for the last decades of the 20th century took place during the
recession of 1982 to 1983, when unemployment levels reached almost 10
percent. The highest U.S. unemployment rate of the 20th century occurred
in 1933, when the Great Depression left almost 25 percent of the labor
force without work.

Sometimes the government can use monetary or fiscal policies to increase
spending by businesses and households, for instance by cutting taxes. Or
the government can increase its own spending to fight this kind of
unemployment. . Perhaps the most famous example of this kind of tax cut
in the United States was the one designed in 1963 and passed in 1964 by
the administrations of U.S. president John F. Kennedy and his successor,
Lyndon B. Johnson.

Structural unemployment occurs when people who are looking for jobs do
not have the education or skills to fill the jobs that are currently
available. Most policies designed to reduce structural unemployment
provide training programs for these workers, or subsidize education and
training programs available from colleges and universities, technical
schools, or businesses. In some cases, the government provides support
for retraining when increased competition from imported goods and
services puts U.S. workers out of work or when factories are shut down
because production is moved to another state or country.

Unemployment rates also vary sharply by occupation and educational
levels. As a group, workers with college degrees experience far lower
unemployment rates than workers with less education. In 1998 the
unemployment rate for U.S. workers who had not graduated from high school
was 7.1 percent; for high school graduates, the rate was 4.0 percent; for
those with some college the rate was 3.0 percent; and for college
graduates the unemployment rate was only 1.8 percent.

Income Inequality

Another issue involving the operation of labor markets in the U.S.
economy has been the growing difference between the earnings of high-
income and low-income workers at the end of the 20th century. From 1977
to 1997, families who make up the top 20 percent of income groups have
seen their money income rise from 40.9 percent of the national income to
47.2 percent. Over the same period, families in the lowest 20 percent of
income groups have experienced a decline from 5.5 percent of the national
income to 4.2 percent. This trend is the result of several factors.

Wages for skilled workers, those with more education and training, have
increased quickly because the supply of these workers in the U.S. has not
risen as quickly as demand for these workers. In addition, wages for
unskilled labor in the United States have been held down more than in
other nations as a result of U.S. immigration policies. The United States
has admitted a larger number of unskilled workers than other
industrialized nations. Other countries often consider job market factors
more heavily in determining who will be allowed to immigrate. As a
result, the supply of unskilled workers in the United States has
increased faster than in other countries, pushing wages in low-paying
jobs lower.

Finally, government assistance programs for low-income families tend to
be more extensive and generous in other industrialized market economies
than they are in the United States. That is perhaps one of the reasons
that workers in those countries are less willing to accept jobs that pay
lower wages, and why unemployment rates in those countries are
substantially higher than they are in the United States. The exact
relationship between those factors has not been determined, however.

It is clear that it has become increasingly difficult for U.S. workers
who have not at least completed high school to achieve a high or moderate
level of income. In 1996 the average annual income for graduates of four-
year colleges was $63,127 for males and $41,339 for females, while the
average annual income for those who did not graduate from high school was
only $25,283 for males and $17,313 for females.

GOVERNMENT AND THE ECONOMY

Although the market system in the United States relies on private
ownership and decentralized decision-making by households and privately
owned businesses, the government does perform important economic
functions. The government passes and enforces laws that protect the
property rights of individuals and businesses. It restricts economic
activities that are considered unfair or socially unacceptable.

In addition, government programs regulate safety in products and in the
workplace, provide national defense, and provide public assistance to
some members of society coping with economic hardship. There are some
products that must be provided to households and firms by the government
because they cannot be produced profitably by private firms. For example,
the government funds the construction of interstate highways, and
operates vaccination programs to maintain public health. Local
governments operate public elementary and secondary schools to ensure
that as many children as possible will receive an education, even when
their parents are unable to afford private schools.

Other kinds of goods and services (such as health care and higher
education) are produced and consumed in private markets, but the
government attempts to increase the amount of these products available in
the economy. For yet other goods and services, the government acts to
decrease the amount produced and consumed; these include alcohol,
tobacco, and products that create high levels of pollution. These special
cases where markets fail to produce the right amount of certain goods and
services mean that the government has a large and important role to play
in adjusting some production patterns in the U.S. economy. But economists
and other analysts have also found special reasons why government
policies and programs often fail, too.

At the most basic level, the government makes it possible for markets to
function more efficiently by clearly defining and enforcing people’s
property or ownership rights to resources and by providing a stable
currency and a central banking system (the Federal Reserve System in the
U.S. economy). Even these basic functions require a wide range of
government programs and employees. For example, the government maintains
offices for recording deeds to property, courts to interpret contracts
and resolve disputes over property rights, and police and other law
enforcement agencies to prevent or punish theft and fraud. The Treasury
Department issues currency and coins and handles the government’s
revenues and expenditures. And as we have seen, the Federal Reserve
System controls the nation’s supply of money and availability of credit.
To perform these basic functions, the government must be able to shift
resources from private to public uses. It does this mainly through taxes,
but also with user fees for some services (such as admission fees to
national parks), and by borrowing money when it issues government bonds.

In the U.S. economy, private markets are generally used to allocate basic
products such as food, housing, and clothing. Most economists—and most
Americans—widely accept that competitive markets perform these functions
most efficiently. One role of government is to maintain competition in
these markets so that they will continue to operate efficiently. In other
areas, however, markets are not allowed to operate because other
considerations have been deemed more important than economic efficiency.
In these cases, the government has declared certain practices illegal.
For example, in the United States people are not free to buy and sell
votes in political elections. Instead, the political system is based on
the democratic rule of “one person, one vote.” It is also illegal to buy
and sell many kinds of drugs. After the Civil War (1861-1865) the
Constitution was amended to make slavery illegal, resulting in a major
change in the structure of U.S. society and the economy.

In other cases, the government allows private markets to operate, but
regulates them. For example, the government makes laws and regulations
concerning product safety. Some of these laws and regulations prohibit
the use of highly flammable material in the manufacture of children’s
clothing. Other regulations call for government inspection of food
products, and still others require extensive government review and
approval of potential prescription drugs.

In still other situations, the government determines that private markets
result in too much production and consumption of some goods, such as
alcohol, tobacco, and products that contribute to environmental
pollution. The government is also concerned when markets provide too
little of other products, such as vaccinations that prevent contagious
diseases. The government can use its spending and taxing authority to
change the level of production and consumption of these products, for
example, by subsidizing vaccinations.

Even the staunchest supporters of private markets have recognized a role
for the government to provide a safety net of support for U.S. citizens.
This support includes providing income, housing, food, and medicine for
those who cannot provide a basic standard of living for themselves or
their families.

Because the federal government has become such a large part of the U.S.
economy over the past century, it sometimes tries to reduce levels of
unemployment or inflation by changing its overall level of spending and
taxes. This is done with an eye to the monetary policies carried out by
the Federal Reserve System, which also have an effect on the national
rates of inflation, unemployment, and economic growth. The Federal
Reserve System itself is chartered by federal legislation, and the
president of the United States appoints board members of the Federal
Reserve, with the approval of the U.S. Senate. However, the private banks
that belong to the system own the Federal Reserve, and its policy and
operational decisions are made independently of Congress and the
president.

Correcting Market Failures

The government attempts to adjust the production and consumption of
particular goods and services where private markets fail to produce
efficient levels of output for those products. The two major examples of
these market failures are what economists call public goods and external
benefits or costs.

Providing Public Goods

Private markets do not provide some essential goods and services, such as
national defense. Because national defense is so important to the
nation’s existence, the government steps in and entirely funds and
administers this product.

Public goods differ from private goods in two key respects. First, a
public good can be used by one person without reducing the amount
available for others to use. This is known as shared consumption. An
example of a public good that has this characteristic is a spraying or
fogging program to kill mosquitoes. The spraying reduces the number of
mosquitoes for all of the people who live in an area, not just for one
person or family. The opposite occurs in the consumption of private
goods. When one person consumes a private good, other people cannot use
the product. This is known as rival consumption. A good example of rival
consumption is a hamburger. If someone else eats the sandwich, you
cannot.

The second key characteristic of public goods is called the nonexclusion
principle: It is not possible to prevent people from using a public good,
regardless of whether they have paid for it. For example, a visitor to a
town who does not pay taxes in that community will still benefit from the
town’s mosquito-spraying program. With private goods, like a hamburger,
when you pay for the hamburger, you get to eat it or decide who does.
Someone who does not pay does not get the hamburger.

Because many people can benefit from the same pubic goods and share in
their consumption, and because those who do not pay for these goods still
get to use them, it is usually impossible to produce these goods in
private markets. Or at least it is impossible to produce enough in
private markets to reach the efficient level of output. That happens
because some people will try to consume the goods without paying for
them, and get a free ride from those who do pay. As a result, the
government must usually take over the decision about how much of these
products to produce. In some cases, the government actually produces the
good; in other cases it pays private firms to make these products.

The classic example of a public good is national defense. It is not a
rival consumption product, since protecting one person from an invading
army or missile attack does not reduce the amount of protection provided
to others in the country. The nonexclusion principle also applies to
national defense. It is not possible to protect only the people who pay
for national defense while letting bombs or bullets hit those who do not
pay. Instead, the government imposes broad-based taxes to pay for
national defense and other public goods.

Adjusting for External Costs or Benefits

There are some private markets in which goods and services are produced,
but too much or too little is produced. Whether too much or too little is
produced depends on whether the problem is one of external costs or
external benefits. In either case, the government can try to correct
these market failures, to get the right amount of the good or service
produced.

External costs occur when not all of the costs involved in the production
or consumption of a product are paid by the producers and consumers of
that product. Instead, some of the costs shift to others. One example is
drunken driving. The consumption of too much alcohol can result in
traffic accidents that hurt or kill people who are neither producers nor
consumers of alcoholic products. Another example is pollution. If a
factory dumps some of its wastes in a river, then people and businesses
downstream will have to pay to clean up the water or they may become ill
from using the water.

When people other than producers and consumers pay some of the costs of
producing or consuming a product, those external costs have no effect on
the product’s market price or production level. As a result, too much of
the product is produced considering the overall social costs. To correct
this situation, the government may tax or fine the producers or consumers
of such products to force them to cover these external costs. If that can
be done correctly, less of the product will be produced and consumed.

An external benefit occurs when people other than producers and consumers
enjoy some of the benefits of the production and consumption of the
product. One example of this situation is vaccinations against contagious
diseases. The company that sells the vaccine and the individuals who
receive the vaccine are better off, but so are other people who are less
likely to be infected by those who have received the vaccine. Many people
also argue that education provides external benefits to the nation as a
whole, in the form of lower unemployment, poverty, and crime rates, and
by providing more equality of opportunity to all families.

When people other than the producers and consumers receive some of the
benefits of producing or consuming a product, those external benefits are
not reflected in the market price and production cost of the product.
Because producers do not receive higher sales or profits based on these
external benefits, their production and price levels will be too
low–based only on those who buy and consume their product. To correct
this, the government may subsidize producers or consumers of these
products and thus encourage more production.

Maintaining Competition

Competitive markets are efficient ways to allocate goods and services
while maintaining freedom of choice for consumers, workers, and
entrepreneurs. If markets are not competitive, however, much of that
freedom and efficiency can be lost. One threat to competition in the
market is a firm with monopoly power. Monopoly power occurs when one
producer, or a small group of producers, controls a large part of the
production of some product. If there are no competitors in the market, a
monopoly can artificially drive up the price for its products, which
means that consumers will pay more for these products and buy less of
them. One of the most famous cases of monopoly power in U.S. history was
the Standard Oil Company, owned by U.S. industrialist John D.
Rockefeller. Rockefeller bought out most of his business rivals and by
1878 controlled 90 percent of the petroleum refineries in the United
States.

Largely in reaction to the business practices of Standard Oil and other
trusts or monopolistic firms, the United States passed laws limiting
monopolies. Since 1890, when the Sherman Antitrust Act was passed, the
federal government has attempted to prevent firms from acquiring monopoly
power or from working together to set prices and limit competition in
other ways. A number of later antitrust laws were passed to extend the
government’s power to promote and maintain competition in the U.S.
economy. Some states have passed their own versions of some of these
laws.

The government does allow what economists call natural monopolies.
However, the government then regulates those businesses to protect
consumers from high prices and poor service, and often limits the profits
these firms can earn. The classic examples of natural monopolies are
local services provided by public utilities. Economies of scale make it
inefficient to have even two companies distributing electricity, gas,
water, or local telephone service to consumers. It would be very
expensive to have even two sets of electric and telephone wires, and two
sets of water, gas, and sewer pipes going to every house. That is why
firms that provide these services are called natural monopolies.

There have been some famous antitrust cases in which large companies were
broken up into smaller firms. One such example is the breakup of American
Telephone and Telegraph (AT&T) in 1982, which led to the formation of a
number of long-distance and regional telephone companies. Other examples
include a ruling in 1911 by the Supreme Court of the United States, which
broke the Standard Oil Trust into a number of smaller oil companies and
ordered a similar breakup of the American Tobacco Company.

Some government policies intentionally reduce competition, at least for
some period of time. For example, patents on new products and copyrights
on books and movies give one producer the exclusive right to sell or
license the distribution of a product for 17 or more years. These
exclusive rights provide the incentive for firms and individuals to spend
the time and money required to develop new products. They know that no
one else will copy and sell their product when it is introduced into the
marketplace, so it pays to devote more resources to developing these new
products.

The benefits of certain other government policies that reduce competition
are not always this clear, however. More controversial examples include
policies that restrict the number of taxicabs in a large city or that
limit the number of companies providing cable television services in a
community. It is much less expensive for cable companies to install and
operate a cable television system than it is for large utilities, such as
the electric and telephone companies, to install the infrastructure they
need to provide services. Therefore, it is often more feasible to have
two or more cable companies in reasonably large cities. There are also
more substitutes for cable television, such as satellite dish systems and
broadcast television. But despite these differences, many cities auction
off cable television rights to a single company because the city receives
more revenue that way. Such a policy results in local monopolies for
cable television, even in areas where more competition might well be
possible and more efficient.

Establishing government policies that efficiently regulate markets is
difficult to do. Policies must often balance the benefits of having more
firms competing in an industry against the possible gains from allowing a
smaller number of firms to compete when those firms can achieve economies
of scale. The government must try to weigh the benefits of such
regulations against the advantages offered by more competitive, less
regulated markets.

Promoting Full Employment and Price Stability

In addition to the monetary policies of the Federal Reserve System, the
federal government can also use its taxing and spending policies, or
fiscal policies, to counteract inflation or the cyclical unemployment
that results from too much or too little total spending in the economy.
Specifically, if inflation is too high because consumers, businesses, and
the government are trying to buy more goods and services than it is
possible to produce at that time, the government can reduce total
spending in the economy by reducing its own spending. Or the government
can raise taxes on households and businesses to reduce the amount of
money the private sector spends. Either of these fiscal policies will
help reduce inflation. Conversely, if inflation is low but unemployment
rates are too high, the government can increase its spending or reduce
taxes on households and businesses. These policies increase total
spending in the economy, encouraging more production and employment.

Some government spending and tax policies work in ways that automatically
stabilize the economy. For example, if the economy is moving into a
recession, with falling prices and higher unemployment, income taxes paid
by individuals and businesses will automatically fall, while spending for
unemployment compensation and other kinds of assistance programs to low-
income families will automatically rise. Just the opposite happens as the
economy recovers and unemployment falls—income taxes rise and government
spending for unemployment benefits falls. In both cases, tax programs and
government-spending programs change automatically and help offset changes
in nongovernment employment and spending.

In some cases, the federal government uses discretionary fiscal policies
in addition to automatic stabilization policies. Discretionary fiscal
policies encompass those changes in government spending and taxation that
are made as a result of deliberations by the legislative and executive
branches of government. Like the automatic stabilization policies,
discretionary fiscal policy can reduce unemployment by increasing
government spending or reducing taxes to encourage the creation of new
jobs. Conversely, it can reduce inflation by decreasing government
spending and raising taxes. .

In general, the federal government tries to consider the condition of the
national economy in its annual budgeting deliberations. However,
discretionary spending is difficult to put into practice unless the
nation is in a particularly severe episode of unemployment or inflation.
In such periods, the severity of the situation builds more consensus
about what should be done, and makes it more likely that the problem will
still be there to deal with by the time the changes in government
spending or tax programs take effect. But in general, it takes time for
discretionary fiscal policy to work effectively, because the economic
problem to be addressed must first be recognized, then agreement must be
reached about how to change spending and tax levels. After that, it takes
more time for the changes in spending or taxes to have an effect on the
economy.

When there is only moderate inflation or unemployment, it becomes harder
to reach agreement about the need for the government to change spending
or taxes. Part of the problem is this: In order to increase or decrease
the overall level of government spending or taxes, specific expenditures
or taxes have to be increased or decreased, meaning that specific
programs and voters are directly affected. Choosing which programs and
voters to help or hurt often becomes a highly controversial political
issue.

Because discretionary fiscal policies affect the government’s annual
deficit or surplus, as well as the national debt, they can often be
controversial and politically sensitive. For these reasons, at the close
of the 20th century, which experienced years with normal levels of
unemployment and inflation, there was more reliance on monetary policies,
rather than on discretionary fiscal policies to try to stabilize the
national economy. There have been, however, some famous episodes of
changing federal spending and tax policies to reduce unemployment and
fight inflation in the U.S. economy during the past 40 years. In the
early 1980s, the administration of U.S. president Ronald Reagan cut
taxes. Other notable tax cuts occurred during the administrations of U.S.
presidents John Kennedy and Lyndon Johnson in 1963 and 1964.

Limitations of Government Programs

Government economic programs are not always successful in correcting
market failures. Just as markets fail to produce the right amount of
certain kinds of goods and services, the government will often spend too
much on some programs and too little on others for a number of reasons.
One is simply that the government is expected to deal with some of the
most difficult problems facing the economy, taking over where markets
fail because consumers or producers are not providing clear signals about
what they want. This lack of clear signals also makes it difficult for
the government to determine a policy that will correct the problem.

Political influences, rather than purely economic factors, often play a
major role in inefficient government policies. Elected officials
generally try to respond to the wishes of the voting public when making
decisions that affect the economy. However, many citizens choose not to
vote at all, so it is not clear how good the political signals are that
elected officials have to work with. In addition, most voters are not
well informed on complicated matters of economic policy.

For example, the federal government’s budget director David Stockman and
other officials in the administration of President Reagan proposed cuts
in income tax rates. Congress adopted the cuts in 1981 and 1984 as a way
to reduce unemployment and make the economy grow so much that tax
revenues would actually end up rising, not falling. Most economists and
many politicians did not believe that would happen, but the tax cuts were
politically popular.

In fact, the tax cuts resulted in very large budget deficits because the
government did not collect enough taxes to cover its expenditures. The
government had to borrow money, and the national debt grew very rapidly
for many years. As the government borrowed large sums of money, the
increased demand caused interest rates to rise. The higher interest rates
made it more expensive for U.S. firms to invest in capital goods, and
increased the demand for dollars on foreign exchange markets as
foreigners bought U.S. bonds paying higher interest rates. That caused
the value of the dollar to rise, compared with other nations’ currencies,
and as a result U.S. exports became more expensive for foreigners to buy.
When that happened in the mid-1980s, most U.S. companies that exported
goods and services faced very difficult times.

In addition, whenever resources are allocated through the political
process, the problem of special interest groups looms large. Many
policies, such as tariffs or quotas on imported goods, create very large
benefits for a small group of people and firms, while the costs are
spread out across a large number of people. That gives those who receive
the benefits strong reasons to lobby for the policy, while those who each
pay a small part of the cost are unlikely to oppose it actively. This
situation can occur even if the overall costs of the program greatly
exceed its overall benefits.

For instance, the United States limits sugar imports. The resulting
higher U.S. price for sugar greatly benefits farmers who grow sugarcane
and sugar beets in the United States. U.S. corn farmers also benefit
because the higher price for sugar increases demand for corn-based
sweeteners that substitute for sugar. Companies in the United States that
refine sugar and corn sweeteners also benefit. But candy and beverage
companies that use sweeteners pay higher prices, which they pass on to
millions of consumers who buy their products. However, these higher
prices are spread across so many consumers that the increased cost for
any one is very small. It therefore does not pay a consumer to spend much
time, money, or effort to oppose the import barriers.

For sugar growers and refiners, of course, the higher price of sugar and
the greater quantity of sugar they can produce and sell makes the import
barriers something they value greatly. It is clearly in their interest to
hire lobbyists and write letters to elected officials supporting these
programs. When these officials hear from the people who benefit from the
policies, but not from those who bear the costs, they may well decide to
vote for the import restrictions. This can happen despite the fact that
many studies indicate the total costs to consumers and the U.S. economy
for these programs are much higher than the benefits received by sugar
producers.

Special interest groups and issues are facts of life in the political
arena. One striking way to see that is to drive around the U.S. national
capital, Washington D.C., or a state capital and notice the number of
lobbying groups that have large offices near the capitol building. Or
simply look at the list of trade and professional associations in the
yellow pages for those cities. These lobbying groups are important and
useful to the political process in many ways. They provide information on
issues and legislation affecting their interests. But these special
interest groups also favor legislation that often benefits their members
at the expense of the overall public welfare.

E The Scope of Government in the U.S. Economy

The size of the government sector in the U.S. economy increased
dramatically during the 20th century. Federal revenues totaled less than
5 percent of total GDP in the early 1930s. In 1995 they made up 22
percent. State, county, and local government revenues represent an
additional 15 percent of GDP.

Although overall government revenues and spending are somewhat lower in
the United States than they are in many other industrialized market
economies, it is still important to consider why the size of government
has increased so rapidly during the 20th century. The general answer is
that the citizens of the United States have elected representatives who
have voted to increase government spending on a variety of programs and
to approve the taxes required to pay for these programs.

Actually, government spending has increased since the 1930s for a number
of specific reasons. First, the different branches of government began to
provide services that improved the economic security of individuals and
families. These services include Social Security and Medicare for the
elderly, as well as health care, food stamps, and subsidized housing
programs for low-income families. In addition, new technology increased
the cost of some government services; for example, sophisticated new
weapons boosted the cost of national defense. As the economy grew, so did
demand for the government to provide more and better transportation
services, such as super highways and modern airports. As the population
increased and became more prosperous, demand grew for government-financed
universities, museums, parks, and arts programs. In other words, as
incomes rose in the United States, people became more willing to be taxed
to support more of the kinds of programs that government agencies
provide.

Social changes have also contributed to the growing role of government.
As the structure of U.S. families changed, the government has
increasingly taken over services that were once provided mainly by
families. For instance, in past times, families provided housing and
health care for their elderly. Today, extended families with several
generations living together are rare, partly because workers move more
often than they did in the past to take new jobs. Also the elderly live
longer today than they once did, and often require much more
sophisticated and expensive forms of medical care. Furthermore, once the
government began to provide more services, people began to look to the
government for more support, forming special interest groups to push
their demands.

Some people and groups in the United States favor further expansion of
government programs, while others favor sharp reductions in the current
size and scope of government. Reliance on a market system implies a
limited role for government and identifies fairly specific kinds of
things for the government to do in the economy. Private households and
businesses are expected to make most economic decisions. It is also true
that if taxes and other government revenues take too large a share of
personal income, incentives to work, save, and invest are diminished,
which hurts the overall performance of the economy. But these general
principles do not establish precise guidelines on how large or small a
role the government should play in a market economy. Judging the
effectiveness of any current or proposed government program requires a
careful analysis of the additional benefits and costs of the program. And
ultimately, of course, the size of government is something that U.S.
citizens decide through democratic elections.

IX IMPACT OF THE WORLD ECONOMY Today, virtually every country
in the world is affected by what happens in other countries. Some of
these effects are a result of political events, such as the overthrow of
one government in favor of another. But a great deal of the
interdependence among the nations is economic in nature, based on the
production and trading of goods and services.

One of the most rapidly growing and changing sectors of the U.S. economy
involves trade with other nations. In recent decades, the level of goods
and services imported from other countries by U.S. consumers, businesses,
and government agencies has increased dramatically. But so, too, has the
level of U.S. goods and services sold as exports to consumers,
businesses, and government agencies in other nations. This international
trade and the policies that encourage or restrict the growth of imports
and exports have wide-ranging effects on the U.S. economy.

As the nation with the world’s largest economy, the United States plays a
key role on the international political and economic stages. The United
States is also the largest trading nation in the world, exporting and
importing more goods and services than any other country.. Some people
worry that extensive levels of international trade may have hurt the U.S.
economy, and U.S. workers in particular. But while some firms and workers
have been hurt by international competition, in general economists view
international trade like any other kind of voluntary trade: Both parties
can gain, and usually do. International trade increases the total level
of production and consumption in the world, lowers the costs of
production and prices that consumers pay, and increases standards of
living. How does that happen?

All over the world, people specialize in producing particular goods and
services, then trade with others to get all of the other goods and
services they can afford to buy and consume. It is far more efficient for
some people to be lawyers and other people doctors, butchers, bakers, and
teachers than it is for each person to try to make or do all of the
things he or she consumes.

In earlier centuries, the majority of trade took place between
individuals living in the same town or city. Later, as transportation and
communications networks improved, individuals began to trade more
frequently with people in other places. The industrial revolution that
began in the 18th century greatly increased the volume of goods that
could be shipped to other cities and regions, and eventually to other
nations. As people became more prosperous, they also traveled more to
other countries and began to demand the new products they encountered
during their travels.

The basic motivation and benefits of international trade are actually no
different from those that lead to trade within a nation. But
international trade differs from trade within a nation in two major ways.
First, international trade involves at least two national currencies,
which must usually be exchanged before goods and services can be imported
or exported. Second, nations sometimes impose barriers on international
trade that they do not impose on trade that occurs entirely inside their
own country.

A U.S. Imports and Exports

U.S. exports are goods and services made in the United States that are
sold to people or businesses in other countries. Goods and services from
other countries that U.S. citizens or firms purchase are imports for the
United States. Like almost all of the other nations of the world, the
United States has seen a rapid increase in both its imports and exports
over the last several decades. In 1959 the combined value of U.S. imports
and exports amounted to less than 9 percent of the country’s gross
domestic product (GDP); by 1997 that figure had risen to 25 percent.
Clearly, the international trade sector has grown much more rapidly than
the overall economy.

Most of this trade occurs between industrialized, developed nations and
involves similar kinds of products as both imports and exports. While it
is true that the U.S. imports some things that are only found or grown in
other parts of the world, most trade involves products that could be made
in the United States or any other industrialized market economies. In
fact, some products that are now imported, such as clothing and textiles,
were once manufactured extensively in the United States. However,
economists note that just because things were or could be made in a
country does not mean that they should be made there.

Just as individuals can increase their standard of living by specializing
in the production of the things they do best, nations also specialize in
the products they can make most efficiently. The kinds of goods and
services that the United States can produce most competitively for export
are determined by its resources. The United States has a great deal of
fertile land, is the most technologically advanced nation in the world,
and has a highly educated and skilled labor force. That explains why U.S.
companies produce and export many agricultural products as well as
sophisticated machines, such as commercial jets and medical diagnostic
equipment.

Many other nations have lower labor costs than the United States, which
allows them to export goods that require a lot of labor, such as shoes,
clothing, and textiles. But even in trading with other industrialized
countries—whose workers are similarly well educated, trained, and highly
paid—the United States finds it advantageous to export some high-tech
products or professional services and to import others. For example, the
United States both imports and exports commercial airplanes, automobiles,
and various kinds of computer products. These trading patterns arise
because within these categories of goods, production is further
specialized into particular kinds of airplanes, automobiles, and computer
products. For example, automobile manufacturers in one nation may focus
production primarily on trucks and utility vehicles, while the automobile
industries in other countries may focus on sport cars or compact
vehicles.

Greater specialization allows producers to take full advantage of
economies of scale. Manufacturers can build large factories geared toward
production of specialized inventories, rather than spending extra
resources on factory equipment needed to produce a wide variety of goods.
Also, by selling more of their products to a greater number of consumers
in global markets, manufacturers can produce enough to make
specialization profitable.

The United States enjoyed a special advantage in the availability of
factories, machinery, and other capital goods after World War II ended in
1945. During the following decade or two, many of the other industrial
nations were recovering from the devastation of the war. But that
situation has largely disappeared, and the quality of the U.S. labor
force and the level of technological innovation in U.S. industry have
become more important in determining trade patterns and other
characteristics of the U.S. economy. A skilled labor force and the
ability of businesses to develop or adapt new technologies are the key to
high standards of living in modern global economies, particularly in
highly industrialized nations. Workers with low levels of education and
training will find it increasingly difficult to earn high wages and
salaries in any part of the world, including the United States.

B Barriers to Trade Despite the mutual advantages of global
trade, governments often adopt policies that reduce or eliminate
international trade in some markets. Historically, the most important
trade barriers have been tariffs (taxes on imports) and quotas (limits on
the number of products that can be imported into a country). In recent
decades, however, many countries have used product safety standards or
legal standards controlling the production or distribution of goods and
services to make it difficult for foreign businesses to sell in their
markets. For example, Russia recently used health standards to limit
imports of frozen chicken from the United States, and the United States
has frequently charged Japan with using legal restrictions and allowing
exclusive trade agreements among Japanese companies. These exclusive
agreements make it very difficult for U.S. banks and other firms to
operate or sell products in Japan.

While there are special reasons for limiting imports or exports of
certain kinds of products—such as products that are vital to a nation’s
national defense—economists generally view trade barriers as hurting both
importing and exporting nations. Although the trade barriers protect
workers and firms in industries competing with foreign firms, the costs
of this protection to consumers and other businesses are typically much
higher than the benefits to the protected workers and firms. And in the
long run it usually becomes prohibitively expensive to continue this kind
of protection. Instead it often makes more sense to end the trade barrier
and help workers in industries that are hurt by the increased imports to
relocate or retrain for jobs with firms that are competitive. In the
United States, trade adjustment assistance payments were provided to
steelworkers and autoworkers in the late 1970s, instead of imposing trade
barriers on imported cars. Since then, these direct cash payments have
been largely phased out in favor of retraining programs.

During recessions, when national unemployment rates are high or rising,
workers and firms facing competition from foreign companies usually want
the government to adopt trade barriers to protect their industries. But
again, historical experience with such policies shows that they do not
work. Perhaps the most famous example of these policies occurred during
the Great Depression of the 1930s. The United States raised its tariffs
and other trade barriers in legislation such as the Smoot-Hawley Act of
1930. Other nations imposed similar kinds of trade barriers, and the
overall result was to make the Great Depression even worse by reducing
world trade.

C World Trade Organization (WTO) and Its Predecessors

As World War II drew to a close, leaders in the United States and other
Western nations began working to promote freer trade for the post-war
world. They set up the International Monetary Fund (IMF) in 1944 to
stabilize exchange rates across member nations. The Marshall Plan,
developed by U.S. general and economist George Marshall, promoted free
trade. It gave U.S. aid to European nations rebuilding after the war,
provided those nations reduced tariffs and other trade barriers.

In 1947 the United States and many of its allies signed the General
Agreement on Tariffs and Trade (GATT), which was especially successful in
reducing tariffs over the next five decades. In 1995 the member nations
of the GATT founded the World Trade Organization (WTO), which set even
greater obligations on member countries to follow the rules established
under GATT. It also established procedures and organizations to deal with
disputes among member nations about the trading policies adopted by
individual nations.

In 1992 the United States also signed the North American Free Trade
Agreement (NAFTA) with its closest neighbors and major trading partners,
Canada and Mexico. The provisions of this agreement took effect in 1994.
Since then, studies by economists have found that NAFTA has benefited all
three nations, although greater competition has resulted in some
factories closing. As a percentage of national income, the benefits from
NAFTA have been greater in Canada and Mexico than in the United States,
because international trade represents a larger part of those economies.
While the United States is the largest trading nation in the world, it
has a very large and prosperous domestic economy; therefore international
trade is a much smaller percentage of the U.S. economy than it is in many
countries with much smaller domestic economies.

D Exchange Rates and the Balance of Payments

Currencies from different nations are traded in the foreign exchange
market, where the price of the U.S. dollar, for instance, rises and falls
against other currencies with changes in supply and demand. When firms in
the United States want to buy goods and services made in France, or when
U.S. tourists visit France, they have to trade dollars for French francs.
That creates a demand for French francs and a supply of dollars in the
foreign exchange market. When people or firms in France want to buy goods
and services made in the United States they supply French francs to the
foreign exchange market and create a demand for U.S. dollars.

Changes in people’s preferences for goods and services from other
countries result in changes in the supply and demand for different
national currencies. Other factors also affect the supply and demand for
a national currency. These include the prices of goods and services in a
country, the country’s national inflation rate, its interest rates, and
its investment opportunities. If people in other countries want to make
investments in the United States, they will demand more dollars. When the
demand for dollars increases faster than the supply of dollars on the
exchange markets, the price of the dollar will rise against other
national currencies. The dollar will fall, or depreciate, against other
currencies when the supply of dollars on the exchange market increases
faster than the demand.

All international transactions made by U.S. citizens, firms, and the
government are recorded in the U.S. annual balance of payments account.
This account has two basic sections. The first is the current account,
which records transactions involving the purchase (imports) and sale
(exports) of goods and services, interest payments paid to and received
from people and firms in other nations, and net transfers (gifts and aid)
paid to other nations. The second section is the capital account, which
records investments in the United States made by people and firms from
other countries, and investments that U.S. citizens and firms make in
other nations.

These two accounts must balance. When the United States runs a deficit on
its current account, often because it imports more that it exports, that
deficit must be offset by a surplus on its capital account. If foreign
investments in the United States do not create a large enough surplus to
cover the deficit on the current account, the U.S. government must
transfer currency and other financial reserves to the governments of the
countries that have the current account surplus. In recent decades, the
United States has usually had annual deficits in its current account,
with most of that deficit offset by a surplus of foreign investments in
the U.S. economy.

Economists offer divergent views on the persistent surpluses in the U.S.
capital account. Some analysts view these surpluses as evidence that the
United States must borrow from foreigners to pay for importing more than
it exports. Other analysts attribute the surpluses to a strong desire by
foreigners to invest their funds in the U.S. economy. Both
interpretations have some validity. But either way, it is clear that
foreign investors have a claim on future production and income generated
in the U.S. economy. Whether that situation is good or bad depends how
the foreign funds are used. If they are used mainly to finance current
consumption, they will prove detrimental to the long-term health of the
U.S. economy. On the other hand, their effect will be positive if they
are used primarily to fund investments that increase future levels of
U.S. output and income.

X CURRENT TRENDS AND ISSUES

In the early decades of the 21st century, many different social, economic
and technological changes in the United States and around the world will
affect the U.S. economy. The population of the United States will become
older and more racially and ethnically diverse. The world population is
expected to continue to grow at a rapid rate, while the U.S. population
will likely grow much more slowly. World trade will almost certainly
continue to expand rapidly if current trade policies and rates of
economic growth are maintained, which in turn will make competition in
the production of many goods and services increasingly global in scope.
Technological progress is likely to continue at least at current rates,
and perhaps faster. How will all of this affect U.S. consumers,
businesses, and government?

Over the next century, average standards of living in the United States
will almost certainly rise, so that on average, people living at the end
of the century are likely to be better off in material terms than people
are today. During the past century, the primary reasons for the increase
in living standards in the United States were technological progress,
business investments in capital goods, and people’s investments in
greater education and training (which were often subsidized by government
programs). There is no evident reason why these same factors will not
continue to be the most important reasons underlying changes in the
standard of living in the United States and other industrialized
economies. A comparatively small number of economists and scientists from
other fields argue that limited supplies of energy or of other natural
resources will eventually slow or stop economic growth. Most, however,
expect those limits to be offset by discoveries of new deposits or new
types of resources, by other technological breakthroughs, and by greater
substitution of other products for the increasingly scarce resources.

Although the U.S. economy will likely remain the world’s largest national
economy for many decades, it is far less certain that U.S. households
will continue to enjoy the highest average standard of living among
industrialized nations. A number of other nations have rapidly caught up
to U.S. levels of income and per capita output over the last five decades
of the 20th century. They did this partly by adopting technologies and
business practices that were first developed in the United States, or by
developing their own technological and managerial innovations. But in
large part, these nations have caught up with the United States because
of their higher rates of savings and investment, and in some cases,
because of their stronger systems for elementary and secondary education
and for training of workers.

Most U.S. workers and families will still be better off as the U.S.
economy grows, even if some other economies are growing faster and
becoming somewhat more prosperous, as measured per capita. Certainly
families in Britain today are far better off materially than they were
150 to 200 years ago, when Britain was the largest and wealthiest economy
in the world, despite the fact that many other nations have since
surpassed the British economy in size and affluence.

A more important problem for the U.S. economy in the next few decades is
the unequal distribution of gains from growth in the economy. In recent
decades, the wealth created by economic growth has not been as evenly
distributed as was the wealth created in earlier periods. Incomes for
highly educated and trained workers have risen faster than average, while
incomes for workers with low levels of education and training have not
increased and have even fallen for some groups of workers, after
adjusting for inflation. Other industrialized market economies have also
experienced rising disparity between high-income and low-income families,
but wages of low-income workers have not actually fallen in real terms in
those countries as they have in the United States.

In most industrialized nations, the demand for highly educated and
trained workers has risen sharply in recent decades. That happened in
part because many kinds of jobs now require higher skill levels, but
other factors were also important. New production methods require workers
to frequently and rapidly change what they do on the job. They also
increase the need for quality products and customer service and the
ability of employees to work in teams. Increased levels of competition,
including competition from foreign producers, have put a higher premium
on producing high quality products.

Several other factors help explain why the relative position of low-
income workers has fallen more in the United States than in other
industrialized Western nations. The growth of college graduates has
slowed in the United States but not in other nations. United States
immigration policies have not been as closely tied to job-market
requirements as immigration policies in many other nations have been.
Also, government assistance programs for low-income families are usually
not as generous in the United States as they are in other industrialized
nations.

Changes in the make-up of the U.S. population are likely to cause income
disparity to grow, at least through the first half of the 21st century.
The U.S. population is growing most rapidly among the groups that are
most likely to have low incomes and experience some form of
discrimination. Children in these groups are less likely to attend
college or to receive other educational opportunities that might help
them acquire higher-paying jobs.

The U.S. population will also be aging during this period. As people born
during the baby boom of 1946 to 1964 reach retirement age, the percentage
of the population that is retired will increase sharply, while the
percentage that is working will fall. The demand for medical care and
long-term care facilities will increase, and the number of people drawing
Social Security benefits will rise sharply. That will increase pressure
on government budgets. Eventually, taxes to pay for these services will
have to be increased, or the level of these services provided by the
government will have to be cut back. Neither of those approaches will be
politically popular.

A few economists have called for radical changes in the Social Security
system to deal with these problems. One suggestion has been to allow
workers to save and invest in private retirement accounts rather than pay
into Social Security. Thus far, those approaches have not been considered
politically feasible or equitable. Current retirees strongly oppose
changing the system, as do people who fear that they will lose future
benefits from a program they have paid taxes to support all their working
lives. Others worry that private accounts will not provide adequate
retirement income for low-income workers, or that the government will
still be called on to support those who make bad investment choices in
their private retirement accounts.

Political and economic events that occur in other parts of the world are
felt sooner and more strongly in the United States than ever before, as a
result of rising levels of international trade and the unique U.S.
position as an economic, military, and political superpower. The 1991
breakup of the Union of Soviet Socialist Republics (USSR)—perhaps the
most dramatic international event to unfold since World War II—has
presented new opportunities for economic trade and cooperation. But it
also has posed new challenges in dealing with the turbulent political and
economic situations that exist in many of the independent nations that
emerged from the breakup . Some fledgling democracies in Africa are
similarly volatile.

Many U.S. firms are eager to sell their products to consumers and firms
in these nations, and U.S. banks and other financial institutions are
eager to lend funds to support investments in these countries, if they
can be reasonably sure that these loans will be repaid. But there are
economic risks to doing business in these countries, including inflation,
low income levels, high crime rates, and frequent government and company
defaults on loans. Also, political upheavals sometimes bring to power
leaders who oppose market reforms.

The greater political and economic unification of nations in the European
Union (EU) offers different kinds of issues. There is much less risk of
inflation, crime, and political upheaval to contend with in this area. On
the other hand, there is more competition to face from well-established
and technologically sophisticated firms, and more concern that the EU
will put trade barriers on products produced in the United States and in
other countries that are not members of the Union. Clearly, the United
States will be concerned with maintaining its trading position with those
nations. It will also look to the EU to act as an ally in settling
international policies in political and economic arenas, such as a peace
initiative in the Middle East and treaties on international trade and
environmental issues.

The United States has other major economic and political interests in the
Middle East, Asia, and around the world. China is likely to become an
even larger trading partner and an increasingly important political power
in the world. Other Asian nations, including Japan, Korea, Indonesia, and
the Philippines, are also important trading partners, and in some cases
strong political and national security allies, too. The same can be said
for Australia and for Canada, which has long been the largest single
trading partner for the United States. Mexico and the other nations of
Central and South America are, similarly, natural trading partners for
the United States, and likely to play an even larger role over the next
century in both economic and political affairs.

It may once have been possible for the United States to practice an
isolationist policy by developing an economy largely cut off from foreign
trade and international relations, but that possibility is no longer
feasible, nor is it advisable. Economic and technological developments
have made the world’s nations increasingly interdependent.

Greater world trade and cooperation offer an enormous range of mutually
beneficial activities. Trading with other countries inevitably increases
opportunities for travel and cultural exchange, as well as business
opportunities. In a very broad sense, nations that buy and sell goods and
services with each other also have a greater stake in other forms of
peaceful cooperation, and in seeing other countries prosper and grow.

On the other hand, global interdependence also raises major
problems—political, economic, and environmental—that require
international solutions. Many of these problems, such as pollution,
global warming, and assistance for developing nations, have been
controversial even when solutions were discussed only at the national
level. Often, controversy increases with the number of nations that must
agree on a solution, but some problems require global remedies. Such
problems will challenge the productive capacity of the U.S. economy and
the wisdom of U.S. citizens and their political leaders.

No nation has ever had the rich supply of resources to face the future
that the U.S. economy has as it enters the 21st century. Despite that, or
perhaps because of it, U.S. consumers, businesses, and political leaders
are still trying to do more than earlier generations of citizens.

XI CHIEF GOODS AND SERVICES OF THE U.S. ECONOMY

The U.S. economy, the largest in the world, produces many different goods
and services. This can be seen more easily by dividing economic
activities into four sectors that produce different kinds of goods and
services. The first sector provides goods that come directly from natural
resources: agriculture, forestry, fishing, and mining. The second sector
includes manufacturing and the generation of electricity. The third
sector, made up of commerce and services, is now the largest part of the
U.S. economy. It encompasses financial services, retail and wholesale
sales, government services, transportation, entertainment, tourism, and
other businesses that provide a wide variety of services to individuals
and businesses. The fourth major economic sector deals with the
recording, processing, and transmission of information, and includes the
communications industry.

A Natural Resource Sector

The United States, more than most countries, enjoys a wide array of
natural resources. Agricultural output in the United States has
historically been among the highest in the world. Rich fishing grounds
and coastal habitats provide abundant seafood. Companies harvest the
nation’s large reserves of timber to use in wood products and housing.
Major mineral resources—including iron ore, lead, and copper, as well as
energy resources such as coal, crude oil, and natural gas—are abundant in
the United States.

A1 Agriculture

The United States contains some of the best cropland in the world.
Cultivated farmland constitutes 19 percent of the land area of the
country and makes the United States the world’s richest agricultural
nation. In part because of the nation’s favorable climate, soil, and
water conditions, farmers produce huge quantities of agricultural
commodities and a variety of crops and livestock.

The United States is the largest producer of corn, soybeans, and sorghum,
and it ranks second in the production of wheat, oats, citrus fruits, and
tobacco. The United States is also a major producer of sugar cane,
potatoes, peanuts, and beet sugar. It ranks fourth in the world in cattle
production and second in hogs. The total annual value of farm output
increased from $55 billion in 1970 to $202 billion in 1996. Farmers in
the United States not only produce enough food to feed the nation’s
population, they also export more farm products than any other nation.
Despite this vast output, the U.S. economy is so large and diversified
that agriculture accounted for only 2 percent of annual GDP and employed
only 3 percent of the workforce in 1998.

During the 20th century, many Americans moved from rural to urban areas
of the United States, resulting in large population decreases in farming
regions. Even though the number of farms has been declining since the
1930s, overall production has increased because of more efficient
operations. Bigger farms, operated as large businesses, have increasingly
replaced small family farms. The owners of larger farms make greater use
of modern machinery and other equipment. By the 1990s, farm operations
were highly mechanized. By applying mechanization, technology, efficient
business practices, and scientific advances in agricultural methods,
larger farms produce great quantities of agricultural output using small
amounts of labor and land.

In 1999 there were 2,194,070 farms in the United States, down from a high
of 6.8 million in 1935. As smaller farms have been consolidated into
larger units, the average farm size in the United States increased from
about 63 hectares (about 155 acres) to 175 hectares (432 acres) by 1999.

Cattle production is widespread throughout the United States. Texas leads
in the production of range cattle, which are allowed to graze freely.
Iowa and Illinois are important for nonrange feeder cattle, which are
cattle that eat feed grain provided by cattle farmers. The Dairy Belt
continues to be concentrated in southern Wisconsin but is also prominent
in the rural landscapes of most northeastern states and fairly common in
other states, too. Hog production tends to be concentrated in Iowa,
Illinois, and surrounding states, where hogs are fattened for market.
Chicken production is widespread, but southern states, including Texas,
Arkansas, and Alabama, dominate.

Corn and soybean production is concentrated heavily in Iowa and Illinois
and is also important in surrounding states, including Missouri, Indiana,
Nebraska, and the southern regions of Minnesota and Wisconsin. Wheat is
another important U.S. crop. Kansas usually leads all states in yearly
wheat production. North Dakota, Montana, Oklahoma, Washington, Idaho,
South Dakota, Colorado, Texas, Minnesota, and Nebraska also are major
wheat producers.

For more than a century and a half, cotton was the predominant cash crop
in the South. Today, however, it is no longer important in some of the
traditional cotton-growing areas east of the Mississippi River. While
some cotton is still produced in the Old South, it has become more
important in the Mississippi Valley, the Panhandle of Texas, and the
Central Valley of California. Cotton is shipped to mills in the eastern
United States and is exported to cotton textile plants in Japan, South
Korea, Indonesia, and Taiwan.

Vegetables are grown widely in the United States. Outside major U.S.
cities, small farms and gardens, known as truck farms, grow vegetables
and some varieties of fruits for urban markets. California is the leading
vegetable producing state; much of its cropland is irrigated.

Most fruits grown in the United States fall in the categories of
midlatitude and citrus fruits. Midlatitude fruits, such as apples, pears,
and plums, grow in northern states including Washington, Michigan,
Pennsylvania, and New York. Citrus fruits—lemons, oranges, and
grapefruits—thrive in Florida, southern Texas, and southern California.
Nuts grow on irrigated land in the Central Valley of California and in
parts of southern California.

Production of specialty crops and livestock has increased in recent
years, particularly along the East and West coasts and in the Southeast.
Ranches in New York and Texas have introduced exotic game, such as emu,
fallow deer, and nilgai and black buck antelope. Deer and antelope meat,
known as venison, is served mainly in restaurants. Specialty vegetable
and fruit operations produce dwarf apples, brown and green cotton,
canola, and jasmine rice. Farmers raise more than 60 specialty crops in
the United States for Asian-American markets, including bean sprouts,
snow peas, and Chinese cabbage.

A2 Forestry

In the 1990s, less than 1 percent of the country’s workforce was involved
in the lumber industry, and forestry accounted for less than 0.5 percent
of the nation’s gross domestic product (GDP). Nevertheless, forests
represent a crucial resource for U.S. industry. Forest resources are used
in producing housing, fuel, foodstuffs, and manufactured goods. The
United States leads the world in lumber production and is second in the
production of wood for pulp and paper manufacture. These high production
levels, however, do not satisfy all of the U.S. demand for forest
products. The United States is the world’s largest importer of lumber,
most of which comes from Canada.

When European settlers first arrived in North America, half of the land
on the continent was covered with forests. The forests of the eastern and
northern portions of the country were fairly continuous. Beginning with
the early colonists, the natural vegetation was altered drastically as
farmers cleared land for crops and pastures, and cut trees for firewood
and lumber. In the north and east, lumbermen quickly cut all of the
valuable trees before moving on to other locations. Only 10 percent of
the original virgin timber remains. Almost two thirds of the forests that
remain have been classified as commercial resources.

Forests still cover 23 percent of the United States. The trees in the
nation’s forests contain an estimated 7.1 billion cu m (249.3 billion cu
ft) of wood suitable for lumber. Private individuals and businesses,
including farmers, lumber companies, paper mills, and other wood-using
industries, own about 73 percent of the commercial forestland. Federal,
state, and local governments own the remaining 27 percent.

Softwoods (wood harvested from cone-bearing trees) make up about three-
fourths of forestry production and hardwoods (wood harvested from broad-
leafed trees) about one-fourth. Nearly half the timber output is used for
making lumber boards, and about one-third is converted to pulpwood, which
is subsequently used to manufacture paper. Most of the remaining output
goes into plywood and veneer. Douglas fir and southern yellow pine are
the primary softwoods used in making lumber, and oak is the most
important hardwood.

About half of the nation’s lumber and all of its fir plywood come from
the forests of the Pacific states, an area dominated by softwoods. In
addition to the Douglas fir forests in Washington and Oregon, this area
includes the famous California redwoods and the Sitka spruce along the
coast of Alaska. Forests in the mountain states of the West cover a
relatively small area, yet they account for more than 10 percent of the
nation’s lumber production. Ponderosa pine is the most important species
cut from the forests of this area.

Forests in the South supply about one-third of the lumber, nearly three-
fifths of the pulpwood, and almost all the turpentine, pitch, resin, and
wood tar produced in the United States. Longleaf, shortleaf, loblolly,
and slash pine are the most important commercial trees of the southern
coastal plain. Commercially valuable hardwood trees, such as gum, ash,
pecan, and oak, grow in the lowlands along the rivers of the South.

The Appalachian Highland and parts of the Great Lakes area have excellent
hardwood forests. Hickory, maple, oak, and other hardwoods removed from
these forests provide fine woods for the manufacture of furniture and
other products.

In the 1990s the forest products industry was undergoing a
transformation. New environmental requirements, designed to protect
wildlife habitat and water resources, were changing forest practices,
particularly in the West. The amount of timber cut on federal land
declined by 50 percent from 1989 to 1993.

A3 Fishing

The U.S. waters off the coast of North America provide a rich marine
harvest, which is about evenly split in commercial value between fish and
shellfish. Humans consume approximately 80 percent of the catch as food.
The remaining 20 percent goes into the manufacturing of products such as
fish oil, fertilizers, and animal food.

In 1997 the United States had a commercial fish catch of 5.4 million
metric tons. The value of the catch was an estimated $3.1 billion in
1998. In most years, the United States ranks fifth among the nations of
the world in weight of total catch, behind China, Peru, Chile, and Japan.

Marine species dominate U.S. commercial catches, with freshwater fish
representing only a small portion of the total catch. Shellfish account
for only one-sixth of the weight of the total catch but nearly one-half
of the value; finfish represent the remaining share of weight and value.
Alaskan pollock and menhaden, a species used in the manufacture of oil
and fertilizer, are the largest catches by tonnage. The most valuable
seafood harvests are crabs, salmon, and shrimp, each representing about
one-sixth of the total value. Other important species include lobsters,
clams, flounders, scallops, Pacific cod, and oysters.

Alaska leads all states in both volume and value of the catch; important
species caught off Alaska’s coast include pollock and salmon. Other
leading fishing states, ranked by value, are Louisiana, Massachusetts,
Texas, Maine, California, Florida, Washington, and Virginia. Important
species caught in the New England region include lobsters, scallops,
clams, oysters, and cod; in the Chesapeake Bay, crabs; and in the Gulf of
Mexico, menhaden and shrimp.

Much of the annual U.S. tonnage of commercial freshwater fish comes from
aquatic farms. The most important species raised on farms are catfish,
trout, salmon, oysters, and crawfish. The total annual output of private
catfish and trout farms in the mid-1990s was 235,800 metric tons, valued
at more than $380 million. In the 1970s catfish farming became important
in states along the lower Mississippi River. Mississippi leads all states
in the production of catfish on farms.

A4 Mining

As a country of continental proportions, the United States has within its
borders substantial mineral deposits. America leads the world in the
production of phosphate, an important ingredient in fertilizers, and
ranks second in gold, silver, copper, lead, natural gas, and coal.
Petroleum production is third in the world, after Russia and Saudi
Arabia.

Mining contributes 1.5 percent of annual GDP and employs 0.5 percent of
all U.S. workers. Although mining accounts for only a small share of the
nation’s economic output, it was historically essential to U.S.
industrial development and remains important today. Coal and iron ore are
the basis for the steel industry, which fabricates components for
manufactured items such as automobiles, appliances, machinery, and other
basic products. Petroleum is refined into gasoline, heating oil, and the
petrochemicals used to make plastics, paint, pharmaceuticals, and
synthetic fibers.

The nation’s three chief mineral products are fuels. In order of value,
they are natural gas, petroleum, and coal. In 1996 the United States
produced 23 percent of the world’s natural gas, 21 percent of its coal,
and 13 percent of its crude oil. From 1990 to 1995, as the inflation-
adjusted prices for these products declined, the extraction of these
fossil fuels declined, increasing U.S. dependence on foreign sources of
oil and natural gas.

The United States contains huge fields of natural gas and oil. These
fields are scattered across the country, with concentrations in the
midcontinent fields of Texas and Oklahoma, the Gulf Coast region of Texas
and Louisiana, and the North Slope of Alaska. Texas and Louisiana account
for almost 60 percent of the country’s natural gas production. Today, oil
and natural gas are pumped to the surface, then sent by pipeline to
refineries located in all parts of the nation. Offshore deposits account
for 13 percent of total production. Coal production, important for
industry and for the generation of electric power, comes primarily from
Wyoming (29 percent of U.S. production in 1997), West Virginia (18
percent), and Kentucky (16 percent).

Important metals mined in the United States include gold, copper, iron
ore, zinc, magnesium, lead, and silver. Iron ore is found mainly in
Minnesota, and to a lesser degree in northern Michigan. The ore consists
of low-grade taconite; U.S. deposits of high-grade ores, such as
hematite, magnetite, and limonite, have been consumed. Leading industrial
minerals include materials used in construction—mainly clays, lime, salt,
phosphate rock, boron, and potassium salts. The United States also
produces large percentages of the world’s output for a number of
important minerals. In 1997 the United States produced 42 percent of the
world’s molybdenum, 34 percent of its phosphate rock, 22 percent of its
elemental sulfur, 17 percent of its copper, and 16 percent of its lead.
Major deposits of many of these minerals are found in the western states.

B Manufacturing and Energy Sector B1 Manufacturing

The United States leads all nations in the value of its yearly
manufacturing output. Manufacturing employs about one-sixth of the
nation’s workers and accounts for 17 percent of annual GDP. In 1996 the
total value added by manufacturing was $1.8 trillion. Value added is the
price of finished goods minus the cost of the materials used to make
them. Although manufacturing remains a key component of the U.S. economy,
it has declined in relative importance since the late 1960s. From 1970 to
1995 the number of employees in manufacturing declined slightly from 20.7
million to 20.5 million, while the total U.S. labor force grew by more
than 46.2 million people.

One of the most important changes in the pattern of U.S. industry in
recent decades has been the growth of manufacturing in regions outside
the Northeast and North Central regions. The nation’s industrial core
first developed in the Northeast. This area still has the greatest number
of industrial firms, but its share of these firms is smaller than in the
past. In 1947 about 75 percent of the nation’s manufacturing employees
lived in the 21 Northeast and Midwest states that extend from New England
to Kansas. By the early 1990s, however, only about one-half of
manufacturing employees resided in the same region. Since 1947, the
South’s share of the nation’s manufacturing workers increased from 19 to
32 percent, and the West’s share grew from 7 to 18 percent.

In the North, manufacturing is centered in the Middle Atlantic and East
North Central states, which accounted for 38 percent of the value added
by all manufacturing in the United States in 1996. Located in this area
are five of the top seven manufacturing statesa—New York, Ohio, Illinois,
Pennsylvania, and Michigan—which together were responsible for
approximately 27 percent of the value added by manufacturing in all
states. Important products in this region include motor vehicles,
fabricated metal products, and industrial equipment. New York, New
Jersey, and Pennsylvania specialize in the production of machinery and
chemicals. This area bore the brunt of the decline in manufacturing’s
value of national output, losing a total of 800,000 jobs from the early
1980s to the early 1990s.

In the South the greatest gains in manufacturing have been in Texas. The
most phenomenal growth in the West has been in California, which in the
late 1990s was the leading manufacturing state, accounting for more than
one-tenth of the annual value added by U.S. manufacturing. California
dominates the Pacific region, which specializes in the production of
transportation equipment, food products, and electrical and electronic
equipment.

B1a International Manufacturing

United States industry has become much more international in recent
years. Most major industries are multinational, which means that they not
only market products in foreign countries but maintain production
facilities and administrative headquarters in other nations. In the late
1990s, giant U.S. corporations began a wave of international
partnerships, with U.S. companies sometimes merging with foreign
companies.

Beginning in the early 1980s, U.S. companies increasingly produced
component parts and even finished goods in foreign countries. The
practice of a company sending work to outside factories to reduce
production costs is called outsourcing. Foreign outsourcing sends
production to countries where labor costs are lower than in the United
States. One of the first methods of foreign outsourcing was the
maquiladora (Spanish for “mill”) in Mexican border towns. Manufacturers
built twin plants, one on the Mexican side and one on the United States
side. Companies in the United States sent partially manufactured products
into Mexico where labor-intensive plants finished the product and sent it
back to the United States for sale. Outsourcing to Mexico became more
widespread after the North American Free Trade Agreement went into effect
in 1994. Firms in the United States also outsource to many other nations,
including South Korea, Indonesia, Malaysia, Jamaica, and the Philippines.

In the 1990s, few products were made entirely within the United States.
Although a product may be fabricated in the United States, some component
parts may have been produced in foreign countries. Despite outsourcing
and the international operations of multinational firms, the United
States is still a major producer of thousands of industrial items and has
a comparative advantage over most foreign countries in several industrial
categories.

B1b Principal Products

Ranked by value added by manufacturing, in 1996 the leading categories of
U.S. manufactured goods were chemicals, industrial machinery, electronic
equipment, processed foods, and transportation equipment. The chemical
industry accounted for about 11.1 percent of the overall annual value
added by manufacturing. Texas and Louisiana are leaders in chemical
manufacturing. The petroleum and natural gas produced and refined in both
states are basic raw materials used in manufacturing many chemical
products.

Industrial machinery accounted for 10.7 percent of the yearly value added
by manufacture. Industrial machinery includes engines, farm equipment,
various kinds of construction machinery, computers, and refrigeration
equipment. California led all states in the annual value added by
industrial machinery, followed by Illinois, Ohio, and Michigan.

Factories in the United States build millions of computers, and the
United States occupies second place in the world in the production of
electronic components (semiconductors, microprocessors, and computer
equipment). Electronic equipment accounted for 10.5 percent of the yearly
value added by manufacturing, and it was one of the fastest growing
manufacturing sectors during the 1990s; production of electronics and
electric equipment increased by 77 percent from 1987 to 1994. High-
technology research and production facilities have developed in the
Silicon Valley of California, south of San Francisco; the area
surrounding Boston; the Research Triangle of Raleigh, Chapel Hill, and
Durham in North Carolina; and the area around Austin, Texas. In addition,
the United States has world leadership in the development and production
of computer software. Leading software producers are located in areas
around Seattle, Washington; Boston, Massachusetts; and San Francisco,
California.

Food processing accounted for about 10.2 percent of the overall annual
value added by manufacturing. Food processing is an important industry in
several states noted for the production of food crops and livestock, or
both. California has a large fruit- and vegetable-processing industry.
Meat-packing is important to agriculture in Illinois and dairy processing
is a large industry in Wisconsin.

Transportation equipment includes passenger cars, trucks, airplanes,
space vehicles, ships and boats, and railroad equipment. This category
accounted for 10.1 percent of the yearly value added by manufacturing.
Michigan, with its huge automobile industry, is a leading producer of
transportation equipment.

The manufacture of fabricated metal and primary metal is concentrated in
the nation’s industrial core region. Iron ore from the Lake Superior
district, plus that imported from Canada and other countries, and
Appalachian coal are the basis for a large iron and steel industry.
Pennsylvania, Ohio, Indiana, Illinois, and Michigan are leading states in
the value of primary metal output. The fabricated metal industry, which
includes the manufacture of cans and other containers, hardware, and
metal forgings and stampings, is important in the same states. The
primary metals industry of these states provides the basic raw materials,
especially steel, that are used in making metal products.

Printing and publishing is a widespread industry, with newspapers
published throughout the country. New York, with its book-publishing
industry, is the leading state, but California, Illinois, and
Pennsylvania also have sizable printing and publishing industries.

The manufacture of paper products is important in several states,
particularly those with large timber resources, especially softwood trees
used to make most paper. The manufacture of paper and paperboard
contributes significantly to the economies of Wisconsin, Alabama,
Georgia, Washington, New York, Maine, and Pennsylvania.

Other major U.S. manufactures include textiles, clothing, precision
instruments, lumber, furniture, tobacco products, leather goods, and
stone, clay, and glass items.

B2 Energy Production

The energy to power the nation's economy—to provide fuels for its
vehicles and furnaces and electricity for its machinery and appliances—is
derived primarily from petroleum, natural gas, and coal. Measured in
terms of heat-producing capacity (British thermal units, or Btu),
petroleum provides 39 percent of the total energy consumed in the United
States. It supplies nearly all of the energy used to power the nation’s
transportation system and heats millions of houses and factories.

Natural gas is the source of 24 percent of the energy consumed. Many
industrial plants use natural gas for heat and power, and several million
households burn it for heating and cooking. Coal provides 22 percent of
the energy consumed. Its major uses are in the generation of electricity,
which uses more than three-fourths of all the coal consumed, and in the
manufacture of steel.

Waterpower generates 4 to 5 percent of the nation’s energy, and nuclear
power supplies about 10 percent. Both are employed mainly to produce
electricity for residential and industrial use. Nuclear energy has been
viewed as an important alternative to expensive petroleum and natural
gas, but its development has proceeded somewhat more slowly than
originally anticipated. People are reluctant to live near nuclear plants
for fear of a radiation-releasing accident. Another obstacle to the
expansion of nuclear power use is that it is very expensive to dispose of
radioactive material used to power the plants. These nuclear fuel
materials remain radioactive for thousands of years and pose health risks
if they are not properly contained.

Some 33 percent of the energy consumed in the United States is used in
the generation of electricity. In 1999 the nation’s generating plants had
a total installed capacity of 728,259 megawatts and produced 3.62
trillion kilowatt-hours of electricity. Coal is the most common fuel used
by electric power plants, and 57 percent of the nation’s yearly
electricity is generated in coal-fired plants. The states producing the
most coal-generated electricity are Ohio, Texas, Indiana, Pennsylvania,
Illinois, West Virginia, Kentucky, and Georgia.

Natural gas accounts for 9 percent of the electricity produced, and
refined petroleum for 2 percent. The states producing the most
electricity from natural gas are Texas and California. Refined petroleum
is especially important in Florida, New York, and Massachusetts. The
leading producers of hydroelectricity are Washington, Oregon, New York,
and California. Illinois, Pennsylvania, South Carolina, and California
have the largest nuclear power industries.

Petroleum is a key resource for an American lifestyle based on extensive
use of private automobiles and trucks for commerce and businesses. Since
1947, when the United States became a net importer of oil, annual
domestic production has not been enough to meet the demands of the highly
mobile American society.

In 1970 domestic crude-oil production reached a record high of 3.5
billion barrels, but this had to be supplemented by imports amounting to
12 percent of the nation’s overall crude oil supply. Most Americans were
unaware of the dependence of the country on foreign petroleum until an
oil embargo imposed by some Middle Eastern nations in 1973 and 1974 led
to government price ceilings for gasoline and other energy products,
which in turn led to shortages. In 1973 the nation imported about one-
fourth of its total supply of crude oil. Imports continued to rise until
1977, when about half of the crude and refined oil supply was imported.
Imports then declined for a time, largely because energy-conservation
measures were introduced and because other domestic energy sources such
as coal were used increasingly. As of 1997, however, 47 percent of the
crude oil needs of the United States were met by net imports. Energy
Supply, World.

The United States consumes 25 percent of the world’s energy, far more
than any other country, despite having less than 5 percent of the world’s
population. The United States also produces a disproportionate share of
the world’s total output of goods and services, which is the main reason
the nation consumes so much energy. In addition, the U.S. population is
spread over a larger area than are the populations in many other
industrialized nations, such as Japan and the countries of Western
Europe. This lower population density in the United States results in a
greater consumption of energy for transportation, as truck, trains, and
planes are needed to move goods and people to the far-flung American
citizenry.

As a result of the nation’s high energy consumption, the United States
accounts for nearly 20 percent of the global emissions of greenhouse
gases. These gases—carbon dioxide, methane, and oxides of nitrogen—result
from the burning of fossil fuels, and they can have a harmful effect on
the environment. C Service and Commerce Sector

By far the largest sector of the economy in terms of output and
employment is the service and commerce sector. This sector grew rapidly
during the last part of the 20th century, creating many new jobs and more
than offsetting the slight loss of jobs in manufacturing industries. In
1998 commerce and service industries generated 72 percent of the GDP and
employed 75 percent of the U.S. workforce. Most of these jobs are
classified as white collar, and many require advanced education. They
include many high-paying jobs in financing, banking, education, and
health services, as well as lower-paying positions that require little
educational background, such as retail store clerks, janitors, and fast-
food restaurant workers.

C1 Service Industries The service sector is extremely diverse.
It includes an assortment of private businesses and government agencies
that provide a wide spectrum of services to the U.S. public. Services
industries can be very different from each other, ranging from health-
care providers to vacation resorts to automobile repair shops. Although
it would be almost impossible to list every kind of service industry
operating in the United States, many of these businesses fall into one of
several large service categories.

C1a Banking and Financial Services

In 1995 the U.S. financial market had a total of 628,500 institutions,
which employed 7.0 million people. These institutions included
investment, commercial, and savings banks; credit unions; mortgage banks;
insurance companies; mutual funds; real estate agencies; and various
holdings and trusts.

Banks play a central role in any economy since they act as intermediaries
in the flow of money. They collect deposits and distribute them as loans,
allowing depositors to save for future consumption and allowing borrowers
to invest. In 1998 the United States had 10,481 insured banks and savings
institutions with a total of 84,123 banking offices. Because of mergers
and closures, the number of banks steadily declined in the 1980s and
1990s while the number of bank offices increased. Combined assets of
insured banks and savings institutions totaled $5.44 trillion in 1998.

Banking in the 1990s was a highly competitive business, as banks offered
a variety of services to attract customers and sought to stem the flow of
investors to brokerage houses and insurance firms. Large banks in the
United States, in terms of assets, include Chase Manhattan Corporation,
Citibank, Morgan Guaranty Trust, and Bankers Trust, all headquartered in
New York City; Bank of America, headquartered in San Francisco; and
NationsBank, headquartered in Charlotte, North Carolina.

In 1998 the United States had 1,687 savings and loan associations (SLAs),
with combined assets of $1.1 trillion. SLAs are similar to banks, in that
they accept deposits from customers, but SLAs focus primarily on the
housing and building industries by making loans to home buyers. The
industry was substantially restructured in the late 1980s and early 1990s
after some prominent SLAs became insolvent largely because of falling
real estate prices in some parts of the country.

In addition, a host of other professions offer financial services to
individuals and corporations. Insurance companies provide insurance as
well as a variety of other services, including deposit accounts, pension
management, mutual funds, and other investments. Stockbrokers, investment
experts, pension managers, and personal financial consultants advise
consumers on investing money. In addition, corporate finance managers,
accountants, and tax consultants make recommendations on financial
planning to businesses and individuals.

C1b Travel and Tourism

One of the largest service industries in the United States is travel and
tourism. In 1997, individual U.S. citizens took 1.3 billion trips within
the United States to destinations that were at least 100 miles
(equivalent to 160 km) from home. In increasing numbers, domestic and
foreign travelers are visiting theme parks, natural wonders, and points
of interest in major cities, and the convention business is booming. New
York City is a popular destination, and tourism is a mainstay of the
economies of California, Florida, and Hawaii.

In recent decades, visitors from overseas have become an increasingly
important part of the U.S. tourism business. In 1970 about 2.3 million
overseas visitors came to the United States, spending $889 million. By
1997 the number of overseas visitors—chiefly from western Europe, Japan,
Latin America, and the Caribbean—was 48 million. Millions of visitors
from Canada and Mexico also cross the border every year. Estimated annual
expenditures in the United States by Canadian travelers totaled $6
billion, and spending by Mexicans was $5 billion.

America’s historic sites and national parks draw many visitors. In 1998,
287 million visits were made to the more than 350 areas administered by
the National Park Service. Millions of people each year visit the
national monuments, buildings, and museums in the Washington, D.C., area.
More than 14 million visits are made annually to Golden Gate National
Recreation Area in the San Francisco region. More than 19 million people
per year travel on the Blue Ridge Parkway in North Carolina and Virginia,
and about 6 million visit the Natchez Trace Parkway in Mississippi,
Alabama, and Tennessee. Located within a day’s drive from most parts of
the eastern United States, Great Smoky Mountains National Park is the
most popular national park in the United States, receiving nearly 10
million visitors annually.

C1c Transportation

Transportation-related businesses are an important part of the service
industry. Trucks, railroads, and ships transport goods to markets across
the country. Commercial airlines, railroads, bus companies, and taxis
move tourists and commuters to their destinations. The U.S. Postal
Service and a number of private carriers deliver goods as well as mail to
consumers. The U.S. transportation network spreads into all sections of
the country, but the web of railroads and highways is much denser in the
eastern half of the United States, where it serves the nation’s largest
urban, industrial, and population concentrations.

As of 1996 the 10 largest railroad companies in the United States
operated 72 percent of tracks. Takeovers and mergers among the major
private railroad companies were common during the 1980s and 1990s. Amtrak
(the National Railroad Passenger Corporation), a federally subsidized
organization, operates almost all the intercity passenger trains in the
United States. It carried 20.2 million passengers in 1997. Although rail
passenger travel has declined in importance during the 20th century, some
U.S. cities still maintain extensive subways or commuter railways,
including New York City, Washington, D.C., Chicago, and the San Francisco-
Oakland area of California.

During the early decades of the 20th century, motor vehicle transport
developed as a serious competitor of the railroads, both for passengers
and freight. Federal aid to states for highway construction began with
the passage of the Federal-Aid Road Act of 1916.

The federal aid program was greatly expanded in 1956 when the government
began an ambitious expansion of the Interstate Highway System, a 74,165-
km (46,084-mi) network of limited-access highways that connects the
nation’s principal cities. This carefully designed system enables
motorists to drive across the country without encountering an
intersection or traffic signal. It carries about 20 percent of U.S. motor-
vehicle traffic, though it accounts for just over 1 percent of U.S. roads
and streets. The system is designed for safe, efficient driving, with
gentle curves, easy grades and long sight distances. Entering and exiting
the highway system is permitted only at planned interchanges.

Air transport began to compete with other modes of transport in the
United States after World War I (1914-1918). The first commercial flights
in the United States were made in 1918 and carried small amounts of mail.
Passenger service began to gain importance in the late 1920s, but air
transport did not become a leading mode of travel until the advent of
commercial jet craft after World War II. By the 1990s a growing number of
Americans flew for personal and business travel, in part because of the
need to cover long distances and in part because they like to get to
their destinations quickly. In 1997 airlines in the United States carried
598.1 million passengers, the vast majority of whom were domestic
travelers.

By the end of the 20th century, large and small airports across the
nation formed a network providing air transportation to individual
travelers. The nation had 5,129 public and 13,263 private airports in
1996. The largest airports in the United States by passenger arrivals and
departures are William B. Hartsfield International Airport near Atlanta,
Georgia; Chicago-O’Hare International Airport in Illinois; Dallas-Fort
Worth Airport in Texas; and Los Angeles International Airport in
California.

The United States has a relatively small commercial shipping fleet. In
1998 only 473 vessels of 1,000 gross tons and larger were registered in
the United States. Only 56 percent were in use; most of the remainder
formed part of a government-owned military reserve fleet. However, many
American ship owners register their vessels in foreign countries such as
Liberia and Panama, where crew wages, taxes, and operating costs are
lower.

In terms of the number of ships docking, New Orleans, Louisiana, is the
busiest port in the nation; each year it handles more than 6,000 vessels.
Other leading ports include Los Angeles-Long Beach, California; Houston,
Texas; New York, New York; San Francisco-Oakland, California; Miami,
Florida; and Philadelphia, Pennsylvania. Crude petroleum accounts for 22
percent of the waterborne tonnage of the United States. Petroleum
products make up 18 percent. Coal accounts for 14 percent, and farm
products for 14 percent.

The inland waterway network of the United States has three main
components—the Mississippi River system, the Great Lakes, and the coastal
waterways. Some 66 percent of the annual water freight traffic is on the
Mississippi River and its tributaries, 17 percent is on the Great Lakes,
and most of the remainder is on the coastal waterways. A major
thoroughfare of the coastal waterways is the Intracoastal Waterway, a
navigable, toll-free shipping route extending for about 1,740 km (about
1,080 mi) along the Atlantic Coast and for about 1,770 km (about 1,100
mi) along the Gulf of Mexico coast. About 45 percent of the total annual
traffic on all coastal waterways travels on the Gulf Intracoastal
Waterway, about 30 percent is on the Atlantic Intracoastal Waterway, and
about 25 percent is on Pacific Coast waterways.

Most goods in the United States travel by railroad and truck, which
compete vigorously for freight transport. In 1996, 38 percent of all
United States freight moved by rail and about 27 percent traveled by
truck. However, other modes of transportation more easily handle special
freight items. An additional 20 percent of all freight, by volume, moved
through pipelines, mainly oil and natural gas pipelines originating in
Texas and Louisiana with destinations in the Midwest and Northeast.
Another 16 percent, mainly bulk commodities like coal, grain, and
industrial limestone, moved by barge on inland waters.

C1d Government

Federal, state, and local governments provide a sizeable portion of
services delivered in the nation. In 1996, government workers made up 4
percent of all workers and together produced 12 percent of GDP.
Government services include items as such Social Security benefits,
national defense, education, public welfare programs, law enforcement,
and the maintenance of transportation systems, libraries, hospitals, and
public parks.

The government sector in the U.S. economy has increased dramatically in
size during the 20th century. Federal revenues grew from less than 5
percent of total GDP in the early 1930s to more than 20 percent by the
late 1990s. Much of this growth took place during two time periods. In
the 1930s, following the economic downturn of the Great Depression, U.S.
president Franklin D. Roosevelt instituted sweeping social programs
designed to provide basic financial security to individuals and families.
Many of these programs, such as unemployment insurance and Social
Security payments to retirees, have remained in place since then. During
the 1960s, U.S. president Lyndon B. Johnson instituted a series of
programs designed to fight poverty, promote education, and provide basic
medical coverage for less-affluent Americans. In addition, during the
last half of the 20th century, government expenditures increased for
medical care and national defense as a result of technological advances.
The cost of transportation construction also rose as the growing
population demanded more and better highway systems.

C1e Entertainment

Another leading industry is the entertainment business. Motion picture
production has been centered in Hollywood, California, since the early
decades of the 20th century, when the budding motion picture industry
discovered that the warm climate and sunny skies of southern California
provided ideal conditions for film production. Other entertainment
industries include theater, which tends to be located in larger urban
areas, particularly New York City, and television, with major networks
operating out of the New York City area. .

C2 Commerce The 1990s have been years of unrivaled prosperity
in the United States, with per capita GDP reaching $30,450 by 1998. This
high quality of life results partly from a rapid expansion of commerce in
the years following World War II.

C2a Domestic Trade

Convenience is the key to consumer markets in the United States, whether
it is fast food, movie theaters, clothing, or any of hundreds of
different types of consumer goods. Products are being delivered to
citizens in a more efficient manner, as industries and business firms
have decentralized to more closely fit the distribution of population.
Malls have sprung up in suburban areas, making the downtown department
store obsolete in many smaller cities. Manufacturers also market their
goods directly to customers in factory outlet malls. Prices are often
lower in these outlets than in regular retail stores. Customers often
travel hundreds of miles to shop at larger factory outlet malls. At the
other end of the spectrum, mail order catalogs and Internet sites have
made it possible for many consumers to purchase products directly from
companies by mail or using personal computers.

Wholesalers and retailers carry on most domestic commerce, or trade, in
the United States. Wholesalers buy goods from producers and sell them
mainly to retail business firms. Retailers sell goods to the final
consumer. Wholesale and retail trade together account for 16 percent of
annual GDP of the United States and employ 21 percent of the labor force.

Wholesale establishments conducted aggregate annual sales of $3.2
trillion in 1992. The leading type of wholesale business is the
distribution of groceries and related products, which accounts for 16
percent of all wholesale activity. Next in rank are motor-vehicle parts
and supplies; petroleum and petroleum products; professional and
commercial equipment, and machinery, equipment, and supplies. Wholesalers
tend to be located in large urban centers that enable them to distribute
goods over wide sections of the nation. The New York City metropolitan
area is the country’s leading wholesale center. It serves as the national
distribution center for a variety of goods and as the main regional
center for the eastern United States. Other leading wholesale centers
include Los Angeles, the main center for the western part of the United
States; Chicago; San Francisco; Philadelphia; Houston; Dallas; and
Atlanta.

In the mid-1990s retail establishments in the United States had aggregate
annual sales of $2.2 trillion. Automotive dealers, with 23 percent of the
total yearly retail trade, and food stores, with 18 percent, are the
leading retailers. The volume of retail sales is directly related to the
number of consumers in an area. The four leading states in annual retail
sales—California, Texas, Florida, and New York—are also the four most
populous states.

C2b Foreign Trade

The United States is the world’s leading trading nation, with total
merchandise exports amounting to $683 billion, and imports to $944.6
billion. Despite its massive size, large population, and economic
prosperity, the United States economy can provide a higher quality of
life for consumers and more opportunity for businesses by trading with
other nations. Foreign, or international, trade enables the United States
to specialize in producing those goods that it is best suited to make
given its available resources. It then imports products that other
nations can make more efficiently, lowering prices of these goods for
U.S. consumers.

Nonagricultural products usually account for 90 percent of the yearly
value of exports, and agricultural products account for about 10 percent.
Machinery and transportation equipment make up the leading categories of
exports, amounting together to one-third of the value of all exports.
Other leading exports include electrical equipment, chemicals, precision
instruments, and food products. Beginning in the mid-1970s, the nation’s
imports of petroleum from the Middle East and manufactured goods from
Canada and Asia (especially Japan) created a trade imbalance.

D Information and Technology Sector

By the end of the 20th century, many technological innovations had been
introduced in the United States. Communications satellites orbited the
earth, computers performed day-to-day functions in many businesses, and
the Internet provided instant information on most aspects of U.S. life
via computer. Developments in communications and technology have
transformed many aspects of daily life in the United States, from
improvements in kitchen appliances to advances in medical treatment to
television broadcasts that are transmitted live via satellite from around
the world.

An increasing number of job opportunities are opening in fields related
to the research and application of new technology. Entirely new
industries have emerged, such as companies that build the equipment used
in space explorations. In addition, technology has opened new
opportunities for investment and employment in established industries,
such as those that manufacture medicines and machines used in the
detection and treatment of diseases and individuals who market and sell
products via the Internet.

D1 Communications

The communications systems in the United States are among the most
developed in the world. Television, radio, newspapers, and other
publications, provide most of the country’s news and entertainment. On
average there are two radios and one television set for every person in
the United States. Although the economic output of the communications
industry is relatively small, the industry has enormous importance to the
political, social, and intellectual activity of the nation. Most
communication media in the United States are privately owned and operate
independently of government control.

The Federal Communications Commission must license all radio and
television broadcasting stations in the United States. In 1997, 1,285
television broadcasters were in operation. All states had television
stations, and more than 40 percent of the stations were concentrated in
nine states: Texas, California, Florida, New York, Pennsylvania, Ohio,
Illinois, Michigan, and North Carolina. A rapidly growing number of U.S.
households (estimated at 64 million in 1997) subscribed to cable
television. An estimated 98.3 percent of U.S. households had at least one
television set. Telephone communication changed as cellular phones
allowed people to communicate via telephone while away from their homes
and businesses or while traveling. There were 69 million cellular phones
in use in 1998.

There were 1,489 daily newspapers published in the United States in 1998,
8 fewer than the year before. Daily newspapers had a circulation of
approximately 60.1 million copies in 1998. The top daily newspapers in
the United States according to circulation were the Wall Street Journal
(published in New York City), USA Today (published in Arlington,
Virginia), the New York Times, and the Los Angeles Times, each with a
circulation in excess of 1 million. Other leading newspapers included the
Washington Post, the New York Daily News, the Chicago Tribune, the
Detroit Free Press, the San Francisco Chronicle, the Chicago Sun-Times,
the Dallas Morning News, the Boston Globe, and the Philadelphia Inquirer.

Nearly 21,300 periodicals were published in 1997. These ranged from
specialized journals reaching only a small number of professionals to
major newsmagazines such as Time, with a circulation of 4.1 million a
week, and Newsweek, with a circulation of 3.2 million a week. Other mass
publications with vast audiences included the weekly TV Guide, reaching
13.2 million readers, and the monthly Reader’s Digest, with a circulation
of 15.1 million copies.

D2 Technology

One of the most far-reaching technological advances of the late 20th
century took place in the field of computer science. Computers developed
from large, cumbersome, and expensive machines to relatively small and
affordable devices. The development of the personal computer (PC) in the
1970s made it possible for many individuals to own computers and allowed
even small businesses to use computer technology in their operations. The
U.S. Bureau of the Census estimates that jobs in the computer industry
are growing at the fastest rate of any employment area, with job openings
for computer specialists expected to double from 1996 to 2006.

The Internet began in the 1960s as a small network of academic and
government computers primarily involved in research for the U.S.
military. Originally limited to researchers at a handful of universities
and government facilities, the Internet quickly became a worldwide
network providing users with information on a range of subjects and
allowing them to purchase goods directly from companies via computer. By
1999, 84 million U.S. citizens had access to the Internet at home or
work. More and more Americans were paying bills, shopping, ordering
airline tickets, and purchasing stocks via computer over the Internet.

This article was written by Michael Watts, with the exception of the
Chief Goods and Services of the U.S. Economy section, which he reviewed.

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