U.S. Economy

United States(Economy)
INTRODUCTION
The U.S. economy is immense. In1998 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, andbusinesses 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 othernations. In addition to spending by private households and businesses,government agencies at all levels (federal, state, and local) spend roughly anadditional $1.5 trillion a year. In total, the annual value of all goods andservices 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 theworld has ever known—despite the fact that some other nations have far morepeople, land, or other resources. Through most of the 20th century, U.S. citizens also enjoyed the highest material standards of living in the world. Somenations have higher per capita (per person) incomes than the United States. However, these comparisons are based on international exchange rates, whichset the value of a country’s currency based on a narrow range of goods andservices traded between nations. Most economists agree that the United States has a higher per capita income based on the total value of goods and servicesthat households consume. American prosperity has attracted worldwide attentionand imitation. There are several key reasons why the U.S. economy has been sosuccessful and other reasons why, in the 21st century, it is possible that someother industrialized nations will surpass the U.S. standard of living. Tounderstand those historical and possible future events, it is important firstto understand what an economic system is and how that system affects the waypeople make decisions about buying, selling, spending, saving, investing,working, and taking time for leisure activities.
Capital, savings, andinvestment are taken up in the fourth section, which explains how the long-termgrowth of any economy depends upon the relationship between investments incapital goods (inventories and the facilities and equipment used to makeproducts) and the level of saving in that economy. The next section explainsthe role money and financial markets play in the economy. Labor markets, thetopic of section six, are also extremely important in the U.S. economy, because most people earn their incomes by working for wages and salaries. Bythe same token, for most firms, labor is the most costly input used inproducing 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 economicroles that private markets cannot provide. It also offers some public servicesthat elected officials believe will be in the best interests of the public. Therelationship between the U.S. economy and the world economy is discussed insection eight. Section nine looks at current trends and issues that the U.Seconomy faces at the start of the 21st century. The final section provides anoverview of the kinds of goods and services produced in the United States.    
U.S. ECONOMIC SYSTEM
An economic system refers tothe laws and institutions in a nation that determine who owns economicresources, how people buy and sell those resources, and how the productionprocess makes use of resources in providing goods and services. The U.S. economy is made up of individual people, business and labor organizations, and socialinstitutions. People have many different economic roles—they function asconsumers, workers, savers, and investors. In the United States, people alsovote on public policies and for the political leaders who set policies thathave 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 withemployers, are another important kind of economic organization. So, too, arecooperatives—organizations formed by producers or consumers who band togetherto share resources—as well as a wide range of nonprofit organizations,including many charities and educational organizations, that provide servicesto 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 determinethe kinds of goods and services produced and the prices of those products. Themost basic economic institution in market economies is the system of markets inwhich goods and services are bought and sold. That is where consumers buy mostof the food, clothing, and shelter they use, and any number of things that theysimply want to have or that they enjoy doing. Private businesses make and sellmost of those goods and services. These markets work by bringing togetherbuyers and sellers who establish market prices and output levels for thousandsof different goods and services.
A guiding principle of the U.S. economy, dating back to the colonial period, has been that individuals own the goodsand services they make for themselves or purchase to consume. Individuals andprivate businesses also control the factors of production. They own buildingsand equipment, and are free to hire workers,  and acquire things thatbusinesses use to produce goods and services. Individuals also own thebusinesses that are established in the United States. In other economicsystems, some or all of the factors of production are owned communally or bythe government.
For the most part, U.S. producers decide which goods and services to make and offer to sell, and what pricesto charge for those products. Goods are tangible things—things you cantouch—that satisfy wants. Examples of goods are cars, clothing, food, houses,and toys. Services are activities that people do for themselves or for otherpeople to satisfy their wants. Examples of services are cutting hair, polishingshoes, teaching school, and providing police or fire protection.
Producers decide which goodsand services to make and sell, and how much to ask for those products. At the sametime, consumers decide what they will purchase and how much money they arewilling to pay for different goods and services. The interaction betweencompeting producers, who attempt to make the highest possible profit, andconsumers, 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, governmentplays a limited role in economic decision making. However, the United States does not have a pure market economy, and the government plays an importantrole in the national economy. It provides services and goods that the marketcannot provide effectively, such as national defense, assistance programs forlow-income families, and interstate highways and airports. The government alsoprovides incentives to encourage the production and consumption of certaintypes of products, and discourage the production and consumption of others. Itsets general guidelines for doing business and makes policy decisions thataffect the economy as a whole. The government also establishes safetyguidelines that regulate consumer products, working conditions, andenvironmental protection.
Factors of Production
The factors of production,which in the United States are controlled by individuals, fall into four majorcategories: natural resources, labor, capital, and entrepreneurship.
Natural Resources
Natural resources, which comedirectly from the land, air, and sea, can satisfy people’s wants directly (forexample, beautiful mountain scenery or a clear lake used for fishing andswimming), 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 manynatural resources. They include vast areas of fertile land for growing crops,extensive coastlines with many natural harbors, and several large navigablerivers and lakes on which large ships and barges carry products to and frommost 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 routinework that people do in their jobs, whether it is performing manual labor,managing employees, or providing skilled professional services. Manual laborusually refers to physical work that requires little formal education ortraining, such as shoveling dirt or moving furniture. Managers include thosewho supervise other workers. Examples of skilled professionals include doctors,lawyers, and dentists.
Of the 270 million peopleliving in the United States in 1998, nearly 138 million adults were working oractively looking for work. This is the nation's labor force, which includesthose who work for wages and salaries and those who file government tax formsfor income earned through self-employment. It does not include homemakers orothers who perform unpaid labor in the home, such as raising, caring for, andeducating children; preparing meals and maintaining the home; and caring forfamily members who are ill. Nor, of course, does it count those who do notreport income to avoid paying taxes, in some cases because their work involvesillegal activities.
Capital
Capital includes buildings,equipment, and other intermediate products that businesses use to make othergoods or services. For example, an automobile company builds factories and buysmachines 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 ofthat is equipment and the other half buildings or other structures. Businesseshave additional capital investments in their inventories of finished products,raw materials, and partially completed goods.
Entrepreneurship
Entrepreneurship is an abilitysome people have to accept risks and combine factors of production in order toproduce goods and services. Entrepreneurs organize the various componentsnecessary to operate a business. They raise the necessary financial backing,acquire a physical site for the business, assemble a team of workers, andmanage the overall operation of the enterprise. They accept the risk of losingthe money they spend on the business in the hope that eventually they will earna profit. If the business is successful, they receive all or some share of theprofits. If the business fails, they bear some or all of the losses.
Many people mistakenly believethat anyone who manages a large company is an entrepreneur. However, many managersat large companies simply carry out decisions made by higher-rankingexecutives. These managers are not entrepreneurs because they do not have finalcontrol over the company and they do not make decisions that involve riskingthe companies resources. On the other hand, many of the nation’s entrepreneursrun small businesses, including restaurants, convenience stores, and farms.These individuals are true entrepreneurs, because entrepreneurship involves notmerely the organization and management of a business, but also an individual’swillingness to accept risks in order to make a profit.
Throughout its history, theUnited States has had many notable entrepreneurs, including 18th-centurystatesman, inventor, and publisher Benjamin Franklin, and early-20th-centuryfigures such as inventor Thomas Edison and automobile producer Henry Ford. Morerecently, internationally recognized leaders have emerged in a number offields: Bill Gates of Microsoft Corporation and Steve Jobs of Apple Computer inthe computer industry; Sam Walton of Wal-Mart in retail sales; Herb Kelleherand Rollin King of Southwest Airlines in the commercial airline business; RayKroc of MacDonald’s, Harland Sanders of Kentucky Fried Chicken (KFC), and DaveThomas of Wendy’s in fast food; and in motion pictures, Michael Eisner of theWalt Disney Company as well as a number of entrepreneurs at smaller independentproduction studios that developed during the 1980s and 1990s.
Acquiring the Factors ofProduction
All four factors ofproduction—natural resources, labor, capital, and entrepreneurship—are tradedin markets where businesses buy these inputs or productive resources fromindividuals. These are called factor markets. Unlike a grocery market, which isa specific physical store where consumers purchase goods, the markets mentionedabove comprise a wide range of locations, businesses, and individuals involvedin the exchange of the goods and services needed to run a business.
Businesses turn to the factormarkets to acquire the means to make goods and services, which they then try tosell to consumers in product or output markets. For example, an agriculturalfirm that grows and sells wheat can buy or rent land from landowners. The firmmay shop for this natural resource by consulting real estate agents and farmersthroughout the Midwest. This same firm may also hire many kinds of workers. Itmay find some of its newly hired workers by recruiting recent graduates of highschools, colleges, or technical schools. But its market for labor may alsoinclude older workers who have decided to move to a new area, or to find a newjob and employer where they currently live.
Firms often buy new factoriesand machines from other firms that specialize in making these kinds of capitalgoods. That kind of investment often requires millions of dollars, which isusually financed by loans from banks or other financial institutions.
Entrepreneurship is perhaps themost difficult resource for a firm to acquire, but there are many examples ofeven the largest and most well-established firms seeking out new presidents andchief executive officers to lead their companies. Small firms that are justbeginning to do business often succeed or fail based on the entrepreneurialskills of the people running the business, who in many cases have little or noprevious experience as entrepreneurs.
Markets and the Problem ofScarcity
A basic principle in everyeconomic 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, theywill not be able to buy all of the things they would like to have. In fact, ifeveryone did have all of the things they wanted, there would be no reason foranyone to worry about economic problems. But no nation has ever been able toprovide all of the goods and services that its citizens wanted, and that istrue of the U.S. economy as much as any other.
Scarcity is also the reason whymaking good economic choices is so important, because even though it is notpossible to satisfy everyone’s wants, all people are able to satisfy some oftheir wants. Similarly, every nation is able to provide some of the things itscitizens want. So the basic problem facing any nation’s economy is how to makesure that the resources available to the people in the nation are used tosatisfy as many as possible of the wants people care about most.
The U.S. economy, with itssystem of private ownership, has an extensive set of markets for final productsand for the factors of production. The economy has been particularly successfulin providing material goods and services to most of its citizens. That is evenmore striking when results in the U.S. economy are compared with those of othernations and economic systems. Nevertheless, most U.S. consumers say they wouldlike 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 economicsystem works, or at least in how the purchasing power and the goods andservices in the system are divided up among different individuals and families.
Not surprisingly, low-incomefamilies would like to receive more income, and often favor higher taxes onupper-income households. But many upper-income families complain thatgovernment already taxes them too much, and some argue that government istaking over too many things in the economy that were, in the past, left up toindividuals, families, and private firms or charities.
These debates take placebecause of the problem of scarcity. For individuals and governments, resourcesthat satisfy a particular want cannot be used to satisfy other wants.Therefore, deciding to satisfy one want means paying the cost of not satisfyinganother. Such choices take place every time the government decides how to spendits tax revenues.
What Are Markets?
Goods and services are tradedin markets. Usually a market is a physical place where buyers and sellers meetto make exchanges, once they have agreed on a price for the product. One kindof marketplace is a grocery store, where people go to buy food and householdproducts. However, many marketsare not confined tospecificlocations. In a broader sense, markets include all the places and sources wheregoods and services are exchanged. For example, the labor market does not existin a specific physical building, as does a grocery market. Instead, the term labormarket describes a multitude of individuals offering their labor for saleas well as all the businesses searching for employees. 
Traders do not always have tomeet in person to buy and sell. Markets can operate via technology, such as atelephone line or a computer site. For example, stocks and other financialsecurities have long been traded electronically or by telephone. It is becomingincreasingly common in the United States for many other kinds of goods andservices to be sold this way. For instance, many people today use theInternet—the worldwide computer-based network of information systems—to buyairline tickets, make hotel reservations, and rent a car for their vacation.Other people buy and sell items ranging from books, clothing, and airlinetickets to baseball cards and other rare collectibles over the Internet.Although these Internet buyers and sellers may never meet face to face the waybuyers and sellers do in more traditional markets, these markets share certainbasic features.
How a Single Market Works
Buyers hope to buy at lowprices and will purchase more units of a product at lower prices than they doat higher prices. Sellers are just the opposite. They hope to sell at highprices, and typically they will be willing to produce and sell more units of aproduct at higher prices than at lower prices.
The price for a product isdetermined in the market if prices are allowed to rise and fall, and are notlegally required to be above some minimum price floor or below somemaximum price ceiling. When a product, for example, a personal computer,reaches the market, consumers learn what producers want to charge for it andproducers learn what consumers are willing to pay. The interaction of producersand consumers quickly establishes what the market price for the computer willactually be. Some people who were considering buying a computer decide that theprice is higher than they are willing to pay. And some producers may determinethat consumers are not willing to pay a price high enough for them profitablyto produce and sell this computer.
But all of the buyers who arewilling and able to pay the market price get the computer, and all of thesellers willing and able to produce it for this price find buyers. If moreconsumers want to buy a computer at a specific market price than there aresuppliers are willing to sell at that price—or in other words, if the quantitydemanded is greater than the quantity supplied—the price for the computerincreases. When producers try to sell more of their computers at a price higherthan consumers are willing to buy, the quantity supplied exceeds the quantitydemanded and the price falls.
The price stops rising orfalling at the price where the amount consumers are willing and able to buy isjust equal to the amount sellers are willing and able to produce and sell. Thisis called the market clearing price. Market clearing prices for many goods andservices change frequently, for reasons that will be discussed below. But somemarket prices are stable for long periods of time, such as the prices of candybars and sodas sold in vending machines, and the prices of pizzas andhamburgers. Most buyers of these products have come to know the general pricethey will have to pay for these items. Sellers know what prices they cancharge, given what consumers will pay and considering the competition they facefrom other sellers of identical, or very similar, products.
A System of Markets for AllGoods and Services
How markets determine price issimple 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 goodsand services produced and consumed in an economy, across the entire country. Inthat context, this reasonably simple process of setting market prices allows aneconomic system as large and complex as the U.S. economy to operate with greatefficiency and a high degree of freedom for consumers and producers.
Efficiency here means producingwhat consumers want to buy, at prices that are as low as they can be forproducers to stay in business. And it turns out this efficiency is directlylinked to the freedom that buyers and sellers have in a market economy. Nocentral authority has to decide how many shirts or cars or sandwiches toproduce 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 mostsatisfaction, and they try to find the best deal they can in terms of price,quality, convenience, assurances that defective products will be replaced orrepaired, or other considerations.
What consumers are willing andable to buy tells producers what they should produce, if they hope to make aprofit. Usually consumers have many options to choose from, because more thanone producer offers the same or reasonably similar products (such as two ormore kinds of cars, colas, and carpets). Producers then compete energeticallyfor the dollars that consumers spend.
Competition among producersdetermines the best ways to produce a good or service. For example, in theearly 1900s automobiles were made largely by hand, one at a time. But onceHenry Ford discovered how to lower the cost of producing cars by using assemblylines, other car makers had to adopt the same production methods or be drivenout of business (as many were).
Competition also determineswhat features and quality standards go into products. And competition holdsdown the costs of production because producers know that consumers comparetheir prices to the prices charged by other firms and for other products theymight buy. In markets where a large number of producers compete, inefficientproducers will be driven out of the market.
For example, at one time mosttowns and cities had independently owned cafes and drive-in restaurants thatsold hamburgers, french fries, and soft drinks. Some of these businesses arestill operating, but many closed down after larger fast-food chains beganopening local franchises all around the nation, with well-known productstandards and relatively low prices. The increased competition led to pricesthat were too low for many of the old cafes and drive-ins to make a profit. Theprivate cafes that did survive were able to meet that level of efficiency, orthey managed to make their products different enough from the national chainsto keep their customers.
Prices for goods and servicescan only fall so far, however. Even the most efficient producers have to payfor the natural resources, labor, capital, and entrepreneurship they use tomake and sell products. The market price cannot stay below the level of thosecosts 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 butalso in the future, they have to pay a price at least high enough to cover thecosts of producing it, including enough profit to make it worthwhile forsellers to stay in that market.
Once market prices for variousgoods and services are set, consumers are free to choose what to buy, andproducers are free to choose what to produce and sell. They both follow theirself-interest and do what makes them as well off as they can be. When allbuyers and sellers do that in an economic system of competitive markets, theoverall economy will also be very efficient and responsive to individualpreferences.
This economic process isextremely decentralized. For example, it is likely that no one person orgovernment 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 likelyto sell and arrange to have enough meat and bread available to meet the demandfrom their customers.
Consumers usually do not makeup their mind about what to eat for lunch or dinner until they walk into therestaurant, grocery store, or sandwich shop. But they know they can go toseveral different places and choose many different things to eat and drink,while individual sellers know about how much they are likely to sell on anaverage business day.
Other businesses sell bread andmeat and drinks to the restaurants and grocers, but they do not really know howmany different sandwiches the different food stores are selling either. Theyonly know how much bread and meat they need to have on hand to satisfy theorders they get from their customers.
Each buyer and seller knows hisor her small part of the market very well and makes choices carefully to avoidwasting money and other resources. When everyone acts this carefully whilefacing competition from other consumers or producers, the overall system usesits scarce resources very efficiently. Efficiency implies two things here:taking into account the preferences and alternative choices that individualbuyers and sellers face, and producing goods and services at the lowestpossible cost.
How and Why Market PricesChange
Another advantage of anycompetitive market system is a high level of flexibility and speed inresponding to changing economic conditions. In economies where governmentagencies and central planners set prices, it often takes much longer to adjustprices 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 othermarket economies in Western Europe, Canada, and Japan.

Market prices change whenever something causes achange in demand (the amount people are willing to buy at differentprices) or a change in supply (the amount producers are willing and ableto make and sell at different prices). see Supply and Demand. Becausethese changes can occur rapidly, with little or no advance warning, it isimportant for both consumers and producers to understand what can cause pricesto rise and fall. Those who anticipate price changes correctly can often gainfinancially from their foresight. Those who do not understand why prices havechanged are likely to feel bewildered and frustrated, and find it moredifficult to know how to respond to changing prices. Market economies are, infact, sometimes called price systems. It is important to understand whyprices rise and fall to understand how a market system works.
Changes in Demand
Demand for most productschanges whenever there is a significant change in the level of consumers’income. In the United States, incomes have risen substantially over the past200 years. As that happened, the demand for most goods and services alsoincreased. There are, however, a few products that people buy less of as incomefalls. Examples of these inferior goods include low quality foods andfabrics.
Demand for a product also changeswhen the price of a substitute product changes. For example, if the price forone brand of blue jeans sharply increases while other brands do not, manyconsumers will switch to the other brands, so the demand for those brands willincrease. Conversely, if the price for beef drops, then many people will buyless pork and chicken.
Some products are complementsrather than substitutes. Complements are products that are consumed together,for example cameras and film, or tennis balls and tennis rackets. When theprice of a complementary good rises, the demand for a product falls. Forexample, if the price of cameras rises, the demand for film will fall. On theother hand, if the price of a complementary good falls, the demand for aproduct will rise. If the price of tennis rackets falls, for example, morepeople will buy rackets and the demand for tennis balls will increase.
Demand can also increase ordecrease as a product goes in or out of style. When famous athletes or moviestars create a popular new look in clothing or tennis shoes, demand soars. Whensomething goes out of style, it soon disappears from stores, and eventuallyfrom people’s closets, too.
If people expect the price ofsomething 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 thefuture, they wait to buy and hope they were right. Sometimes these choicesinvolve very serious decisions and large amounts of money. For example, peoplewho buy stocks on the stock market are hoping that prices will rise, while atleast some of the people selling those stocks expect the prices to fall. Butnot all economic decisions are this serious. For example, in the 1970s therewas a brief episode when toilet paper disappeared from the shelves of grocerystores, because people were afraid that there were going to be shortages andrising prices. It turns out that some of these unfounded fears were based onremarks made by a comedian on a late-night talk show.
The final factor that affectsthe demand for most goods and services is the number of consumers in the marketfor a product. In cities where population is rising rapidly, the demand forhouses, food, clothing, and entertainment increases dramatically. In areaswhere population is falling—as it has in many small towns where farmpopulations are shrinking—demand for these goods and services falls.
Changes in Supply
The supply of most products isalso affected by a number of factors. Most important is the cost of producingproducts. If the price of natural resources, labor, capital, orentrepreneurship rises, sellers will make less profit and will not be asmotivated to produce as many units as they were before the cost of productionincreased. On the other hand, when production costs fall, the amount producersare willing and able to sell increases.
Technological change alsoaffects supply. A new invention or discovery can allow producers to makesomething that could not be made before. It could also mean that producers canmake more of a product using the same or fewer inputs. The most dramaticexample of technological change in the U.S. economy over the past few decadeshas been in the computer industry. In the 1990s, small computers that peoplecarry to and from work each day were more powerful and many times lessexpensive than computers that filled entire rooms just 20 to 30 years earlier.
Opportunities to make profitsby producing different goods and services also affect the supply of anyindividual product. Because many producers are willing to move their resourcesto completely different markets, profits in one part of the economy can affectthe supply of almost any other product. For example, if someone running abarbershop decided to sign a contract to provide and operate the machines thatclean runways at a large airport, this would decrease the supply of haircuttingservices and increase the supply of runway sweeping services.
When suppliers believe theprice of the good or service they provide is going to rise in the future, theyoften 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 thefuture, they try to sell more today, increasing the current supply. We see thisbehavior by large and small sellers. Examples include individuals who arethinking about selling a house or car, corn and wheat farmers deciding whetherto sell or store their crops, and corporations selling manufactured products orreserves of natural resources.
Finally, the number of sellersin a market can also affect the level of supply. Generally, markets with alarger number of sellers are more competitive and have a greater supply of theproduct to be sold than markets with fewer sellers. But in some cases, thetechnology of producing a product makes it more efficient to produce largequantities at just a few production sites, or perhaps even at just one. Forexample, it would not make sense to have two or more water and sewage companiesrunning pipes to every house and business in a city. And automobiles can beproduced at a much lower cost in large plants than in small ones, because largeplants can take greater advantage of assembly-line production methods.
All these different factors canlead to changes in what consumers demand and what producers supply. As aresult, on any given day prices for some things will be rising and those forothers will be falling. This creates opportunities for some individuals andfirms, and problems for others. For example, firms producing goods for whichthe demand and the price are falling may have to lay off workers or even go outof business. But for the economy as a whole, allowing prices to rise and fallquickly in response to changes in any of the market forces that affect supplyand demand offers important advantages. It provides an extremely flexible anddecentralized system for getting goods and services produced and delivered tohouseholds while responding to a vast number of unpredictable changes.
Creative Destruction
Taking advantage of newopportunities while curtailing production of things that are no longer indemand or no longer competitive was described as the process of creativedestruction 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 systemsof canals (such as the Erie Canal) during the mid-19th century. But then thecanal systems were replaced or “destroyed” by the railroads, which in turn sawtheir role diminished with the rise of national systems of highways andairports. The same thing happened in the communications industry in the United States. The Pony Express, which carried mail between Missouri and California in theearly 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 andtime again, one decade’s innovation is partially replaced or even destroyed bythe next round of technological change.
In the modern world, priceschange not only as a result of things that happen in one country, butincreasingly 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 weatherconditions someplace else in the world that affect the production of grain,coffee, sugar, or other crops. Sometimes it reflects political or financialupheavals in Europe, Asia, or other parts of the world. There have been severalexamples of such events in the U.S. economy in the 1990s. Higher coffee pricesoccurred 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 suchas Indonesia and Russia.
The ability to respond quicklyto an increasingly volatile economic and political environment is, in manyways, one of the greatest strengths of the U.S. economic system. But thesechanges can result in hardships for some people or even some large segments ofthe economy. For example, importing clothing produced in other nations hasbenefited U.S. consumers by keeping clothing prices lower. In addition, it hasbeen profitable for the firms that import and sell this clothing. However, ithas also reduced the number of jobs available in clothing manufacturing for U.S. workers.
Many people think the mostimportant general issue facing the U.S. economy today is how to balance thebenefits of quickly adapting to changing economic conditions against the costsof abandoning the old ways. It is vital for the economy to adapt quickly tochanging conditions and to focus on producing goods and services that will meetthe most recent demands of the market place. However, when businesses closebecause their products no longer meet the demands of the market, it isimportant to make retraining or new jobs available to workers who lost theirmeans of making a living.
PRODUCTION OF GOODS ANDSERVICES
Before goods and services canbe distributed to households and consumed, they must be produced by someone, orby some business or organization. In the United States and other marketeconomies, privately owned firms produce most goods and services using avariety of techniques. One of the most important is specialization, in whichdifferent firms make different kinds of products and individual workers performspecific jobs within a company.
Successful firms earn profitsfor their owners, who accept the risk of losing money if the products the firmstry to sell are not purchased by consumers at prices high enough to cover thecosts of production. In the modern economy, most firms and workers have foundthat to be competitive with other firms and workers they must become very goodat 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 certainadvantages and disadvantages. Because of that, these three types of businessorganizations often operate in different kinds of markets. For example, mostfirms with large amounts of money invested in factories and equipment areorganized as corporations.
Specialization and the Divisionof Labor
In earlier centuries,especially in frontier areas, families in the United States were much moreself-sufficient, producing for themselves most of the goods and services theyconsumed. But as the U.S. population and economy grew, it became easier forpeople 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 otherthings that they could do, is it less expensive to make something themselves orto let someone else produce it and buy it from them?
Over the years, most people andbusinesses realized that they could make better use of their time and resourcesby concentrating on one particular kind of work, rather than trying to producefor themselves all the items they want to consume. Most people now work in jobswhere they do one kind of work; they are carpenters, bankers, cooks, mechanics,and so forth. Likewise, most businesses produce only certain kinds of goods orservices, such as cars, tacos, or gardening services.This feature ofproduction is known as specialization. A high degree of specialization is a keypart of the economic system in the United States and all other industrializedeconomies. When businesses specialize, they focus on providing a particularproduct or type of product. For instance, some large companies produce onlyautomobiles and trucks, or even special parts of cars and trucks, such astires.
At almost all businesses, whengoods and services are produced, labor is divided among workers, with differentemployees responsible for completing different tasks. This is known as divisionof labor. For example, the individual parts of cars and televisions are made bymany different workers and then put together in an assembly line. Otherwell-known examples of this specialization and division of labor are seen inthe production of computers and electrical appliances. But even kitchens inlarge restaurants have different chefs for different items, and professionalworkers such as doctors and dentists have also become more specialized duringthe past century.
Advantages of Specialization
By specializing in what theyproduce, workers become more expert at a particular part of the productionprocess. As a result, they become more efficient in these jobs, which lowersthe costs of production. Specialization also makes it possible to develop toolsand machines that help workers do highly specialized tasks. Carpenters use manytools that plumbers and painters do not. Commercial bakeries have much largerovens and mixers than those used by people who only bake bread and pies once ayear. And unlike a household kitchen, a commercial bakery has machines to sliceand package bread. All of these tools and machines help workers and businessesproduce more efficiently, and lower the cost of producing goods and services.
The advantages ofspecialization have led to the creation of many very large productionfacilities in the United States and other industrialized nations. This trend isespecially prevalent in the manufacturing sector. For example, many automobilefactories produce thousands of cars each day, and some shipyards employ morethan 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 productis very large, and a company can sell enough goods or services in that marketto support a very large production facility, it will often choose to produce ona large scale to take advantage of specialization and division of labor. Aslong as producing more in larger facilities lowers the average costs ofproduction, the producer enjoys what are known as economies of scale.
But bigger is not alwaysbetter, and eventually almost all producers encounter diseconomies of scalein which larger plants or production sites become less efficient and morecostly to operate. Usually that happens because monitoring and managingincreasingly larger production facilities becomes more difficult. That is why mostlarge manufacturers have more than one factory to make their products, insteadof one massive facility where they make everything they produce. In recentyears, many steel companies have found it more efficient to build and operatesmaller steel mills than they once operated.
Specialization andInternational Trade
Over the past few decades,international trade has led to greater specialization and competition amongproducers in the United States and throughout the world. By selling worldwide,companies in the United States and in other countries can reach many morecustomers. Specialization is ultimately limited by the size of the market for agood or service. In other words, larger markets always allow for greater levelsof specialization. For example, in small towns with few customers to serve,there is often only one clothing store that carries a small selection of manydifferent kinds of clothing. In large cities with a million or more potentialcustomers, there are much larger clothing stores with many more choices ofitems and styles, and even some stores that sell only hats, gloves, or someother particular kind of clothing.
International trade is adramatic way of expanding the size of a firm’s market. In markets wheretransportation costs are low compared with the selling price of a product, ithas become possible for producers to compete globally to take full advantage ofhighly specialized production. But international trade also means thatbusinesses must compete more efficiently against firms from all around theworld. That competition also makes them try to take advantage of greaterspecialization and the division of labor.
In many cases, products areproduced and sold by firms from two or more countries that have largeproduction and employment levels in the same industry. Often, however, thesefirms 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 utilityvehicles are often exported from the United States to Japan and other nations. Similarly, the United States exports large commercial passengerjets to most countries, but imports many small jets from Canada, Brazil, and other nations. While this may seem strange at first glance, it allowsgreater specialization in production for particular kinds of products.
Transportation costs can alsohelp to explain the pattern of international production and trade. It oftenmakes sense to produce goods close to the markets where they will be sold, orclose 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 hasbecome more important to producers in many different industries, so newfactories are often located in areas with large numbers of well-trained workersand good schools that provide a future supply of well-educated workers.
Production Patterns: Past,Present, and Future
Several dramatic changes in productionpatterns occurred in the United States during the 20th century. First, mostemployment shifted from farming in rural areas to industrial jobs in cities andsuburbs. Then, during the second half of the century, production and employmentpatterns changed again as a result of technological advances, increased levelsof world trade, and a rapid increase in the demand for services.
Technological changes in thetransportation, communications, and computer industries created entirely newkinds of jobs and businesses, and altered the kinds of skills workers wereexpected to have in many others. World trade led to increased specializationand competition, as businesses adapted to meet the demands of internationalcompetition.
Perhaps the greatest change inthe U.S. economy came with the nation’s growing prosperity in the yearsfollowing World War II (1939-1945). This prosperity resulted in a populationwith more money to spend on services and leisure activities. More people begandining out at restaurants, taking vacations to far-off locations, and going tomovies and other forms of entertainment. As family incomes increased, awealthier population became more willing to pay others for services.
As a result of thesedevelopments, the closing decades of the 20th century saw a dramatic increasein 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-producingindustries. By the late 1990s, only 26 percent worked in goods-producingindustries, and 74 percent worked in service-producing industries. This changewas driven by powerful market forces, including technological change andincreased levels of world trade, competition, and income.
Some observers worried thatthis growth of employment in service-producing industries would result indeclining living standards for most U.S. workers, but in fact most of thisgrowth has occurred in industries where job skill requirements and wages haverisen or at least remained high. That is less surprising when you consider thatthis employment includes business and repair services, entertainment andrecreation occupations, and professional and related services (including healthcare, 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 forservices has increased so rapidly.
During the 20th century,businesses and their workers had to adjust to many changes in the kinds ofgoods and services people demanded. These changes naturally led to changes inwhere jobs were available, and in what kinds of education, training, and skillsemployees 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 injobs that required completely different sets of skills. Standards of livingdeclined in some communities whose economies centered on farming or aroundlarge factories that shut down. In recent decades, populations have decreasedin some states where agriculture provides a significant number of jobs. Whilehigh-technology industries in places such as California's Silicon Valley werebooming and attracting larger populations, some textile and clothing factoriesin 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 fromchanging levels of demand or competition. There have been some notable exceptions,including the federal government’s guarantee of $1.5 billion in loans to theChrysler Corporation, the nation’s third-largest automobile manufacturer, whenit faced bankruptcy in 1980.
Although direct financialassistance to corporations has been rare, the government has provided subsidiesor partial protection from international competition to a large number ofindustries. Economic analysis of these programs rarely finds such subsidies andprotection to be a good idea for the nation as a whole, though naturally thecompanies and workers who receive the support are better off. But usually theseprograms result in higher prices for consumers, higher taxes, and they hurtother 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 Japanesecars sold in the United States increased by an average of $2,000. The price ofnew U.S. cars also rose on average by about $1,000. Although the import limitsdid save some jobs in the U.S. automobile industry, the total cost of savingthe jobs was several times higher than what workers earned from these jobs.When fewer dollars are sent to Japan to buy new automobiles, the Japanesecompanies and consumers also have fewer dollars to spend on U.S. exports to Japan, such as grain, music cassettes and CDs, and commercial passengerjets. 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 tosubsidize and protect everyone in the U.S. economy from changes in consumerdemands and technology, or from international trade and competition. And whilemost people agree that the government should subsidize the production ofcertain types of goods required for national defense, such as electronicnavigation and surveillance systems, economists warn against the futility oftrying to protect large numbers of firms and workers from change andcompetition. Typically such support cannot be sustained over the long run, whenthe cost of protection and subsidies begins to mount up, except in cases whereproducers and workers represent a strong special interest group with enoughpolitical clout to maintain their special protection or subsidies.
When the special protection orsupport is removed, the adjustments that producers and workers often have tomake then can be much more severe than they would have been when the governmentprograms were first adopted. That has happened when price support programs formilk and other agricultural products were phased out, and when policies thatsubsidized U.S. oil production and limited imports of oil were dropped in the1970s, during the worldwide oil shortage.
For these reasons, if publicassistance is provided to a particular industry, economists are likely to favoronly temporary payments to cover some of the costs of relocation and retrainingof workers. That policy limits the cost of such assistance and leaves workersand firms free to move their resources into whatever opportunities they believewill work best for them.
Most producers in the United States and other market economies must face competition every day. If they aresuccessful, they stand to earn large returns. But they also risk thepossibility of failure and large losses. The lure of profits and the risk oflosses are both part of what makes production in a market economy efficient andresponsive to consumer demands.
CORPORATIONS AND OTHER TYPES OFBUSINESSES
Three major types of firmscarry 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 millionpartnerships; and about 4.3 million corporations. The corporations, however,produce far more goods and services than the proprietorships and partnershipscombined.
Proprietorships andPartnerships
Sole proprietorships aretypically owned and operated by one person or family. The owner is personallyresponsible for all debts incurred by the business, but the owner gets to keepany profits the firm earns, after paying taxes. The owner’s liability orresponsibility for paying debts incurred by the business is consideredunlimited. That is, any individual or organization that is owed money by thebusiness can claim all of the business owner’s assets (such as personal savingsand belongings), except those protected under bankruptcy laws.
Normally when the person whoowns or operates a proprietorship retires or dies, the business is either soldto someone else, or simply closes down after any creditors are paid. Many smallretail businesses are operated as sole proprietorships, often by people whoalso work part-time or even full-time in other jobs. Some farms are operated assole proprietorships, though today corporations own many of the nation’s farms.
Partnerships are like soleproprietorships except that there are two or more owners who have agreed todivide, in some proportion, the risks taken and the profits earned by the firm.Legally, the partners still face unlimited liability and may have theirpersonal property and savings claimed to pay off the business’s debts. Thereare 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 moreslowly than the number of sole proprietorships and corporations. Even many ofthe professions that once operated predominantly as partnerships have found itimportant 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. Thatmeans it is, in law, a separate entity from its owners, who own shares of stockin the corporation. In the United States, corporate names often end with theabbreviation Inc., which stands for incorporated and refers tothe idea that the business is a separate legal body.
Limited Liability
 The keyfeature of corporations is limited liability. Unlike proprietorships andpartnerships, the owners of a corporation are not personally responsible forany debts of the business. The only thing stockholders risk by investing in acorporation is what they have paid for their ownership shares, or stocks. Thosewho are owed money by the corporation cannot claim stockholders’ savings andother personal assets, even if the corporation goes into bankruptcy. Instead,the corporation is a separate legal entity, with the right to enter intocontracts, to sue or be sued, and to continue to operate as long as it isprofitable, which could be hundreds of years.
When the stockholders who ownthe corporation die, their stock is part of their estate and will be inheritedby 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 ortwo major stockholders. The largest U.S. corporations often have millions ofstockholders, with no one person owning as much as 1 percent of the business.Limited liability and the possibility of operating for hundreds of years makecorporations an attractive business structure, especially for large-scaleoperations where millions or even billions of dollars may be at risk.
When a new corporation isformed, a legal document called a prospectus is prepared to describe what thebusiness will do, as well as who the directors of the corporation and its majorinvestors will be. Those who buy this initial stock offering become the firstowners of the corporation, and their investments provide the funds that allowthe corporation to begin doing business.
Separation of Ownership andControl
The advantages of limitedliability and of an unlimited number of years to operate have made corporationsthe dominant form of business for large-scale enterprises in the United States. However, there is one major drawback to this form of business. With soleproprietorships, the owners of the business are usually the same people whomanage and operate the business. But in large corporations, corporate officersmanage the business on behalf of the stockholders. This separation ofmanagement and ownership creates a potential conflict of interest. Inparticular, managers may care about their salaries, fringe benefits, or thesize of their offices and support staffs, or perhaps even the overall size ofthe business they are running, more than they care about the stockholders’profits.
The top managers of acorporation are appointed or dismissed by a corporation’s board of directors,which represents stockholders’ interests. However, in practice, the board ofdirectors is often made up of people who were nominated by the top managers ofthe company. Members of the board of directors are elected by a majority ofvoting stockholders, but most stockholders vote for the nominees recommended bythe current board members. Stockholders can also vote by proxy—a process inwhich they authorize someone else, usually the current board, to decide how tovote for them.
There are, however, two strongforces that encourage the managers of a corporation to act in stockholders’interests. One is competition. Direct competition from other firms that sell inthe same markets forces a corporation’s managers to make sound businessdecisions if they want the business to remain competitive and profitable. Thesecond is the threat that if the corporation does not use its resourcesefficiently, it will be taken over by a more efficient company that wantscontrol of those resources. If a corporation becomes financially unsound or istaken over by a competing company, the top managers of the firm face theprospect of being replaced. As a result, corporate managers will often act inthe best interests of a corporation’s stockholders in order to preserve theirown jobs and incomes.
In practice, the most commonway for a takeover to occur is for one company to purchase the stock of anothercompany, or for the two companies to merge by legal agreement under some newmanagement structure. Stock purchases are more common in what are called hostiletakeovers, where the company that is being taken over is fighting toremain independent. Mergers are more common in friendly takeovers,where two companies mutually agree that it makes sense for the companies tocombine. In 1996 there were over $556.3 billion worth of mergers andacquisitions in the U.S. economy. Examples of mergers include the purchase ofLotus Development Corporation, a computer software company, by computermanufacturer International Business Machines Corporation (IBM) and the acquisitionof Miramax Films by entertainment and media giant Walt Disney Company.
Takeovers by other firms becamecommonplace in the closing decades of the 20th century, and some researchindicates that these takeovers made firms operate more efficiently and profitably.Those outcomes have been good news for shareholders and for consumers. In thelong run, takeovers can help protect a firm’s workers, too, because their jobswill be more secure if the firm is operating efficiently. But initiallytakeovers often result in job losses, which force many workers to relocate,retrain, or in some cases retire sooner than they had planned. Such workforcereductions happen because if a firm was not operating efficiently, it wasprobably either operating in markets where it could not compete effectively, orit was using too many workers and other inputs to produce the goods andservices it was selling. Sometimes corporate mergers can result in job lossesbecause management combines and streamlines departments within the newly mergedcompanies. Although this streamlining leads to greater efficiency, it oftenresults in fewer jobs. In many cases, some workers are likely to be laid offand face a period of unemployment until they can find work with another firm.
How Corporations Raise Fundsfor Investment
By investing in new issues of acompany’s stock, shareholders provide the funds for a company to begin new orexpanded operations. However, most stock sales do not involve new issues ofstock. Instead, when someone who owns stock decides to sell some or all oftheir shares, that stock is typically traded on one of the national stockexchanges, which are specialized markets for buying and selling stocks. Inthose transactions, the person who sells the stock—not the corporation whosestock is traded—receives the funds from that sale.
An existing corporation thatwants to secure funds to expand its operations has three options. It can issuenew shares of stock, using the process described earlier. That option willreduce the share of the business that current stockholders own, so a majorityof 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 andincreased dividends. Dividends are corporate profits that some companiesperiodically pay out to shareholders.
The second way for acorporation to secure funds is by borrowing money from banks, from otherfinancial institutions, or from individuals. To do this the corporation oftenissues bonds, which are legal obligations to repay the amount of moneyborrowed, plus interest, at a designated time. If a corporation goes out ofbusiness, it is legally required to pay off any bonds it has issued before anymoney is returned to stockholders. That means that stocks are riskierinvestments than bonds. On the other hand, all a bondholder will ever receiveis the amount of money specified in the bond. Stockholders can enjoy much largerreturns, if the corporation is profitable.
The final way for a corporationto 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 orheld 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 thestockholders own and have risked in the business, which is known asstockholders’ equity. On the other hand, if the corporation incurs losses, thevalue of what the stockholders own in the business goes down, so stockholders’equity decreases.
Entrepreneurs and Profits
Entrepreneurs raise money toinvest in new enterprises that produce goods and services for consumers tobuy—if consumers want these products more than other things they can buy.Entrepreneurs often make decisions on which businesses to pursue based onconsumer demands. Making decisions to move resources into more profitablemarkets, and accepting the risk of losses if they make bad decisions—or fail toproduce products that stand the test of competition—is the key role ofentrepreneurs in the U.S. economy.

Profits are the financial incentives that leadbusiness owners to risk their resources making goods and services for consumersto buy. But there are no guarantees that consumers will pay prices high enoughto cover a firm’s costs of production, so there is an inherent risk that a firmwill lose money and not make profits. Even during good years for mostbusinesses, about 70,000 businesses fail in the United States. In years whenbusiness conditions are poor, the number approaches 100,000 failures a year.And even among the largest 500 U.S. industrial corporations, a few of thesefirms lose money in any given year.
Entrepreneurs invest money infirms with the expectation of making a profit. Therefore, if the profits acompany earns are not high enough, entrepreneurs will not continue to invest inthat firm. Instead, they will invest in other companies that they hope will bemore profitable. Or if they want to reduce their risk, they can put their moneyinto savings accounts where banks guarantee a minimum return. They can alsoinvest in other kinds of financial securities (such as government or corporatebonds) that are riskier than savings accounts, but less risky than investmentsin most businesses. Generally, the riskier the investment, the higher thereturn investors will require to invest their money.
Calculating Profits
The dollar value of profitsearned by U.S. businesses—about $700 billion a year in the late 1990s—is agreat deal of money. However, it is important to see how profits compare withthe money that business owners have risked in the business. Profits are alsooften compared to the level of sales for individual firms, or for all firms inthe U.S. economy.
Accountants calculate profitsby 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 isthe dollar level of profits. To evaluate whether that figure is high or low, itmust be compared to some measure of the size of the firm. Obviously, $1 millionwould be an incredibly large amount of profits for a very small firm, and notmuch profit at all for one of the largest corporations in the country, such astelecommunications giant AT&T Corp. or automobile manufacturer GeneralMotors (GM).
To take into consideration thesize of the firm, profits are calculated as a percentage of several differentaspects of the business, including the firm’s level of sales, employment, andstockholders’ equity. Various individuals will use one of these differentmethods to evaluate a company’s performance, depending on what they want toknow about how the firm operates. For example, an efficiency expert mightexamine the firm’s profits as a percentage of employment to determine how muchprofit 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 inprofit as a percentage of stockholder equity, which allows them to gauge whatkind of return to expect on their investments. A sales executive in the samefirm might be more interested in learning about the company’s profit as apercentage of sales in order to compare its performance to the performances ofcompeting firms in the same industry.
Using these differentaccounting methods often results in different profit percent figures for thesame 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 areturn 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 ownerswith profits at this level or lower like to say that they earn only about whatpeople can earn on the interest from their savings accounts. That sounds low,especially considering that the federal government insures many savingsaccounts, so that most people with deposits at a bank run no risk of losingtheir savings if the bank goes out of business. And in fact, given the risksinherent in almost all businesses, few stockholders would be satisfied with areturn on their investment that was this low.
Although it is true that onaverage, 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 areturn on sales of only 1 to 2 percent, while some other kinds of firmstypically earn more than the 5-percent average profit on sales. But sellingmore or less does not really increase what the owners of a grocery store (ormost other businesses) are risking. Each time a grocery store sells $100 worthof canned spinach, it keeps about one or two dollars as profit, and uses therest of the money to put more cans of spinach on the shelves for consumers tobuy. At the end of the year, the grocery store may have sold thousands ofdollars worth of canned spinach, but it never really risked those thousands ofdollars. At any given time, it only risked what it spent for the cans that wereat the store. When some cans were sold, the store bought new cans to put on theshelves, and it turned over its inventory of canned spinach many times duringthe year.
But the total value of thesesales at the end of the year says little or nothing about the actual level ofrisk that the grocery store owners accepted at any point during the year. Andin fact, the grocery industry is a relatively low-risk business, because peoplebuy food in good times and bad. Providing goods or services where production orconsumer demand is more variable—such as exploring for oil and uranium, ormaking movies and high fashion clothing—is far riskier.
Return on Equity
What stockholders risk—theamount they stand to lose if a business incurs losses and shuts down—is themoney they have invested in the business, their equity. These are the fundsstockholders provide for the firm whenever it offers a new issue of stock, orwhen the firm keeps some of the profits it earns to use in the businessasretained earnings, rather than paying those profits out to stockholders asdividends.
Profits as a return onstockholders’ equity for U.S. corporations usually average from 12 to 16percent, for larger and smaller corporations alike. That is more than peoplecan earn on savings accounts, or on long-term government and corporate bonds.That is not surprising, however, because stockholders usually accept more riskby investing in companies than people do when they put money in savingsaccounts or buy bonds. The higher average yield for corporate profits isrequired to make up for the fact that there are likely to be some years whenreturns are lower, or perhaps even some when a company loses money.
At least part of any firm’sprofits are required for it to continue to do business. Business owners couldput their funds into savings accounts and earn a guaranteed level of return, orput them in government bonds that carry hardly any risk of default. If abusiness does not earn a rate of return in a particular market at least as highas a savings account or government bonds, its owners will decide to get out ofthat market and use the resources elsewhere—unless they expect higher levels ofprofits in the future.
Over time, high profits in somebusinesses or industries are a signal to other producers to put more resourcesinto those markets. Low profits, or losses, are a signal to move resources outof a market into something that provides a better return for the level of riskinvolved. That is a key part of how markets work and respond to changing demandand supply conditions. Markets worked exactly that way in the U.S. economy when people left the blacksmith business to start making automobiles at thebeginning of the 20th century. They worked the same way at the end of thecentury, when many companies stopped making typewriters and started makingcomputers and printers.
CAPITAL, SAVINGS, ANDINVESTMENT
In the United States and in other market economies, financial firms and markets channel savingsinto capital investments. Financial markets, and the economy as a whole, workmuch better when the value of the dollar is stable, experiencing neither rapidinflation nor deflation. In the United States, the Federal Reserve Systemfunctions as the central banking institution. It has the primary responsibilityto keep the right amount of money circulating in the economy.
Investments are one of the mostimportant ways that economies are able to grow over time. Investments allowbusinesses to purchase factories, machines, and other capital goods, which inturn increase the production of goods and services and thus the standard ofliving of those who live in the economy. That is especially true when capitalgoods incorporate recently developed technologies that allow new goods andservices to be produced, or existing goods and services to be produced moreefficiently with fewer resources.
Investing in capital goods hasa cost, however. For investment to take place, some resources that could havebeen used to produce goods and services for consumption today must be used,instead, to make the capital goods. People must save and reduce their currentconsumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those fundsto buy capital goods. Banks and other financial institutions in the economyplay a key role by providing incentives for some people to save, and then lendthose funds to firms and other people who are investing in capital goods.
Interest rates are the pricesomeone pays to borrow money. Savings institutions pay interest to people whodeposit funds with the institution, and borrowers pay interest on their loans.Like any other price in a market economy, supply and demand determine theinterest rate. The demand for money depends on how much money people andorganizations want to have to meet their everyday expenses, how much they wantto save to protect themselves against times when their income may fall or theirexpenses may rise, and how much they want to borrow to invest. The supply ofmoney 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 themoney supply to try to keep the right amount of money in the economy. Too muchmoney leads to inflation. Too little results in high interest rates that makeit more expensive to invest and may lead to a slowdown in the national economy,with rising levels of unemployment.
Providing Funds for Investmentsin Capital
To take advantage ofspecialization and economies of scale, firms must build large productionfacilities that can cost hundreds of millions of dollars. The firms that buildthese plants raise some funds with new issues of stock, as described above. Butfirms also borrow huge sums of money every year to undertake these capitalinvestments. When they do that, they compete with government agencies that areborrowing money to finance construction projects and other public spendingprograms, and with households that are borrowing money to finance the purchaseof housing, automobiles, and other goods and services.
Savings play an important rolein the lending process. For any of this borrowing to take place, banks andother lenders must have funds to lend out. They obtain these funds from peopleor organizations that are willing to deposit money in accounts at the bank,including savings accounts. If everyone spent all of the income they earnedeach year, there would be no funds available for banks to lend out.
Among the three major sectorsof the U.S. economy—households, businesses, and government—only households arenet savers. In other words, households save more money than they borrow.Conversely, businesses and government are net borrowers. A few businesses maysave more than they invest in business ventures. However, overall, businessesin the United States, like businesses in virtually all countries, invest farmore 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. Likecorporate bonds, government bonds are contractual obligations to repay what isborrowed, plus some specified rate of interest, at a specified time.
Matching Borrowers and Lendersin Financial Markets
Households save money forseveral reasons: to provide a cushion against bad times, as when wage earnersor others in the household become sick, injured, or disabled; to pay for largeexpenditures such as houses, cars, and vacations; to set aside money forretirement; or to invest. Banks and other financial institutions compete forhouseholds’ savings deposits by paying interest to the savers. Then banks lendthose funds out to borrowers at a higher rate of interest than they pay tosavers. The difference between the interest rates charged to borrowers and paidto savers is the main way that banks earn profits.
Of course banks must also becareful to lend the money to people and firms that are creditworthy—meaningthey will be able to repay the loans. The creditworthiness of the borrower isone reason why some kinds of loans have higher rates of interest than othersdo. Short-term loans made to people or businesses with a long history of stableincome and employment, and who have assets that can be pledged as collateralthat will become the bank’s property if a loan is not repaid, will receive thelowest interest rates. For example, well-established firms such as AT&Toften pay what is called the bank’s prime rate—the lowest available ratefor business loans—when they borrow money. New, start-up companies pay higherrates because there is a greater risk they will default on the loan or even goout of business.
Other kinds of loans also havegreater risks of default, so banks and other lenders charge different rates ofinterest. Mortgage loans are backed by the collateral of the property the loanwas used to purchase. If someone does not pay his or her mortgage, the bank hasthe right to sell the property that was pledged as collateral and to collectthe proceeds as payment for what it is owed. That means the bank’s risks arelower, so interest rates on these loans are typically lower, too. The moneythat is loaned to people who do not pay off the balances on their credit cardsevery month represents a greater risk to banks, because no collateral isprovided. Because the bank does not hold any title to the consumer’s propertyfor these loans, it charges a higher interest rate than it charges onmortgages. The higher rate allows the bank to collect enough money overall sothat it can cover its losses when some of these riskier loans are not repaid.
If a bank makes too many loansthat are not repaid, it will go out of business. The effects of bank failureson depositors and the overall economy can be very severe, especially if manybanks 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 duringthe Great Depression of the 1930s, when a large number of banks failed. Manyother businesses also closed and many people lost both their jobs and savings.
Bank failures are fairly rareevents in the U.S. economy. Banks do not want to lose money or go out ofbusiness, and they try to avoid making loans to individuals and businesses whowill be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal DepositInsurance Corporation (FDIC) insures most bank and savings and loan deposits upto $100,000. Government examiners conduct regular inspections of banks andother financial institutions to try to ensure that these firms are operatingsafely 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 thiscountry, compared to that of many other industrialized nations. People who livein the United States save less of their annual income than people who live inmany other industrialized market economies, including Japan, Germany, and Italy.
There is considerable debateabout why the U.S. savings rate is low, and several factors are oftendiscussed. U.S. citizens may simply choose to enjoy more of their income in theform of current consumption than people in nations where living standards havehistorically been lower. But other considerations may also be important. Thereare significant differences among nations in how savings, dividends, investmentincome, housing expenditures, and retirement programs are taxed and financed.These differences may lead to different decisions about saving.
For example, many other nationsdo not tax interest on savings accounts as much as they do other forms ofincome, and some countries do not tax at least part of the income people earnon savings accounts at all. In the United States, such favorable tax treatmentdoes not apply to regular savings accounts. The government does offer morelimited advantages on special retirement accounts, but such accounts have manyrestrictions on how much people can deposit or withdraw before retirementwithout facing tax penalties.
In addition, U.S. consumers can deduct from their taxes the interest they pay on mortgages for the homesthey live in. That encourages people to spend more on housing than theyotherwise would. As a result, some funds that would otherwise be saved are,instead, put into housing.
Another factor that has adirect effect on the U.S. savings rate is the Social Security system, thegovernment program that provides some retirement income to most older people.The money that workers pay into the Social Security system does not go intoindividual savings accounts for those workers. Instead, it is used to makeSocial Security payments to current retirees. No savings are created under thissystem unless it happens that the total amount being paid into the system isgreater than the current payments to retirees. Even when that has happened inthe past, the federal government often used the surplus to pay for some of itsother expenditures. Individuals are also likely to save less for their ownretirement because they expect to receive Social Security benefits when theyretire.
The low U.S. savings rate has two significant consequences. First, with fewer dollars available assavings to banks and other financial institutions, interest rates are higherfor both savers and borrowers than they would otherwise be. That makes it morecostly to finance investment in factories, equipment, and other goods, whichslows 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 willsee below, such foreign investments can have several effects on the U.S. economy.
Borrowing from Foreign Savers
The flow of funds from othernations enables U.S. firms to finance more investments in capital goods, but italso 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. Asthey demand dollars for these investments, the price of the dollar in terms ofother nations’ currencies rises. When the price of the dollar is rising, peoplein 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 andindustrial equipment, saw the sales of their products to their internationalcustomers 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 largerdeficit (or smaller surplus) in the U.S. balance of trade, the amount ofexports compared to imports.
Foreign investment has othereffects on the U.S. economy. Eventually the money borrowed must be repaid. Howthose repayments will affect the U.S. economy will depend on how the borrowedmoney is invested. If the money borrowed from foreign individuals and companiesis 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 sentoverseas to repay the loans. The concern is that instead of using foreign fundsfor additional investments in capital goods, today these funds are simplymaking it possible for U.S. consumers and government agencies to spend more onconsumption goods and social services, which will not increase output andliving 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 withoutlowering 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 incapital projects, now that the United States, with the largest and wealthiesteconomy in the world, faces a low national savings rate.
MONEY AND FINANCIAL MARKETS
AMoney and theValue of Money

Money is anything generally accepted as final paymentfor goods and services. Throughout history many things have been used aroundthe world as money, including gold, silver, tobacco, cattle, and rare feathersor animal skins. In the U.S. economy today, there are three basic forms ofmoney: currency (dollar bills), coins, and checks drawn on deposits at banksand other financial firms that offer checking services. Most of the time, whenhouseholds, businesses, and government agencies pay their bills they usechecks, but for smaller purchases they also use currency or coins.
People can change the type ofthe money they hold by withdrawing funds from their checking account to receivecurrency or coins, or by depositing currency and coins in their checkingaccounts. But the money that people have in their checking accounts is reallyjust the balance in that account, and most of those balances are neverconverted to currency or coins. Most people deposit their paychecks and thenwrite checks to pay most of their bills. They only convert a small part oftheir pay to currency and coins. Strange as it seems, therefore, most money inthe U.S. economy is just the dollar amount written on checks or showing inchecking account balances. Sometimes, economists also count money in savingsaccounts in broader measures of the U.S. money supply, because it is easy andinexpensive to move money from savings accounts to checking accounts.
Most people are surprised tolearn that when banks make loans, the loans create new money in the economy. Aswe’ve seen, banks earn profits by lending out some of the money that peoplehave deposited. A bank can make loans safely because on most days, the amountsome customers are depositing in the bank is about the same amount that othercustomers are withdrawing. A bank with many customers holding a lot of depositscan lend out a lot of money and earn interest on those loans. But of coursewhen that happens, the bank does not subtract the amount it has loaned out fromthe accounts of the people who deposited funds in savings and checkingaccounts. Instead, these depositors still have the money in their accounts, butnow the people and firms to whom the bank has loaned money also have that moneyin their accounts to spend. That means the total amount of money in the economyhas increased. This process is called fractional reserve banking, because aftermaking loans the bank retains only a fraction of its deposits as reserves. Thebank really could not pay all of its depositors without calling in the loans ithas made. It also means that money is created when banks make loans butdestroyed when loans are paid off.
At one time the dollar, likemost other national currencies, was backed by a specified quantity of gold orsilver held by the federal government. At that time, people could redeem theirdollars for gold or silver. But in practice paper currency is much easier tocarry around than large amounts of gold or silver. Therefore, most people havepreferred to hold paper money or checking balances, as long as paper currencyand checks are accepted as payment for goods and services and maintain theirvalue in terms of the amount of goods and services they can buy.
Eventually governments aroundthe world also found it expensive to hold and guard large quantities of gold orsilver. As foreign trade grew, governments found it especially difficult totransfer gold and silver to other countries that decided to redeem paper moneyacquired through international trade. They, too, changed to using papercurrencies and writing checks against deposits in accounts. In 1971 the United States suspended the international payment of gold for U.S. currency. This actioneffectively ended the gold standard, the name for this official link betweenthe dollar and the price of gold. Since then, there has been no official linkbetween the dollar and a set price for gold, or to the amount of gold or otherprecious metals held by the U.S. government.
The real value of the dollartoday depends only on the amount of goods and services a dollar can purchase.That purchasing power depends primarily on the relationship between the numberof dollars people are holding as currency and in their checking and savingsaccounts, and the quantity of goods and services that are produced in theeconomy each year. If the number of dollars increases much more rapidly thanthe quantity of goods and services produced each year, or if people startspending the dollars they hold more rapidly, the result is likely to beinflation. Inflation is an increase in the average price of all goods andservices. In other words, it is a decrease in the value of what each dollar canbuy.
The Federal Reserve System andMonetary Policy
Governments often attempt toreduce inflation by controlling the supply of money. Consequently, organizationsthat control how much money is issued in an economy play a major role in howthe economy performs, in terms of prices, output and employment levels, andeconomic growth. In the United States, that organization is the nation’scentral bank, the Federal Reserve System. The system’s name comes from the factthat the Federal Reserve has the legal authority to make banks hold some oftheir deposits as reserves, which means the banks cannot lend out thosedeposits. These reserve funds are held in the Federal Reserve Bank. The FederalReserve also acts as the banker for the federal government, but the governmentdoes 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 FederalReserve banks. These banks are not commercial banks. They do not accept savingsdeposits from or provide loans to individuals or businesses. Instead, theFederal Reserve functions as a central bank for other banks and for the federalgovernment. In that role the Federal Reserve System performs several importantfunctions in the national economy. First, the branches of the Federal Reservedistribute paper currency in their regions. Dollar bills are actually FederalReserve notes. You can look at a dollar bill of any denomination and see thenumber for the regional Federal Reserve Bank where the bill was originallyissued. But of course the dollar is a national currency, so a bill issued byany regional Federal Reserve Bank is good anyplace in the country. Thedistribution of currency occurs as commercial banks convert some of theirreserve balances at the Federal Reserve System into currency, and then providethat currency to bank depositors who decide to hold some of their moneybalances as currency rather than deposits in checking accounts. The U.S.Treasury prints new currency for the Federal Reserve System. The bills areintroduced into circulation when commercial banks use their reserves to buycurrency from the Federal Reserve Bank.
Second, the regional FederalReserve banks transfer funds for checks that are deposited by a bank in onepart of the country, but were written by someone who has a checking accountwith a bank in another part of the country. Millions of checks are processedthis way every business day. Third, the regional Federal Reserve Banks collectand analyze data on the economic performance of their regions, and provide thatinformation and their analysis of it to the national Federal Reserve System. Eachof the 12 regions served by the Federal Reserve banks has its own economiccharacteristics. Some of these regional economies are concerned more withagricultural issues than others; some with different types of manufacturing andindustries; some with international trade; and some with financial markets andfirms. After reviewing the reports from all different parts of the country, thenational Federal Reserve System then adopts policies that have major effects onthe entire U.S. economy.
By far the most importantfunction of the Federal Reserve System is controlling the nation’s money supplyand the overall availability of credit in the economy. If the Federal ReserveSystem wants to put more money in the economy, it does not ask the Treasury toprint more dollar bills. Remember, much more money is held in checking andsavings accounts than as currency, and it is through those deposit accountsthat the Federal Reserve System most directly controls the money supply. TheFederal Reserve affects deposit accounts in one of three ways.
First, it can allow banks tohold a smaller percentage of their deposits as reserves at the Federal ReserveSystem.  A lower reserve requirement allows banks to make more loans andearn more money from the interest paid on those loans. Banks making more loansincrease the money supply. Conversely, a higher reserve requirement reduces theamount of loans banks can make, which reduces or tightens the money supply.
The second way the FederalReserve System can put more money into the economy is by lowering the rate itcharges banks when they borrow money from the Federal Reserve System. Thisparticular interest rate is known as the discount rate. When the discount rategoes down, it is more likely that banks will borrow money from the FederalReserve System, to cover their reserve requirements and support more loans toborrowers. Once again, those loans will increase the nation’s money supply.Therefore, a decrease in the discount rate can increase the money supply, whilean increase in the discount rate can decrease the money supply.
In practice, however, banksrarely borrow money from the Federal Reserve, so changes in the discount rateare more important as a signal of whether the Federal Reserve wants to increaseor decrease the money supply. For example, raising the discount rate may alertbanks that the Federal Reserve might take other actions, such as increasing thereserve requirement. That signal can lead banks to reduce the amount of loansthey are making.
The third way the FederalReserve System can adjust the supply of money and the availability of credit inthe economy is through its open market operations—the buying or selling ofgovernment bonds. Open market operations are actually the tool that the FederalReserve uses most often to change the money supply. These open-marketoperations take place in the market for government securities. The U.S. government borrows money by issuing bonds that are regularly auctioned on the bondmarket in New York. The Federal Reserve System is one of the largest purchasersof those bonds, and the bank changes the amount of money in the economy when itbuys or sells bonds.
Government bonds are not money,because they are not generally accepted as final payment for goods andservices. (Just try paying for a hamburger with a government savings bond.) Butwhen the Federal Reserve System pays for a federal government bond with acheck, that check is new money—specifically, it represents a loan to thegovernment. This loan creates a higher balance in the government’s own checkingaccount after the funds have been transferred from the privately owned FederalReserve Bank to the government. That new money is put into the economy as soonas the government spends the funds. On the other hand, if the Federal Reservesells government bonds, it collects money that is taken out of circulation,since the bonds that the Federal Reserve sells to banks, firms, or householdscannot be used as money until they are redeemed at a later date.
The Wall Street Journaland other financial media regularly report on purchases of bonds made by theFederal Reserve and other buyers at auctions of U.S. government bonds. TheFederal Reserve System itself also publishes a record of its buying and sellingin the bond market. In practice, since the U.S. economy is growing and themoney supply must grow with it to keep prices stable, the Federal Reserve isalmost always buying bonds, not selling them. What changes over time is howfast the Federal Reserve wants the money supply to grow, and how many dollarsworth of bonds it purchases from month to month.
To summarize the FederalReserve System’s tools of monetary policy: It can increase the supply of moneyand the availability of credit by lowering the percentage of deposits that banksmust hold as reserves at the Federal Reserve System, by lowering the discountrate, or by purchasing government bonds through open market operations. TheFederal Reserve System can decrease the supply of money and the availability ofcredit by raising reserve ratios, raising the discount rate, or by sellinggovernment bonds.
The Federal Reserve Systemincreases the money supply when it wants to encourage more spending in theeconomy, and especially when it is concerned about high levels of unemployment.Increasing the money supply usually decreases interest rates—which are theprice 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 morespending by households for houses, automobiles, and other “big ticket” itemsthat are often financed by borrowing money. That additional spending increasesnational levels of production, employment, and income. However, the FederalReserve Bank must be very careful when increasing the money supply. If it doesso when the economy is already operating close to full employment, theadditional spending will increase only prices, not output and employment.
Effect of Monetary Policies onthe U.S. Economy
The monetary policies adopted bythe Federal Reserve System can have dramatic effects on the national economyand, in particular, on financial markets. Most directly, of course, when theFederal Reserve System increases the money supply and expands the availabilityof credit, then the interest rate, which determines the amount of money thatborrowers pay for loans, is likely to decrease. Lower interest rates, in turn,will encourage businesses to borrow more money to invest in capital goods, andwill stimulate households to borrow more money to purchase housing,automobiles, and other goods.
But the Federal Reserve Systemcan go too far in expanding the money supply. If the supply of money and creditgrows 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 aserious problem for those who live on fixed incomes, since the income of thoseindividuals remains constant while the amount of goods and services they canpurchase with their income decreases. Inflation may also hurt banks and otherfinancial institutions that lend money, as well as savers. In a period ofunanticipated inflation, as the value of money decreases in terms of what itwill purchase, loans are repaid with dollars that are worth less. The fundsthat people have saved are worth less, too.
When banks and saversanticipate higher inflation, they will try to protect themselves by demandinghigher interest rates on loans and savings accounts. This will be especiallytrue on long-term loans and savings deposits, if the higher inflation isconsidered likely to continue for many years. But higher interest rates createproblems for borrowers and those who want to invest in capital goods.
If the supply of money andcredit grows too slowly, however, then interest rates are again likely to rise,leading to decreased spending for capital investments and consumer durablegoods (products designed for long-term use, such as television sets,refrigerators, and personal computers). Such decreased spending will hurt manybusinesses and may lead to a recession, an economic slowdown in which thenational output of goods and services falls. When that happens, wages andsalaries paid to individual workers will fall or grow more slowly, and someworkers 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 withmonetary policy very closely. There are regular reports in the media aboutpolicy changes made by the Federal Reserve System, and even about statementsmade by Federal Reserve officials that may indicate that the Federal Reserve isgoing to change the supply of money and interest rates. The chairman of theFederal Reserve System is widely considered to be one of the most influentialpeople in the world because what the Federal Reserve does so dramaticallyaffects the U.S. and world economies, especially financial markets.
LABOR AND LABOR MARKETS
Labor includes work done foremployers and work done in a person’s own household, but labor markets dealonly with work that is done for some form of financial compensation. Labormarkets include all the means by which workers find jobs and by which employerslocate workers to staff their businesses. A number of factors influence laborand 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, waitingto be recalled from a layoff, or actively looking for work within the past 30days. In 1998 the U.S. labor force included nearly 138 million people, most ofthem 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 hiredindividuals to work as their employees. Those wages and salaries are the pricesthey receive for the labor services they provide to their employers. Like otherprices, 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, andaccording to workers’ levels of education, training, experience, and skill. Aswith goods and services purchased by consumers, labor is traded in markets thatreflect both supply and demand. In general, higher wages and salaries are paidin occupations where labor is more scarce—that is, in jobs where the demand forworkers is relatively high and the supply of workers with the qualificationsand ability to do that work is relatively low. The demand for workers inparticular occupations depends largely on how much the work they do adds to afirm’s revenues. In other words, workers who create more products orhigher-priced products will be worth more to employers than workers who makefewer or less valuable products. The supply of workers in any occupation isaffected by the amount of time and effort required to enter that occupationcompared to other things workers might do.
Workers seeking higher wagesoften learn skills that will increase the likelihood of finding a higher-payingjob. The knowledge, skills, and experience a worker has acquired are theworker’s human capital. Education and training can clearly increase workers’human capital and productivity, which makes them more valuable to employers. Ingeneral, more educated individuals make more money at their jobs. However, agreater level of education does not always guarantee higher wages. Certainprofessions that demand a high level of education, such as teaching elementaryand secondary school, are not high-paying. Such situations arise when thenumber of people with the training to do that job is relatively large comparedwith the number of people that employers want to hire. Of course this situationcan change over time if, for example, fewer young people choose to train forthe profession.
Supply and demand factorschange in labor markets, just as they do in markets for goods and services. Asa result, occupations that paid high wages and salaries in the past sometimesbecome outdated, while entirely new occupations are created as a result oftechnological change or changes in the goods and services consumers demand. Forexample, 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 creativedestruction carries over from product markets to labor markets because thedemand for particular goods and services creates a demand for the labor toproduce them. Conversely, when the demand for particular goods or servicesdecreases, the demand for labor to produce them will also fall. Similarly, whennew technologies create new products or new ways of producing existingproducts, some workers will have new job opportunities, but other workers mighthave to retrain, relocate, or take new jobs.
Factors Affecting Labor Markets
Changes in society and in themakeup of the population also affect labor markets. For example, starting inthe 1960s it became more common for married women to work outside the home.Unprecedented numbers of women—many with little previous job experience andtraining—entered the labor markets for the first time during the 1970s. As aresult, wages for entry-level jobs were pushed down and did not rise as rapidlyas they had in the past. This decline in entry-level wages was further fueledby huge numbers of teens who were also entering the labor market for the firsttime. These young people were the children of the baby boom of 1946 to1964, 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 otherin the makeup of the age of the workforce—combined to affect the labor market.
The baby boomers’ effects havecontinued to reverberate through the U.S. economy. For example, startingsalaries for people with college degrees became depressed when large numbers ofbaby boomers started graduating from college. And as workers born during theboom have aged, the work force in the United States has grown progressivelyolder, with the percentage of workers under the age of 25 falling from 20.3 percentin 1980 to 14.3 percent in 1997.
By the 1990s, the women andbaby boomers who first entered the job market in the 1970s had acquired moreexperience and training. Therefore, the aging of the labor force was notaffecting entry-level jobs as it once did, and starting salaries for collegegraduates were rising rapidly again. There will be, however, other kinds oflabor market and public policy issues to face when the baby boomers begin toretire 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 andworkers from other nations. Most families and workers in the United States can trace their heritage to immigrants. In fact, before the 20th century, whilethe United States was trying to settle its frontiers, it allowed essentiallyunlimited immigration. see Immigration: A Nation of Immigrants. In theseperiods the U.S. economy had more land and other natural resources than it wasable to use, because labor was so scarce. Immigration served as one of the mainremedies for this shortage of labor.
Generally, immigration raisesnational output and income levels. These changes occur because immigrationincreases the number of workers in the economy, which allows employers toproduce more goods and services. Capital resources in the economy may alsobecome more valuable as immigration increases. The number of workers availableto work with machines and tools increases, as does the number of consumers whowant to buy goods and services.However, wages for jobs that are filledby large numbers of immigrants may decrease. This wage decline stems fromgreater competition for these jobs and from the fact that many immigrants arewilling 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 immigrantswho can legally enter the country each year. In 1964 Congress changedimmigration policies to give preference to those with families already in the United States, to refugees facing political persecution, and to individuals with otherhumanitarian concerns. Before that time, more weight had been placed onimmigrants’ labor-market skills. Although this change in policy helped reunitefamilies, it also increased the supply of unskilled labor in the nation,especially in the states of California, Florida, and New York. In 1990 Congressmodified the immigration legislation to set a separate annual quota forimmigrants with job skills needed in the United States. But people with familymembers who are already U.S. citizens remain the largest category ofimmigrants, and U.S. immigration law still puts less focus on job skills thando immigration laws in many other market economies, including Canada and many of the nations of Western Europe.
Discrimination
Women and many minorities havelong faced discrimination in U.S. labor markets. Employed women earn less, onaverage, than men with similar levels of education. In part this wage disparityreflects different educational choices that women and men have made. In thepast, women have been less likely to study engineering, sciences, and othertechnical fields that generally pay more. In part, the wage differences resultfrom 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 thereis still a considerable degree of occupational segregation between males andfemales—for example, nurses are much more likely to be females and dentistsmales. But even after allowing for those factors, studies have generally foundthat, on average, women earn roughly 10 percent less than men even incomparable jobs, with equal levels of education, training, and experience.
Analysis of wage discriminationagainst black Americans leads to similar conclusions. Specifically, aftercontrolling for differences in age, education, hours worked, experience,occupation, and region of the country, wages for black men are roughly 10 percentlower than for white men, though occupational segregation appears to be lesscommon by race than by gender. Issues other than wage discrimination are alsoimportant to note for black workers. In particular, unemployment rates forblack workers are about twice as high as they are for white workers. Partlybecause of that, a much lower percentage of the U.S. black population isemployed than the white population.
Hispanic workers generallyreceive wages about 5 percent lower than white workers, after adjusting fordifferences in education, training, experience, and other characteristics thataffect workers’ productivity. Some studies suggest that differences in theability to speak English are particularly important in understanding wagedifferences for Hispanic workers.
The differences between theearnings of white males and earnings of females and minorities slowly decreasedin the closing decades of the 20th century. Some laws and regulationsprohibiting discrimination seem to have helped in this process. A large part ofthose gains occurred shortly after the adoption of the 1964 Civil Rights Act,which among other things, outlawed discrimination by employers and unions. Manyeconomists worry that the discrimination that remains may be more difficult toidentify and eliminate through legislation.
Discrimination in competitivelabor markets is economically inefficient as well as unfair. When workers arenot paid based on the value of what they add to employers’ production andprofit levels, society loses opportunities to use labor resources in their mostvaluable ways. As a result, fewer goods and services are produced. If employersdiscriminate against certain groups of workers, they will pay for that behaviorin competitive markets by earning lower profits. Similarly, if workers refuseto work with (or for) coworkers of a different gender, race, or ethnicbackground, they will have to accept lower wages in competitive markets becausetheir 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, orethnicity in certain kinds of jobs, they will have to pay higher prices incompetitive markets because their discrimination raises the costs of providingthese goods and services.
Those who are discriminatedagainst receive lower wages and often experience other forms of economichardship, such as more frequent and longer periods of unemployment. Beyondthat, the lower wage rates and restricted career opportunities they face willnaturally affect their decisions about how much education and training toacquire and what kinds of careers to pursue. For that reason, some of the costsof discrimination are paid over very long periods of time, sometimes for aworker’s entire life.
It is clear that there is stilldiscrimination in the U.S. economy. What is not always so clear is how muchthat discrimination costs the economy as a whole, and that it costs not onlythose who are discriminated against, but also those who practice discrimination.
Unions
Many U.S. workers belong tounions or to professional associations (such as the National EducationAssociation for teachers) that act like unions. These unions and associationsrepresent groups of workers in collective bargaining with employers to agree oncontracts. During this bargaining, workers and employers establish wages andfringe benefits, such as health care and pension benefits, for different typesof jobs. They also set grievance procedures to resolve labor disputes duringthe life of the contract and often address many other issues, such asprocedures for job transfers and promotions of workers.
Many studies indicate thatwages for union workers in the United States are 10 to 15 percent higher thanfor nonunion workers in similar jobs and that fringe benefits for union workersalso tend to be higher. That compensation difference is an importantconsideration both for workers thinking about joining unions, and for employerswho are concerned about paying higher wages and benefits than theircompetitors. In some cases, it appears that the higher wages and benefits arepaid because union workers are more productive than nonunion workers are. Butin other cases unions have been found to decrease productivity, sometimes bylimiting the kinds of work that certain employees can do, or by requiring moreworkers in some jobs than employers would otherwise hire. Economists have notreached definite conclusions on some of these issues, but it is evident thatthere are many other broad effects of unions on the economy.
Unions and collectivebargaining in the United States are markedly different from such organizationsand procedures in other industrialized nations. U.S. unions generally practicewhat is often described as business unionism, which focuses mainly onthe direct economic interests of their members. In contrast, unions in Europe and South America focus more on influencing national policy agendas and politicalparties.
The different focus by U.S. unions partly reflects the special history of unions in the United States, where thefirst sustained successes were achieved by craft unions representing skilledworkers such as carpenters, printers, and plumbers. These skilled workers hadmore bargaining power and were more difficult for employers to replace or dowithout than workers with less training. Unions representing these skilledworkers were also able to provide special services to employers that allowedboth the unions and employers to operate more efficiently. For example, craft unionsin large cities often ran apprenticeship programs to train young workers inthese occupations. And many craft unions operated hiring halls that employerscould call to find trained workers on short notice or for short periods oftime.
Most of these craft unions weremembers of the American Federation of Labor (AFL), founded in 1886. The strongbargaining position of these skilled workers, and the fact that these workerstypically earned much higher wages than most other workers, led the AFL unionsto focus on wages and other financial benefits for their members. SamuelGompers, the president of the AFL for nearly all of its first 38 years, oncesummarized his philosophy of unions by saying, “What do we want? More. When dowe want it? Now.”
By contrast, industrialunions—which represent all of the workers at a firm or work site, regardless oftheir 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 byemployers, and made it easier for unions representing all workers to win thatrecognition. The Wagner Act largely put an end to the violent strikes thatoften occurred when unions were trying to be recognized as the bargaining agentfor employees at some firm or work site. The act established clear proceduresfor calling and holding elections in which the workers decide whether they wantto be represented by a union, and if so by which union. The Wagner Act alsoestablished a government agency known as the National Labor Relations Board(NLRB) to hear charges of unfair labor practices. Either employees or employersmay file charges of unfair labor practices with the NLRB.
After the Wagner Act waspassed, the number of workers who belonged to unions increased rapidly. Thistrend continued through World War II (1939-1945), when unions successfullynegotiated more fringe benefits for their members. These fringe benefits werepartly a result of wage and price controls established during the war, whichmade large wage increases impossible. In the 1950s union strength continued togrow, and the national association of industrial unions, known as the Congressof Industrial Organization (CIO) merged with the AFL.
Since the late 1970s, totalunion membership has fallen. The percentage of the U.S. labor force thatbelongs to unions has decreased dramatically in the last half of the 20thcentury, from more than 25 percent in the mid-1950s to 14 percent in 1997. Anumber of reasons explain the decline in union representation of the U.S. labor force. First, unions are traditionally strong in manufacturing industries, butsince the 1950s manufacturing has accounted for a smaller percentage of overallemployment in the U.S. economy. Employment has grown more rapidly in theservice sector, particularly in professional services and white-collar jobs.Unions have not had as much success in acquiring new members in the servicesector, with the exception of  government employees.
Union membership has alsodeclined as the government established laws and regulations that mandate forall workers many of the benefits and guarantees that unions had achieved fortheir members. These mandates include minimum wage, workplace safety, higherpay rates for overtime, and oversight of the management of pension funds ifemployers fund or partially fund pensions.
Third, many U.S. firms havebecome more aggressive in opposing the recognition of unions as bargainingagents for their employees, and in dealing with confrontations involvingexisting unions. For example, it is increasingly common for firms to hirepermanent replacement workers if strikes occur at a firm or work site.
Finally, workers with collegedegrees held a larger percentage of jobs in the U.S. economy in the late 1990sthan in earlier decades. These workers are more likely to be in jobs with somelevel of managerial responsibilities, and less likely to think of themselves aspotential union members.
Unions, however, continue toplay many valuable roles in representing their members on economic issues.Equally or perhaps more importantly, unions provide workers with a strongervoice in how work is done and how workers are treated. This is particularlytrue in jobs where it is difficult to identify clearly how much an individualworker contributes to total output in the production process. During the 1990s,many U.S. manufacturing firms adopted team production methods, in which smallgroups of workers function as a team. Any member of the team can suggest ideasfor different ways of doing jobs. But management is likely to consider morecarefully those that are recommended by the union or have union support.Workers may also be more willing to present ideas for job improvements to unionrepresentatives than to managers. In some cases, workers feel that the unionwould consider how the changes can be made without reducing jobs, wages, orother benefits.
Unemployment
A persistent problem for the U.S. economy and some of its workers is unemployment—not being able to find a job despiteactively looking for work for at least 30 consecutive days. There are threemajor kinds of unemployment: frictional, cyclical, and structural. Each type ofunemployment has different causes and consequences, and so public policiesdesigned to reduce each type of unemployment must be different, too.
Frictional unemployment occursas a result of labor mobility, when workers change jobs or wait to begin a newjob. Labor mobility is, in general, a good thing for workers and the economyoverall. It allows workers to look for the best available job for which theyare qualified and lets employers find the best-qualified people for their jobopenings. Because this searching and matching by employees and employers takestime, on any given day in a market economy there will be some workers who arelooking for a new job, or waiting to begin a job. Even when economists describethe economy as being at full employment there will be some frictionalunemployment (as much as 5 to 6 percent of the labor force in some years). Thiskind of unemployment is generally not a major economic problem.
Cyclical unemployment occurswhen the economy goes into a recession. The basic causes of cyclicalunemployment are decreases in the levels of consumption, investment, orgovernment spending in the economy, or a decrease in the demand for goods andservices exported to other countries. As national spending and productionlevels fall, some employers begin to lay off workers. Cyclical unemploymentvaries greatly according to the health of the economy. Some of the highestunemployment rates for the last decades of the 20th century took place duringthe recession of 1982 to 1983, when unemployment levels reached almost 10percent. The highest U.S. unemployment rate of the 20th century occurred in1933, when the Great Depression left almost 25 percent of the labor forcewithout work.
Sometimes the government canuse monetary or fiscal policies to increase spending by businesses andhouseholds, for instance by cutting taxes. Or the government can increase itsown spending to fight this kind of unemployment… Perhaps the most famousexample of this kind of tax cut in the United States was the one designed in1963 and passed in 1964 by the administrations of U.S. president John F.Kennedy and his successor, Lyndon B. Johnson.
Structural unemployment occurswhen people who are looking for jobs do not have the education or skills tofill the jobs that are currently available. Most policies designed to reducestructural unemployment provide training programs for these workers, orsubsidize education and training programs available from colleges anduniversities, technical schools, or businesses. In some cases, the governmentprovides support for retraining when increased competition from imported goodsand services puts U.S. workers out of work or when factories are shut downbecause production is moved to another state or country.
Unemployment rates also varysharply by occupation and educational levels. As a group, workers with collegedegrees experience far lower unemployment rates than workers with lesseducation. In 1998 the unemployment rate for U.S. workers who had not graduatedfrom high school was 7.1 percent; for high school graduates, the rate was 4.0percent; for those with some college the rate was 3.0 percent; and for collegegraduates the unemployment rate was only 1.8 percent.
Income Inequality
Another issue involving theoperation of labor markets in the U.S. economy has been the growing differencebetween the earnings of high-income and low-income workers at the end of the20th century. From 1977 to 1997, families who make up the top 20 percent ofincome groups have seen their money income rise from 40.9 percent of thenational income to 47.2 percent. Over the same period, families in the lowest20 percent of income groups have experienced a decline from 5.5 percent of thenational 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 thesupply of these workers in the U.S. has not risen as quickly as demand forthese 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 unskilledworkers than other industrialized nations. Other countries often consider jobmarket factors more heavily in determining who will be allowed to immigrate. Asa result, the supply of unskilled workers in the United States has increasedfaster than in other countries, pushing wages in low-paying jobs lower.
Finally, government assistanceprograms for low-income families tend to be more extensive and generous inother industrialized market economies than they are in the United States. That is perhaps one of the reasons that workers in those countries are lesswilling to accept jobs that pay lower wages, and why unemployment rates inthose 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 becomeincreasingly difficult for U.S. workers who have not at least completed highschool to achieve a high or moderate level of income. In 1996 the averageannual 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 notgraduate from high school was only $25,283 for males and $17,313 for females.
GOVERNMENT AND THE ECONOMY
Although the market system inthe United States relies on private ownership and decentralized decision-makingby households and privately owned businesses, the government does performimportant economic functions. The government passes and enforces laws thatprotect the property rights of individuals and businesses. It restrictseconomic activities that are considered unfair or socially unacceptable.
In addition, governmentprograms regulate safety in products and in the workplace, provide nationaldefense, and provide public assistance to some members of society coping witheconomic hardship. There are some products that must be provided to householdsand firms by the government because they cannot be produced profitably byprivate firms. For example, the government funds the construction of interstatehighways, and operates vaccination programs to maintain public health. Localgovernments operate public elementary and secondary schools to ensure that asmany children as possible will receive an education, even when their parentsare unable to afford private schools.
Other kinds of goods andservices (such as health care and higher education) are produced and consumedin private markets, but the government attempts to increase the amount of theseproducts available in the economy. For yet other goods and services, thegovernment acts to decrease the amount produced and consumed; these includealcohol, tobacco, and products that create high levels of pollution. Thesespecial cases where markets fail to produce the right amount of certain goodsand services mean that the government has a large and important role to play inadjusting some production patterns in the U.S. economy. But economists andother analysts have also found special reasons why government policies andprograms often fail, too.
At the most basic level, thegovernment makes it possible for markets to function more efficiently byclearly defining and enforcing people’s property or ownership rights toresources and by providing a stable currency and a central banking system (theFederal Reserve System in the U.S. economy). Even these basic functions requirea wide range of government programs and employees. For example, the governmentmaintains offices for recording deeds to property, courts to interpretcontracts and resolve disputes over property rights, and police and other lawenforcement agencies to prevent or punish theft and fraud. The TreasuryDepartment issues currency and coins and handles the government’s revenues andexpenditures. And as we have seen, the Federal Reserve System controls thenation’s supply of money and availability of credit. To perform these basicfunctions, the government must be able to shift resources from private topublic uses. It does this mainly through taxes, but also with user feesfor some services (such as admission fees to national parks), and by borrowingmoney 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 thatcompetitive markets perform these functions most efficiently. One role ofgovernment is to maintain competition in these markets so that they willcontinue to operate efficiently. In other areas, however, markets are notallowed to operate because other considerations have been deemed more importantthan economic efficiency. In these cases, the government has declared certainpractices illegal. For example, in the United States people are not free to buyand sell votes in political elections. Instead, the political system is basedon the democratic rule of “one person, one vote.” It is also illegal to buy andsell many kinds of drugs. After the Civil War (1861-1865) the Constitution wasamended to make slavery illegal, resulting in a major change in the structureof U.S. society and the economy.
In other cases, the governmentallows private markets to operate, but regulates them. For example, thegovernment makes laws and regulations concerning product safety. Some of theselaws and regulations prohibit the use of highly flammable material in themanufacture of children’s clothing. Other regulations call for governmentinspection of food products, and still others require extensive governmentreview and approval of potential prescription drugs.
In still other situations, thegovernment determines that private markets result in too much production andconsumption of some goods, such as alcohol, tobacco, and products thatcontribute to environmental pollution. The government is also concerned whenmarkets provide too little of other products, such as vaccinations that preventcontagious diseases. The government can use its spending and taxing authorityto change the level of production and consumption of these products, forexample, by subsidizing vaccinations.
Even the staunchest supportersof private markets have recognized a role for the government to provide asafety net of support for U.S. citizens. This support includes providingincome, housing, food, and medicine for those who cannot provide a basicstandard of living for themselves or their families.
Because the federal governmenthas become such a large part of the U.S. economy over the past century, itsometimes tries to reduce levels of unemployment or inflation by changing itsoverall level of spending and taxes. This is done with an eye to the monetary policiescarried out by the Federal Reserve System, which also have an effect on thenational rates of inflation, unemployment, and economic growth. The FederalReserve System itself is chartered by federal legislation, and the president ofthe United States appoints board members of the Federal Reserve, with theapproval of the U.S. Senate. However, the private banks that belong to thesystem own the Federal Reserve, and its policy and operational decisions aremade independently of Congress and the president.
Correcting Market Failures
The government attempts toadjust the production and consumption of particular goods and services whereprivate markets fail to produce efficient levels of output for those products.The two major examples of these market failures are what economists call publicgoods and external benefits or costs.
Providing Public Goods
Private markets do not providesome essential goods and services, such as national defense. Because nationaldefense is so important to the nation’s existence, the government steps in andentirely funds and administers this product.
Public goods differ fromprivate goods in two key respects. First, a public good can be used by oneperson without reducing the amount available for others to use. This is known asshared consumption. An example of a public good that has this characteristic isa spraying or fogging program to kill mosquitoes. The spraying reduces thenumber of mosquitoes for all of the people who live in an area, not just forone 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 ahamburger. If someone else eats the sandwich, you cannot.
The second key characteristicof public goods is called the nonexclusion principle: It is not possible toprevent people from using a public good, regardless of whether they have paidfor it. For example, a visitor to a town who does not pay taxes in thatcommunity will still benefit from the town’s mosquito-spraying program. Withprivate goods, like a hamburger, when you pay for the hamburger, you get to eatit or decide who does. Someone who does not pay does not get the hamburger.
Because many people can benefitfrom the same pubic goods and share in their consumption, and because those whodo not pay for these goods still get to use them, it is usually impossible toproduce these goods in private markets. Or at least it is impossible to produceenough in private markets to reach the efficient level of output. That happensbecause some people will try to consume the goods without paying for them, andget a free ride from those who do pay. As a result, the government must usuallytake over the decision about how much of these products to produce. In somecases, the government actually produces the good; in other cases it paysprivate firms to make these products.
The classic example of a publicgood is national defense. It is not a rival consumption product, sinceprotecting one person from an invading army or missile attack does not reducethe amount of protection provided to others in the country. The nonexclusionprinciple also applies to national defense. It is not possible to protect only thepeople who pay for national defense while letting bombs or bullets hit thosewho do not pay. Instead, the government imposes broad-based taxes to pay fornational defense and other public goods.
Adjusting for External Costs orBenefits
There are some private marketsin which goods and services are produced, but too much or too little isproduced. Whether too much or too little is produced depends on whether theproblem is one of external costs or external benefits. In either case, thegovernment can try to correct these market failures, to get the right amount ofthe good or service produced.
External costs occur when notall of the costs involved in the production or consumption of a product arepaid by the producers and consumers of that product. Instead, some of the costsshift to others. One example is drunken driving. The consumption of too muchalcohol can result in traffic accidents that hurt or kill people who areneither producers nor consumers of alcoholic products. Another example ispollution. If a factory dumps some of its wastes in a river, then people andbusinesses downstream will have to pay to clean up the water or they may becomeill from using the water.
When people other thanproducers and consumers pay some of the costs of producing or consuming aproduct, those external costs have no effect on the product’s market price orproduction level. As a result, too much of the product is produced consideringthe overall social costs. To correct this situation, the government may tax orfine the producers or consumers of such products to force them to cover theseexternal costs. If that can be done correctly, less of the product will beproduced and consumed.
An external benefit occurs whenpeople other than producers and consumers enjoy some of the benefits of theproduction and consumption of the product. One example of this situation isvaccinations against contagious diseases. The company that sells the vaccineand the individuals who receive the vaccine are better off, but so are other peoplewho are less likely to be infected by those who have received the vaccine. Manypeople also argue that education provides external benefits to the nation as awhole, in the form of lower unemployment, poverty, and crime rates, and byproviding more equality of opportunity to all families.
When people other than theproducers and consumers receive some of the benefits of producing or consuminga product, those external benefits are not reflected in the market price andproduction cost of the product. Because producers do not receive higher salesor profits based on these external benefits, their production and price levelswill be too low–based only on those who buy and consume their product. Tocorrect this, the government may subsidize producers or consumers of theseproducts and thus encourage more production.
Maintaining Competition
Competitive markets areefficient ways to allocate goods and services while maintaining freedom ofchoice for consumers, workers, and entrepreneurs. If markets are not competitive,however, much of that freedom and efficiency can be lost. One threat tocompetition in the market is a firm with monopoly power. Monopoly power occurswhen one producer, or a small group of producers, controls a large part of theproduction of some product. If there are no competitors in the market, amonopoly can artificially drive up the price for its products, which means thatconsumers will pay more for these products and buy less of them. One of themost famous cases of monopoly power in U.S. history was the Standard OilCompany, owned by U.S. industrialist John D. Rockefeller. Rockefeller boughtout most of his business rivals and by 1878 controlled 90 percent of thepetroleum refineries in the United States.
Largely in reaction to thebusiness practices of Standard Oil and other trusts or monopolisticfirms, the United States passed laws limiting monopolies. Since 1890, when theSherman Antitrust Act was passed, the federal government has attempted toprevent firms from acquiring monopoly power or from working together to setprices and limit competition in other ways. A number of later antitrust lawswere passed to extend the government’s power to promote and maintaincompetition in the U.S. economy. Some states have passed their own versions ofsome of these laws.
The government does allow whateconomists call natural monopolies. However, the government thenregulates those businesses to protect consumers from high prices and poorservice, and often limits the profits these firms can earn. The classicexamples of natural monopolies are local services provided by public utilities.Economies of scale make it inefficient to have even two companies distributingelectricity, gas, water, or local telephone service to consumers. It would bevery expensive to have even two sets of electric and telephone wires, and twosets of water, gas, and sewer pipes going to every house. That is why firmsthat provide these services are called natural monopolies.
There have been some famousantitrust cases in which large companies were broken up into smaller firms. Onesuch example is the breakup of American Telephone and Telegraph (AT&T) in1982, which led to the formation of a number of long-distance and regionaltelephone companies. Other examples include a ruling in 1911 by the SupremeCourt of the United States, which broke the Standard Oil Trust into a number ofsmaller oil companies and ordered a similar breakup of the American TobaccoCompany.
Some government policiesintentionally reduce competition, at least for some period of time. Forexample, patents on new products and copyrights on books and movies give oneproducer the exclusive right to sell or license the distribution of a productfor 17 or more years. These exclusive rights provide the incentive for firmsand 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 isintroduced into the marketplace, so it pays to devote more resources todeveloping these new products.
The benefits of certain othergovernment policies that reduce competition are not always this clear, however.More controversial examples include policies that restrict the number oftaxicabs in a large city or that limit the number of companies providing cabletelevision services in a community. It is much less expensive for cablecompanies to install and operate a cable television system than it is for largeutilities, such as the electric and telephone companies, to install theinfrastructure they need to provide services. Therefore, it is often morefeasible to have two or more cable companies in reasonably large cities. Thereare also more substitutes for cable television, such as satellite dish systemsand broadcast television. But despite these differences, many cities auctionoff cable television rights to a single company because the city receives morerevenue that way. Such a policy results in local monopolies for cabletelevision, even in areas where more competition might well be possible and moreefficient.
Establishing governmentpolicies that efficiently regulate markets is difficult to do. Policies mustoften balance the benefits of having more firms competing in an industryagainst the possible gains from allowing a smaller number of firms to competewhen those firms can achieve economies of scale. The government must try toweigh the benefits of such regulations against the advantages offered by morecompetitive, less regulated markets.
Promoting Full Employment andPrice Stability
In addition to the monetarypolicies of the Federal Reserve System, the federal government can also use itstaxing and spending policies, or fiscal policies, to counteract inflation orthe cyclical unemployment that results from too much or too little total spendingin the economy. Specifically, if inflation is too high because consumers,businesses, and the government are trying to buy more goods and services thanit is possible to produce at that time, the government can reduce totalspending in the economy by reducing its own spending. Or the government canraise taxes on households and businesses to reduce the amount of money theprivate sector spends. Either of these fiscal policies will help reduceinflation. Conversely, if inflation is low but unemployment rates are too high,the government can increase its spending or reduce taxes on households andbusinesses. These policies increase total spending in the economy, encouragingmore production and employment.
Some government spending andtax policies work in ways that automatically stabilize the economy. Forexample, if the economy is moving into a recession, with falling prices andhigher unemployment, income taxes paid by individuals and businesses willautomatically fall, while spending for unemployment compensation and otherkinds of assistance programs to low-income families will automatically rise.Just the opposite happens as the economy recovers and unemployment falls—incometaxes rise and government spending for unemployment benefits falls. In bothcases, tax programs and government-spending programs change automatically andhelp offset changes in nongovernment employment and spending.
In some cases, the federalgovernment uses discretionary fiscal policies in addition to automaticstabilization policies. Discretionary fiscal policies encompass those changesin government spending and taxation that are made as a result of deliberationsby the legislative and executive branches of government. Like the automaticstabilization policies, discretionary fiscal policy can reduce unemployment byincreasing government spending or reducing taxes to encourage the creation ofnew jobs. Conversely, it can reduce inflation by decreasing government spendingand raising taxes. .
In general, the federalgovernment tries to consider the condition of the national economy in itsannual budgeting deliberations. However, discretionary spending is difficult toput into practice unless the nation is in a particularly severe episode ofunemployment or inflation. In such periods, the severity of the situationbuilds more consensus about what should be done, and makes it more likely thatthe problem will still be there to deal with by the time the changes ingovernment spending or tax programs take effect. But in general, it takes time fordiscretionary fiscal policy to work effectively, because the economic problemto be addressed must first be recognized, then agreement must be reached abouthow to change spending and tax levels. After that, it takes more time for thechanges in spending or taxes to have an effect on the economy.
When there is only moderateinflation or unemployment, it becomes harder to reach agreement about the needfor the government to change spending or taxes. Part of the problem is this: Inorder to increase or decrease the overall level of government spending ortaxes, specific expenditures or taxes have to be increased or decreased,meaning that specific programs and voters are directly affected. Choosing whichprograms and voters to help or hurt often becomes a highly controversialpolitical issue. 
Because discretionary fiscalpolicies affect the government’s annual deficit or surplus, as well as thenational debt, they can often be controversial and politically sensitive. Forthese reasons, at the close of the 20th century, which experienced years withnormal levels of unemployment and inflation, there was more reliance onmonetary policies, rather than on discretionary fiscal policies to try tostabilize the national economy. There have been, however, some famous episodesof changing federal spending and tax policies to reduce unemployment and fightinflation in the U.S. economy during the past 40 years. In the early 1980s, theadministration of U.S. president Ronald Reagan cut taxes. Other notable taxcuts occurred during the administrations of U.S. presidents John Kennedy andLyndon Johnson in 1963 and 1964.
Limitations of GovernmentPrograms
Government economic programsare not always successful in correcting market failures. Just as markets failto produce the right amount of certain kinds of goods and services, thegovernment will often spend too much on some programs and too little on othersfor a number of reasons. One is simply that the government is expected to dealwith some of the most difficult problems facing the economy, taking over wheremarkets fail because consumers or producers are not providing clear signalsabout what they want. This lack of clear signals also makes it difficult forthe government to determine a policy that will correct the problem.
Political influences, ratherthan purely economic factors, often play a major role in inefficient governmentpolicies. Elected officials generally try to respond to the wishes of thevoting public when making decisions that affect the economy. However, manycitizens choose not to vote at all, so it is not clear how good the politicalsignals are that elected officials have to work with. In addition, most votersare not well informed on complicated matters of economic policy.
For example, the federal government’sbudget director David Stockman and other officials in the administration ofPresident Reagan proposed cuts in income tax rates. Congress adopted the cutsin 1981 and 1984 as a way to reduce unemployment and make the economy grow somuch that tax revenues would actually end up rising, not falling. Mosteconomists and many politicians did not believe that would happen, but the taxcuts were politically popular.
In fact, the tax cuts resultedin very large budget deficits because the government did not collect enoughtaxes to cover its expenditures. The government had to borrow money, and thenational debt grew very rapidly for many years. As the government borrowedlarge sums of money, the increased demand caused interest rates to rise. Thehigher interest rates made it more expensive for U.S. firms to invest incapital goods, and increased the demand for dollars on foreign exchange marketsas foreigners bought U.S. bonds paying higher interest rates. That caused thevalue of the dollar to rise, compared with other nations’ currencies, and as aresult U.S. exports became more expensive for foreigners to buy. When thathappened in the mid-1980s, most U.S. companies that exported goods and servicesfaced very difficult times.
In addition, whenever resourcesare allocated through the political process, the problem of special interestgroups 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 thecosts are spread out across a large number of people. That gives those whoreceive the benefits strong reasons to lobby for the policy, while those whoeach pay a small part of the cost are unlikely to oppose it actively. Thissituation can occur even if the overall costs of the program greatly exceed itsoverall benefits.
For instance, the United States limits sugar imports. The resulting higher U.S. price for sugar greatlybenefits farmers who grow sugarcane and sugar beets in the United States. U.S. corn farmers also benefit because the higher price for sugar increasesdemand for corn-based sweeteners that substitute for sugar. Companies in the United States that refine sugar and corn sweeteners also benefit. But candy and beveragecompanies that use sweeteners pay higher prices, which they pass on to millionsof consumers who buy their products. However, these higher prices are spreadacross so many consumers that the increased cost for any one is very small. Ittherefore does not pay a consumer to spend much time, money, or effort tooppose the import barriers.
For sugar growers and refiners,of course, the higher price of sugar and the greater quantity of sugar they canproduce and sell makes the import barriers something they value greatly. It isclearly in their interest to hire lobbyists and write letters to electedofficials supporting these programs. When these officials hear from the peoplewho benefit from the policies, but not from those who bear the costs, they maywell decide to vote for the import restrictions. This can happen despite thefact 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 sugarproducers.

Special interest groups and issues are facts of lifein 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 oflobbying groups that have large offices near the capitol building. Or simplylook at the list of trade and professional associations in the yellow pages forthose cities. These lobbying groups are important and useful to the politicalprocess in many ways. They provide information on issues and legislationaffecting their interests. But these special interest groups also favorlegislation that often benefits their members at the expense of the overallpublic 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 lessthan 5 percent of total GDP in the early 1930s. In 1995 they made up 22percent. State, county, and local government revenues represent an additional15 percent of GDP.

Although overall government revenues and spending aresomewhat lower in the United States than they are in many other industrializedmarket economies, it is still important to consider why the size of governmenthas increased so rapidly during the 20th century. The general answer is thatthe citizens of the United States have elected representatives who have votedto increase government spending on a variety of programs and to approve thetaxes required to pay for these programs.
Actually, government spendinghas increased since the 1930s for a number of specific reasons. First, thedifferent branches of government began to provide services that improved theeconomic security of individuals and families. These services include SocialSecurity and Medicare for the elderly, as well as health care, food stamps, andsubsidized housing programs for low-income families. In addition, newtechnology increased the cost of some government services; for example,sophisticated new weapons boosted the cost of national defense. As the economygrew, so did demand for the government to provide more and bettertransportation services, such as super highways and modern airports. As thepopulation increased and became more prosperous, demand grew forgovernment-financed universities, museums, parks, and arts programs. In otherwords, as incomes rose in the United States, people became more willing to betaxed to support more of the kinds of programs that government agenciesprovide.
Social changes have alsocontributed to the growing role of government. As the structure of U.S. families changed, the government has increasingly taken over services that were onceprovided mainly by families. For instance, in past times, families providedhousing and health care for their elderly. Today, extended families withseveral generations living together are rare, partly because workers move moreoften than they did in the past to take new jobs. Also the elderly live longertoday than they once did, and often require much more sophisticated andexpensive forms of medical care. Furthermore, once the government began toprovide 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 sharpreductions in the current size and scope of government. Reliance on a marketsystem implies a limited role for government and identifies fairly specifickinds of things for the government to do in the economy. Private households andbusinesses are expected to make most economic decisions. It is also true thatif taxes and other government revenues take too large a share of personalincome, incentives to work, save, and invest are diminished, which hurts theoverall performance of the economy. But these general principles do notestablish precise guidelines on how large or small a role the government shouldplay in a market economy. Judging the effectiveness of any current or proposedgovernment program requires a careful analysis of the additional benefits andcosts of the program. And ultimately, of course, the size of government issomething that U.S. citizens decide through democratic elections.
    IX           IMPACT OF THE WORLD ECONOMY  Today, virtually every country in the world is affected bywhat happens in other countries. Some of these effects are a result ofpolitical events, such as the overthrow of one government in favor of another.But a great deal of the interdependence among the nations is economic innature, based on the production and trading of goods and services.
One of the most rapidly growingand changing sectors of the U.S. economy involves trade with other nations. Inrecent decades, the level of goods and services imported from other countriesby U.S. consumers, businesses, and government agencies has increaseddramatically. But so, too, has the level of U.S. goods and services sold asexports to consumers, businesses, and government agencies in other nations.This international trade and the policies that encourage or restrict the growthof imports and exports have wide-ranging effects on the U.S. economy.

As the nation with the world’s largest economy, theUnited States plays a key role on the international political and economicstages. The United States is also the largest trading nation in the world,exporting and importing more goods and services than any other country… Somepeople 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 beenhurt by international competition, in general economists view internationaltrade like any other kind of voluntary trade: Both parties can gain, andusually do. International trade increases the total level of production andconsumption in the world, lowers the costs of production and prices thatconsumers pay, and increases standards of living. How does that happen?
All over the world, peoplespecialize in producing particular goods and services, then trade with othersto 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 peopledoctors, butchers, bakers, and teachers than it is for each person to try tomake or do all of the things he or she consumes.
In earlier centuries, themajority of trade took place between individuals living in the same town orcity. Later, as transportation and communications networks improved,individuals began to trade more frequently with people in other places. The industrialrevolution that began in the 18th century greatly increased the volume of goodsthat could be shipped to other cities and regions, and eventually to othernations. As people became more prosperous, they also traveled more to othercountries and began to demand the new products they encountered during theirtravels.
The basic motivation andbenefits of international trade are actually no different from those that leadto trade within a nation. But international trade differs from trade within anation in two major ways. First, international trade involves at least twonational currencies, which must usually be exchanged before goods and servicescan be imported or exported. Second, nations sometimes impose barriers oninternational trade that they do not impose on trade that occurs entirelyinside 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 servicesfrom other countries that U.S. citizens or firms purchase are imports for theUnited States. Like almost all of the other nations of the world, the UnitedStates has seen a rapid increase in both its imports and exports over the lastseveral decades. In 1959 the combined value of U.S. imports and exportsamounted 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 tradesector 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 andexports. While it is true that the U.S. imports some things that are only foundor grown in other parts of the world, most trade involves products that couldbe made in the United States or any other industrialized market economies. Infact, some products that are now imported, such as clothing and textiles, wereonce manufactured extensively in the United States. However, economists note thatjust because things were or could be made in a country does not mean that theyshould be made there.
Just as individuals canincrease their standard of living by specializing in the production of thethings they do best, nations also specialize in the products they can make mostefficiently. The kinds of goods and services that the United States can producemost competitively for export are determined by its resources. The UnitedStates has a great deal of fertile land, is the most technologically advancednation in the world, and has a highly educated and skilled labor force. Thatexplains why U.S. companies produce and export many agricultural products aswell as sophisticated machines, such as commercial jets and medical diagnosticequipment.

Many other nations have lower labor costs than the United States, which allows them to export goods that require a lot of labor, such asshoes, clothing, and textiles. But even in trading with other industrializedcountries—whose workers are similarly well educated, trained, and highlypaid—the United States finds it advantageous to export some high-tech productsor professional services and to import others. For example, the United Statesboth imports and exports commercial airplanes, automobiles, and various kindsof computer products. These trading patterns arise because within thesecategories of goods, production is further specialized into particular kinds ofairplanes, automobiles, and computer products. For example, automobilemanufacturers in one nation may focus production primarily on trucks andutility vehicles, while the automobile industries in other countries may focuson sport cars or compact vehicles.
Greater specialization allowsproducers to take full advantage of economies of scale. Manufacturers can buildlarge factories geared toward production of specialized inventories, ratherthan spending extra resources on factory equipment needed to produce a widevariety of goods. Also, by selling more of their products to a greater numberof consumers in global markets, manufacturers can produce enough to makespecialization profitable.
The United States enjoyed aspecial advantage in the availability of factories, machinery, and othercapital goods after World War II ended in 1945. During the following decade ortwo, many of the other industrial nations were recovering from the devastationof the war. But that situation has largely disappeared, and the quality of theU.S. labor force and the level of technological innovation in U.S. industryhave become more important in determining trade patterns and othercharacteristics of the U.S. economy. A skilled labor force and the ability ofbusinesses to develop or adapt new technologies are the key to high standardsof living in modern global economies, particularly in highly industrializednations. Workers with low levels of education and training will find itincreasingly difficult to earn high wages and salaries in any part of theworld, including the United States.
    B             Barriers to Trade  Despitethe mutual advantages of global trade, governments often adopt policies thatreduce or eliminate international trade in some markets. Historically, the mostimportant trade barriers have been tariffs (taxes on imports) and quotas(limits on the number of products that can be imported into a country). Inrecent decades, however, many countries have used product safety standards orlegal standards controlling the production or distribution of goods andservices to make it difficult for foreign businesses to sell in their markets.For example, Russia recently used health standards to limit imports of frozenchicken 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 reasonsfor limiting imports or exports of certain kinds of products—such as productsthat are vital to a nation’s national defense—economists generally view tradebarriers as hurting both importing and exporting nations. Although the tradebarriers protect workers and firms in industries competing with foreign firms,the costs of this protection to consumers and other businesses are typicallymuch higher than the benefits to the protected workers and firms. And in thelong run it usually becomes prohibitively expensive to continue this kind ofprotection. Instead it often makes more sense to end the trade barrier and helpworkers in industries that are hurt by the increased imports to relocate orretrain for jobs with firms that are competitive. In the United States, trade adjustment assistance payments were provided to steelworkers andautoworkers in the late 1970s, instead of imposing trade barriers on importedcars. Since then, these direct cash payments have been largely phased out infavor of retraining programs.
During recessions, whennational unemployment rates are high or rising, workers and firms facingcompetition from foreign companies usually want the government to adopt tradebarriers to protect their industries. But again, historical experience withsuch policies shows that they do not work. Perhaps the most famous example ofthese policies occurred during the Great Depression of the 1930s. The United States raised its tariffs and other trade barriers in legislation such as theSmoot-Hawley Act of 1930. Other nations imposed similar kinds of tradebarriers, and the overall result was to make the Great Depression even worse byreducing 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 thepost-war world. They set up the International Monetary Fund (IMF) in 1944 tostabilize 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 reducedtariffs and other trade barriers.

In 1947 the United States and many of its alliessigned the General Agreement on Tariffs and Trade (GATT), which was especiallysuccessful in reducing tariffs over the next five decades. In 1995 the membernations of the GATT founded the World Trade Organization (WTO), which set evengreater obligations on member countries to follow the rules established underGATT. It also established procedures and organizations to deal with disputesamong 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 closestneighbors and major trading partners, Canada and Mexico. The provisions of thisagreement took effect in 1994. Since then, studies by economists have foundthat NAFTA has benefited all three nations, although greater competition hasresulted in some factories closing. As a percentage of national income, thebenefits 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 avery large and prosperous domestic economy; therefore international trade is amuch smaller percentage of the U.S. economy than it is in many countries withmuch smaller domestic economies.
    D             Exchange Rates and the Balance of Payments  
Currencies from different nations are traded in theforeign 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 foreignexchange market. When people or firms in France want to buy goods and servicesmade in the United States they supply French francs to the foreign exchangemarket and create a demand for U.S. dollars.
Changes in people’s preferencesfor goods and services from other countries result in changes in the supply anddemand for different national currencies. Other factors also affect the supplyand demand for a national currency. These include the prices of goods andservices in a country, the country’s national inflation rate, its interestrates, and its investment opportunities. If people in other countries want tomake investments in the United States, they will demand more dollars. When thedemand for dollars increases faster than the supply of dollars on the exchangemarkets, the price of the dollar will rise against other national currencies.The dollar will fall, or depreciate, against other currencies when the supplyof dollars on the exchange market increases faster than the demand.
All international transactionsmade 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 isthe current account, which records transactions involving the purchase(imports) and sale (exports) of goods and services, interest payments paid toand received from people and firms in other nations, and net transfers (giftsand aid) paid to other nations. The second section is the capital account,which records investments in the United States made by people and firms fromother countries, and investments that U.S. citizens and firms make in othernations.
These two accounts mustbalance. When the United States runs a deficit on its current account, oftenbecause it imports more that it exports, that deficit must be offset by asurplus on its capital account. If foreign investments in the United States do not create a large enough surplus to cover the deficit on the currentaccount, the U.S. government must transfer currency and other financialreserves to the governments of the countries that have the current accountsurplus. In recent decades, the United States has usually had annual deficitsin its current account, with most of that deficit offset by a surplus offoreign investments in the U.S. economy.
Economists offer divergentviews on the persistent surpluses in the U.S. capital account. Some analystsview these surpluses as evidence that the United States must borrow fromforeigners to pay for importing more than it exports. Other analysts attributethe 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 thatforeign 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 foreignfunds are used. If they are used mainly to finance current consumption, theywill 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 primarilyto 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, manydifferent 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 worldpopulation 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 certainlycontinue to expand rapidly if current trade policies and rates of economicgrowth are maintained, which in turn will make competition in the production ofmany goods and services increasingly global in scope. Technological progress islikely to continue at least at current rates, and perhaps faster. How will allof this affect U.S. consumers, businesses, and government?
Over the next century, averagestandards of living in the United States will almost certainly rise, so that onaverage, people living at the end of the century are likely to be better off inmaterial terms than people are today. During the past century, the primaryreasons for the increase in living standards in the United States weretechnological progress, business investments in capital goods, and people’sinvestments in greater education and training (which were often subsidized bygovernment programs). There is no evident reason why these same factors willnot continue to be the most important reasons underlying changes in thestandard of living in the United States and other industrialized economies. Acomparatively small number of economists and scientists from other fields arguethat limited supplies of energy or of other natural resources will eventuallyslow or stop economic growth. Most, however, expect those limits to be offsetby discoveries of new deposits or new types of resources, by othertechnological breakthroughs, and by greater substitution of other products forthe increasingly scarce resources.
Although the U.S. economy willlikely remain the world’s largest national economy for many decades, it is farless certain that U.S. households will continue to enjoy the highest averagestandard of living among industrialized nations. A number of other nations haverapidly caught up to U.S. levels of income and per capita output over the lastfive decades of the 20th century. They did this partly by adopting technologiesand business practices that were first developed in the United States, or bydeveloping their own technological and managerial innovations. But in large part,these nations have caught up with the United States because of their higherrates of savings and investment, and in some cases, because of their strongersystems for elementary and secondary education and for training of workers.
Most U.S. workers and familieswill still be better off as the U.S. economy grows, even if some othereconomies are growing faster and becoming somewhat more prosperous, as measuredper capita. Certainly families in Britain today are far better off materiallythan they were 150 to 200 years ago, when Britain was the largest andwealthiest economy in the world, despite the fact that many other nations havesince surpassed the British economy in size and affluence.

A more important problem for the U.S. economy in thenext few decades is the unequal distribution of gains from growth in theeconomy. In recent decades, the wealth created by economic growth has not beenas evenly distributed as was the wealth created in earlier periods. Incomes forhighly educated and trained workers have risen faster than average, whileincomes for workers with low levels of education and training have notincreased and have even fallen for some groups of workers, after adjusting forinflation. Other industrialized market economies have also experienced risingdisparity between high-income and low-income families, but wages of low-incomeworkers have not actually fallen in real terms in those countries as they havein the United States.
In most industrialized nations,the demand for highly educated and trained workers has risen sharply in recentdecades. That happened in part because many kinds of jobs now require higherskill levels, but other factors were also important. New production methodsrequire workers to frequently and rapidly change what they do on the job. Theyalso increase the need for quality products and customer service and theability of employees to work in teams. Increased levels of competition,including competition from foreign producers, have put a higher premium onproducing high quality products.
Several other factors helpexplain why the relative position of low-income workers has fallen more in theUnited States than in other industrialized Western nations. The growth ofcollege 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 requirementsas immigration policies in many other nations have been. Also, governmentassistance 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 firsthalf of the 21st century. The U.S. population is growing most rapidly among thegroups that are most likely to have low incomes and experience some form ofdiscrimination. Children in these groups are less likely to attend college orto receive other educational opportunities that might help them acquirehigher-paying jobs.
The U.S. population will alsobe aging during this period. As people born during the baby boom of 1946 to1964 reach retirement age, the percentage of the population that is retiredwill increase sharply, while the percentage that is working will fall. The demandfor medical care and long-term care facilities will increase, and the number ofpeople drawing Social Security benefits will rise sharply. That will increasepressure on government budgets. Eventually, taxes to pay for these serviceswill have to be increased, or the level of these services provided by thegovernment will have to be cut back. Neither of those approaches will bepolitically popular.

A few economists have called for radical changes inthe Social Security system to deal with these problems. One suggestion has beento allow workers to save and invest in private retirement accounts rather thanpay into Social Security. Thus far, those approaches have not been consideredpolitically feasible or equitable. Current retirees strongly oppose changingthe system, as do people who fear that they will lose future benefits from aprogram they have paid taxes to support all their working lives. Others worrythat private accounts will not provide adequate retirement income forlow-income workers, or that the government will still be called on to supportthose who make bad investment choices in their private retirement accounts.
Political and economic eventsthat 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 internationaltrade and the unique U.S. position as an economic, military, and politicalsuperpower. The 1991 breakup of the Union of Soviet Socialist Republics (USSR)—perhaps the most dramatic international event to unfold since World War II—haspresented new opportunities for economic trade and cooperation. But it also hasposed new challenges in dealing with the turbulent political and economicsituations that exist in many of the independent nations that emerged from thebreakup. Some fledgling democracies in Africa are similarly volatile.
Many U.S. firms are eager tosell their products to consumers and firms in these nations, and U.S. banks and other financial institutions are eager to lend funds to support investmentsin these countries, if they can be reasonably sure that these loans will berepaid. But there are economic risks to doing business in these countries,including inflation, low income levels, high crime rates, and frequentgovernment and company defaults on loans. Also, political upheavals sometimesbring to power leaders who oppose market reforms.
The greater political andeconomic unification of nations in the European Union (EU) offers differentkinds of issues. There is much less risk of inflation, crime, and politicalupheaval to contend with in this area. On the other hand, there is morecompetition to face from well-established and technologically sophisticatedfirms, and more concern that the EU will put trade barriers on products producedin 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 positionwith those nations. It will also look to the EU to act as an ally in settlinginternational policies in political and economic arenas, such as a peaceinitiative in the Middle East and treaties on international trade andenvironmental issues.
The United States has othermajor economic and political interests in the Middle East, Asia, and around theworld. China is likely to become an even larger trading partner and anincreasingly important political power in the world. Other Asian nations,including Japan, Korea, Indonesia, and the Philippines, are also importanttrading partners, and in some cases strong political and national securityallies, 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 evenlarger role over the next century in both economic and political affairs.
It may once have been possiblefor the United States to practice an isolationist policy by developing aneconomy largely cut off from foreign trade and international relations, butthat possibility is no longer feasible, nor is it advisable. Economic andtechnological developments have made the world’s nations increasinglyinterdependent.

Greater world trade and cooperation offer an enormousrange of mutually beneficial activities. Trading with other countriesinevitably increases opportunities for travel and cultural exchange, as well asbusiness opportunities. In a very broad sense, nations that buy and sell goodsand services with each other also have a greater stake in other forms ofpeaceful cooperation, and in seeing other countries prosper and grow.
On the other hand, globalinterdependence also raises major problems—political, economic, and environmental—thatrequire international solutions. Many of these problems, such as pollution,global warming, and assistance for developing nations, have been controversialeven 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 theproductive capacity of the U.S. economy and the wisdom of U.S. citizens and their political leaders.
No nation has ever had the richsupply of resources to face the future that the U.S. economy has as it entersthe 21st century. Despite that, or perhaps because of it, U.S. consumers, businesses, and political leaders are still trying to do more than earliergenerations of citizens.
    XI           CHIEF GOODS AND SERVICES OF THE U.S. ECONOMY  
The U.S. economy, the largest in the world, producesmany different goods and services. This can be seen more easily by dividingeconomic activities into four sectors that produce different kinds of goods andservices. The first sector provides goods that come directly from naturalresources: agriculture, forestry, fishing, and mining. The second sectorincludes 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, governmentservices, transportation, entertainment, tourism, and other businesses thatprovide a wide variety of services to individuals and businesses. The fourthmajor economic sector deals with the recording, processing, and transmission ofinformation, and includes the communications industry.
    A             Natural Resource Sector  
The United States, more than most countries, enjoys awide array of natural resources. Agricultural output in the United States has historically been among the highest in the world. Rich fishing groundsand coastal habitats provide abundant seafood. Companies harvest the nation’slarge reserves of timber to use in wood products and housing. Major mineralresources—including iron ore, lead, and copper, as well as energy resourcessuch as coal, crude oil, and natural gas—are abundant in the United States.
    A1          Agriculture  
The United States contains some of the best croplandin the world. Cultivated farmland constitutes 19 percent of the land area ofthe country and makes the United States the world’s richest agriculturalnation. In part because of the nation’s favorable climate, soil, and waterconditions, farmers produce huge quantities of agricultural commodities and avariety 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 sugarcane, potatoes, peanuts, and beet sugar. It ranks fourth in the world in cattleproduction and second in hogs. The total annual value of farm output increasedfrom $55 billion in 1970 to $202 billion in 1996. Farmers in the United Statesnot only produce enough food to feed the nation’s population, they also exportmore 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 percentof annual GDP and employed only 3 percent of the workforce in 1998.

During the 20th century, many Americans moved fromrural to urban areas of the United States, resulting in large populationdecreases in farming regions. Even though the number of farms has beendeclining since the 1930s, overall production has increased because of moreefficient operations. Bigger farms, operated as large businesses, haveincreasingly replaced small family farms. The owners of larger farms makegreater use of modern machinery and other equipment. By the 1990s, farmoperations 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 smallamounts of labor and land.

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

Cattle production is widespread throughout the UnitedStates. Texas leads in the production of range cattle, which are allowed tograze freely. Iowa and Illinois are important for nonrange feeder cattle, whichare cattle that eat feed grain provided by cattle farmers. The Dairy Beltcontinues to be concentrated in southern Wisconsin but is also prominent in therural landscapes of most northeastern states and fairly common in other states,too. Hog production tends to be concentrated in Iowa, Illinois, and surroundingstates, 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 heavilyin Iowa and Illinois and is also important in surrounding states, including Missouri, Indiana, Nebraska, and the southern regions of Minnesota and Wisconsin. Wheat isanother important U.S. crop. Kansas usually leads all states in yearly wheatproduction. 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 thepredominant cash crop in the South. Today, however, it is no longer importantin 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 moreimportant in the Mississippi Valley, the Panhandle of Texas, and the CentralValley 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, andgrapefruits—thrive in Florida, southern Texas, and southern California. Nutsgrow on irrigated land in the Central Valley of California and in parts ofsouthern California.
Production of specialty cropsand livestock has increased in recent years, particularly along the East andWest coasts and in the Southeast. Ranches in New York and Texas have introducedexotic game, such as emu, fallow deer, and nilgai and black buck antelope. Deerand antelope meat, known as venison, is served mainly in restaurants. Specialtyvegetable and fruit operations produce dwarf apples, brown and green cotton,canola, and jasmine rice. Farmers raise more than 60 specialty crops in theUnited 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’sworkforce was involved in the lumber industry, and forestry accounted for lessthan 0.5 percent of the nation’s gross domestic product (GDP). Nevertheless,forests represent a crucial resource for U.S. industry. Forest resources areused in producing housing, fuel, foodstuffs, and manufactured goods. The United States leads the world in lumber production and is second in the production of woodfor pulp and paper manufacture. These high production levels, however, do notsatisfy 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 ofthe eastern and northern portions of the country were fairly continuous.Beginning with the early colonists, the natural vegetation was altereddrastically as farmers cleared land for crops and pastures, and cut trees forfirewood and lumber. In the north and east, lumbermen quickly cut all of thevaluable trees before moving on to other locations. Only 10 percent of theoriginal virgin timber remains. Almost two thirds of the forests that remainhave 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 andbusinesses, including farmers, lumber companies, paper mills, and otherwood-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 (woodharvested from broad-leafed trees) about one-fourth. Nearly half the timberoutput is used for making lumber boards, and about one-third is converted topulpwood, which is subsequently used to manufacture paper. Most of the remainingoutput goes into plywood and veneer. Douglas fir and southern yellow pine arethe primary softwoods used in making lumber, and oak is the most importanthardwood.

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

Forests in the South supply about one-third of thelumber, 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 thesouthern 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 andparts of the Great Lakes area have excellent hardwood forests. Hickory, maple, oak, and other hardwoods removed from these forests provide fine woods forthe manufacture of furniture and other products.
In the 1990s the forestproducts industry was undergoing a transformation. New environmentalrequirements, designed to protect wildlife habitat and water resources, werechanging forest practices, particularly in the West. The amount of timber cuton 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 valuebetween fish and shellfish. Humans consume approximately 80 percent of thecatch as food. The remaining 20 percent goes into the manufacturing of productssuch as fish oil, fertilizers, and animal food.

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

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

Alaska leads allstates 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 includelobsters, scallops, clams, oysters, and cod; in the Chesapeake Bay, crabs; andin the Gulf of Mexico, menhaden and shrimp.
Much of the annual U.S. tonnage of commercial freshwater fish comes from aquatic farms. The most importantspecies raised on farms are catfish, trout, salmon, oysters, and crawfish. Thetotal annual output of private catfish and trout farms in the mid-1990s was235,800 metric tons, valued at more than $380 million. In the 1970s catfishfarming 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 infertilizers, and ranks second in gold, silver, copper, lead, natural gas, andcoal. Petroleum production is third in the world, after Russia and Saudi Arabia.
Mining contributes 1.5 percentof annual GDP and employs 0.5 percent of all U.S. workers. Although miningaccounts for only a small share of the nation’s economic output, it washistorically essential to U.S. industrial development and remains importanttoday. Coal and iron ore are the basis for the steel industry, which fabricatescomponents for manufactured items such as automobiles, appliances, machinery,and other basic products. Petroleum is refined into gasoline, heating oil, andthe petrochemicals used to make plastics, paint, pharmaceuticals, and syntheticfibers.

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, and13 percent of its crude oil. From 1990 to 1995, as the inflation-adjustedprices for these products declined, the extraction of these fossil fuelsdeclined, increasing U.S. dependence on foreign sources of oil and natural gas.

The United States contains huge fields of natural gasand oil. These fields are scattered across the country, with concentrations inthe 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 almost60 percent of the country’s natural gas production. Today, oil and natural gasare pumped to the surface, then sent by pipeline to refineries located in allparts of the nation. Offshore deposits account for 13 percent of totalproduction. Coal production, important for industry and for the generation ofelectric 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 oreis 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 ashematite, magnetite, and limonite, have been consumed. Leading industrialminerals include materials used in construction—mainly clays, lime, salt,phosphate rock, boron, and potassium salts. The United States also produceslarge percentages of the world’s output for a number of important minerals. In1997 the United States produced 42 percent of the world’s molybdenum, 34percent of its phosphate rock, 22 percent of its elemental sulfur, 17 percentof its copper, and 16 percent of its lead. Major deposits of many of theseminerals are found in the western states.
    B             Manufacturing and Energy Sector                 B1          Manufacturing  
The United States leads all nations in the value ofits yearly manufacturing output. Manufacturing employs about one-sixth of thenation’s workers and accounts for 17 percent of annual GDP. In 1996 the totalvalue added by manufacturing was $1.8 trillion. Value added is the price offinished goods minus the cost of the materials used to make them. Althoughmanufacturing remains a key component of the U.S. economy, it has declined inrelative importance since the late 1960s. From 1970 to 1995 the number ofemployees 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 theNortheast and North Central regions. The nation’s industrial core firstdeveloped in the Northeast. This area still has the greatest number ofindustrial firms, but its share of these firms is smaller than in the past. In1947 about 75 percent of the nation’s manufacturing employees lived in the 21Northeast and Midwest states that extend from New England to Kansas. By theearly 1990s, however, only about one-half of manufacturing employees resided inthe same region. Since 1947, the South’s share of the nation’s manufacturingworkers increased from 19 to 32 percent, and the West’s share grew from 7 to 18percent.

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

In the South the greatest gains in manufacturing havebeen in Texas. The most phenomenal growth in the West has been in California, which in the late 1990s was the leading manufacturing state, accounting formore than one-tenth of the annual value added by U.S. manufacturing. California dominates the Pacific region, which specializes in the production oftransportation equipment, food products, and electrical and electronicequipment.
    B1a        International Manufacturing  
United States industry has become much moreinternational in recent years. Most major industries are multinational, whichmeans that they not only market products in foreign countries but maintainproduction facilities and administrative headquarters in other nations. In thelate 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 foreigncountries. The practice of a company sending work to outside factories toreduce production costs is called outsourcing. Foreign outsourcing sendsproduction 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 plantsfinished the product and sent it back to the United States for sale.Outsourcing to Mexico became more widespread after the North American FreeTrade 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 weremade entirely within the United States. Although a product may be fabricated inthe United States, some component parts may have been produced in foreigncountries. Despite outsourcing and the international operations ofmultinational firms, the United States is still a major producer of thousandsof industrial items and has a comparative advantage over most foreign countriesin several industrial categories.
    B1b        Principal Products  
Ranked by value added by manufacturing, in 1996 the leadingcategories of U.S. manufactured goods were chemicals, industrial machinery,electronic equipment, processed foods, and transportation equipment. Thechemical industry accounted for about 11.1 percent of the overall annual valueadded by manufacturing. Texas and Louisiana are leaders in chemicalmanufacturing. The petroleum and natural gas produced and refined in bothstates are basic raw materials used in manufacturing many chemical products.

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

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

Food processing accounted for about 10.2 percent ofthe overall annual value added by manufacturing. Food processing is animportant industry in several states noted for the production of food crops andlivestock, or both. California has a large fruit- and vegetable-processingindustry. Meat-packing is important to agriculture in Illinois and dairyprocessing 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 bymanufacturing. Michigan, with its huge automobile industry, is a leadingproducer of transportation equipment.

The manufacture of fabricated metal and primary metalis concentrated in the nation’s industrial core region. Iron ore from the LakeSuperior district, plus that imported from Canada and other countries, andAppalachian coal are the basis for a large iron and steel industry.Pennsylvania, Ohio, Indiana, Illinois, and Michigan are leading states in thevalue of primary metal output. The fabricated metal industry, which includesthe manufacture of cans and other containers, hardware, and metal forgings andstampings, is important in the same states. The primary metals industry ofthese states provides the basic raw materials, especially steel, that are usedin making metal products.

Printing and publishing is a widespread industry,with newspapers published throughout the country. New York, with itsbook-publishing industry, is the leading state, but California, Illinois, andPennsylvania also have sizable printing and publishing industries.
The manufacture of paperproducts is important in several states, particularly those with large timberresources, especially softwood trees used to make most paper. The manufactureof paper and paperboard contributes significantly to the economies ofWisconsin, Alabama, Georgia, Washington, New York, Maine, and Pennsylvania.
Other major U.S. manufacturesinclude textiles, clothing, precision instruments, lumber, furniture, tobaccoproducts, leather goods, and stone, clay, and glass items.
    B2          Energy Production  
The energy to power the nation's economy—to providefuels for its vehicles and furnaces and electricity for its machinery and appliances—isderived primarily from petroleum, natural gas, and coal. Measured in terms ofheat-producing capacity (British thermal units, or Btu), petroleum provides 39percent of the total energy consumed in the United States. It supplies nearlyall of the energy used to power the nation’s transportation system and heatsmillions of houses and factories.

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

Waterpower generates 4 to 5 percent of the nation’senergy, and nuclear power supplies about 10 percent. Both are employed mainlyto produce electricity for residential and industrial use. Nuclear energy hasbeen viewed as an important alternative to expensive petroleum and natural gas,but its development has proceeded somewhat more slowly than originallyanticipated. People are reluctant to live near nuclear plants for fear of aradiation-releasing accident. Another obstacle to the expansion of nuclearpower use is that it is very expensive to dispose of radioactive material usedto power the plants. These nuclear fuel materials remain radioactive forthousands 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 generatingplants had a total installed capacity of 728,259 megawatts and produced 3.62trillion kilowatt-hours of electricity. Coal is the most common fuel used byelectric power plants, and 57 percent of the nation’s yearly electricity isgenerated in coal-fired plants. The states producing the most coal-generatedelectricity are Ohio, Texas, Indiana, Pennsylvania, Illinois, West Virginia, Kentucky, and Georgia.

Natural gas accounts for 9 percent of the electricityproduced, and refined petroleum for 2 percent. The states producing the mostelectricity from natural gas are Texas and California. Refined petroleum isespecially important in Florida, New York, and Massachusetts. The leadingproducers of hydroelectricity are Washington, Oregon, New York, and California. Illinois, Pennsylvania, South Carolina, and California have the largestnuclear power industries.

Petroleum is a key resource for an American lifestylebased on extensive use of private automobiles and trucks for commerce andbusinesses. Since 1947, when the United States became a net importer of oil,annual domestic production has not been enough to meet the demands of thehighly mobile American society.
In 1970 domestic crude-oilproduction reached a record high of 3.5 billion barrels, but this had to besupplemented by imports amounting to 12 percent of the nation’s overall crudeoil supply. Most Americans were unaware of the dependence of the country onforeign petroleum until an oil embargo imposed by some Middle Eastern nationsin 1973 and 1974 led to government price ceilings for gasoline and other energyproducts, which in turn led to shortages. In 1973 the nation imported aboutone-fourth of its total supply of crude oil. Imports continued to rise until1977, when about half of the crude and refined oil supply was imported. Importsthen declined for a time, largely because energy-conservation measures wereintroduced and because other domestic energy sources such as coal were usedincreasingly. 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 25percent of the world’s energy, far more than any other country, despite havingless than 5 percent of the world’s population. The United States also producesa 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 otherindustrialized nations, such as Japan and the countries of Western Europe. Thislower population density in the United States results in a greater consumptionof energy for transportation, as truck, trains, and planes are needed to movegoods and people to the far-flung American citizenry.
As a result of the nation’shigh energy consumption, the United States accounts for nearly 20 percent ofthe global emissions of greenhouse gases. These gases—carbon dioxide, methane,and oxides of nitrogen—result from the burning of fossil fuels, and they canhave a harmful effect on the environment.    C             Service and Commerce Sector  
By far the largest sector of the economy in terms ofoutput and employment is the service and commerce sector. This sector grewrapidly during the last part of the 20th century, creating many new jobs andmore than offsetting the slight loss of jobs in manufacturing industries. In1998 commerce and service industries generated 72 percent of the GDP andemployed 75 percent of the U.S. workforce. Most of these jobs are classified aswhite collar, and many require advanced education. They include manyhigh-paying jobs in financing, banking, education, and health services, as wellas lower-paying positions that require little educational background, such asretail store clerks, janitors, and fast-food restaurant workers.
    C1          Service Industries  Theservice sector is extremely diverse. It includes an assortment of privatebusinesses and government agencies that provide a wide spectrum of services tothe U.S. public. Services industries can be very different from each other,ranging from health-care providers to vacation resorts to automobile repairshops. Although it would be almost impossible to list every kind of serviceindustry operating in the United States, many of these businesses fall into oneof several large service categories.
    C1a        Banking and Financial Services  
In 1995 the U.S. financial market had a total of628,500 institutions, which employed 7.0 million people. These institutionsincluded investment, commercial, and savings banks; credit unions; mortgagebanks; insurance companies; mutual funds; real estate agencies; and variousholdings and trusts.
Banks play a central role inany economy since they act as intermediaries in the flow of money. They collectdeposits and distribute them as loans, allowing depositors to save for futureconsumption and allowing borrowers to invest. In 1998 the United States had 10,481 insured banks and savings institutions with a total of 84,123banking offices. Because of mergers and closures, the number of banks steadilydeclined in the 1980s and 1990s while the number of bank offices increased.Combined assets of insured banks and savings institutions totaled $5.44trillion in 1998.

Banking in the 1990s was a highly competitivebusiness, as banks offered a variety of services to attract customers andsought to stem the flow of investors to brokerage houses and insurance firms.Large banks in the United States, in terms of assets, include Chase ManhattanCorporation, Citibank, Morgan Guaranty Trust, and Bankers Trust, allheadquartered 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 $1.1trillion. SLAs are similar to banks, in that they accept deposits fromcustomers, but SLAs focus primarily on the housing and building industries bymaking loans to home buyers. The industry was substantially restructured in thelate 1980s and early 1990s after some prominent SLAs became insolvent largelybecause of falling real estate prices in some parts of the country.

In addition, a host of other professions offerfinancial services to individuals and corporations. Insurance companies provideinsurance 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 adviseconsumers on investing money. In addition, corporate finance managers,accountants, and tax consultants make recommendations on financial planning tobusinesses 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 billiontrips within the United States to destinations that were at least 100 miles(equivalent to 160 km) from home. In increasing numbers, domestic and foreigntravelers are visiting theme parks, natural wonders, and points of interest inmajor cities, and the convention business is booming. New York City is apopular destination, and tourism is a mainstay of the economies of California, Florida, and Hawaii.

In recent decades, visitors from overseas have becomean increasingly important part of the U.S. tourism business. In 1970 about 2.3million overseas visitors came to the United States, spending $889 million. By1997 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 $5billion.

America’s historicsites and national parks draw many visitors. In 1998, 287 million visits weremade to the more than 350 areas administered by the National Park Service.Millions of people each year visit the national monuments, buildings, andmuseums in the Washington, D.C., area. More than 14 million visits are madeannually 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 theeastern United States, Great Smoky Mountains National Park is the most popularnational park in the United States, receiving nearly 10 million visitorsannually.
    C1c        Transportation   
Transportation-related businesses are an importantpart of the service industry. Trucks, railroads, and ships transport goods tomarkets across the country. Commercial airlines, railroads, bus companies, andtaxis move tourists and commuters to their destinations. The U.S. PostalService and a number of private carriers deliver goods as well as mail toconsumers. The U.S. transportation network spreads into all sections of thecountry, but the web of railroads and highways is much denser in the easternhalf 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 privaterailroad companies were common during the 1980s and 1990s. Amtrak (the NationalRailroad Passenger Corporation), a federally subsidized organization, operatesalmost all the intercity passenger trains in the United States. It carried 20.2million passengers in 1997. Although rail passenger travel has declined inimportance during the 20th century, some U.S. cities still maintain extensivesubways 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, motorvehicle transport developed as a serious competitor of the railroads, both forpassengers and freight. Federal aid to states for highway construction beganwith the passage of the Federal-Aid Road Act of 1916.

The federal aid program was greatly expanded in 1956when the government began an ambitious expansion of the Interstate HighwaySystem, a 74,165-km (46,084-mi) network of limited-access highways thatconnects the nation’s principal cities. This carefully designed system enablesmotorists to drive across the country without encountering an intersection ortraffic 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. Thesystem is designed for safe, efficient driving, with gentle curves, easy gradesand long sight distances. Entering and exiting the highway system is permittedonly at planned interchanges.

Air transport began to compete with other modes oftransport in the United States after World War I (1914-1918). The firstcommercial flights in the United States were made in 1918 and carried smallamounts 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 ofcommercial jet craft after World War II. By the 1990s a growing number ofAmericans flew for personal and business travel, in part because of the need tocover long distances and in part because they like to get to their destinationsquickly. 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 smallairports across the nation formed a network providing air transportation toindividual travelers. The nation had 5,129 public and 13,263 private airportsin 1996. The largest airports in the United States by passenger arrivals anddepartures 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 commercialshipping fleet. In 1998 only 473 vessels of 1,000 gross tons and larger wereregistered in the United States. Only 56 percent were in use; most of the remainderformed part of a government-owned military reserve fleet. However, manyAmerican ship owners register their vessels in foreign countries such asLiberia and Panama, where crew wages, taxes, and operating costs are lower.
In terms of the number of shipsdocking, New Orleans, Louisiana, is the busiest port in the nation; each yearit handles more than 6,000 vessels. Other leading ports include LosAngeles-Long Beach, California; Houston, Texas; New York, New York; SanFrancisco-Oakland, California; Miami, Florida; and Philadelphia, Pennsylvania.Crude petroleum accounts for 22 percent of the waterborne tonnage of the UnitedStates. Petroleum products make up 18 percent. Coal accounts for 14 percent,and farm products for 14 percent.
The inland waterway network ofthe 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 trafficis 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 ofthe coastal waterways is the Intracoastal Waterway, a navigable, toll-freeshipping 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 travelson 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 27percent traveled by truck. However, other modes of transportation more easilyhandle special freight items. An additional 20 percent of all freight, byvolume, moved through pipelines, mainly oil and natural gas pipelinesoriginating in Texas and Louisiana with destinations in the Midwest and Northeast.Another 16 percent, mainly bulk commodities like coal, grain, and industriallimestone, moved by barge on inland waters.
    C1d        Government   
Federal, state, and local governments provide asizeable portion of services delivered in the nation. In 1996, governmentworkers made up 4 percent of all workers and together produced 12 percent ofGDP. Government services include items as such Social Security benefits,national defense, education, public welfare programs, law enforcement, and themaintenance 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 revenuesgrew from less than 5 percent of total GDP in the early 1930s to more than 20percent by the late 1990s. Much of this growth took place during two timeperiods. In the 1930s, following the economic downturn of the Great Depression, U.S. president Franklin D. Roosevelt instituted sweeping social programsdesigned to provide basic financial security to individuals and families. Manyof these programs, such as unemployment insurance and Social Security paymentsto 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-affluentAmericans. In addition, during the last half of the 20th century, governmentexpenditures increased for medical care and national defense as a result oftechnological advances. The cost of transportation construction also rose asthe growing population demanded more and better highway systems.
    C1e        Entertainment  
Another leading industry is the entertainmentbusiness. Motion picture production has been centered in Hollywood, California, since the early decades of the 20th century, when the budding motion pictureindustry discovered that the warm climate and sunny skies of southern California provided ideal conditions for film production. Other entertainment industriesinclude 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 Cityarea. .
    C2          Commerce  The 1990shave been years of unrivaled prosperity in the United States, with per capitaGDP reaching $30,450 by 1998. This high quality of life results partly from arapid 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 ofdifferent types of consumer goods. Products are being delivered to citizens ina more efficient manner, as industries and business firms have decentralized tomore closely fit the distribution of population. Malls have sprung up insuburban areas, making the downtown department store obsolete in many smallercities. Manufacturers also market their goods directly to customers in factoryoutlet malls. Prices are often lower in these outlets than in regular retailstores. Customers often travel hundreds of miles to shop at larger factoryoutlet malls. At the other end of the spectrum, mail order catalogs andInternet sites have made it possible for many consumers to purchase productsdirectly from companies by mail or using personal computers.
Wholesalers and retailers carryon most domestic commerce, or trade, in the United States. Wholesalers buygoods from producers and sell them mainly to retail business firms. Retailerssell goods to the final consumer. Wholesale and retail trade together accountfor 16 percent of annual GDP of the United States and employ 21 percent of thelabor force.

Wholesale establishments conducted aggregate annualsales of $3.2 trillion in 1992. The leading type of wholesale business is thedistribution of groceries and related products, which accounts for 16 percentof all wholesale activity. Next in rank are motor-vehicle parts and supplies;petroleum and petroleum products; professional and commercial equipment, andmachinery, equipment, and supplies. Wholesalers tend to be located in largeurban centers that enable them to distribute goods over wide sections of thenation. 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 themain regional center for the eastern United States. Other leading wholesalecenters include Los Angeles, the main center for the western part of the UnitedStates; Chicago; San Francisco; Philadelphia; Houston; Dallas; and Atlanta.
In the mid-1990s retailestablishments in the United States had aggregate annual sales of $2.2trillion. Automotive dealers, with 23 percent of the total yearly retail trade,and food stores, with 18 percent, are the leading retailers. The volume ofretail sales is directly related to the number of consumers in an area. Thefour 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 tradingnation, with total merchandise exports amounting to $683 billion, and importsto $944.6 billion. Despite its massive size, large population, and economicprosperity, the United States economy can provide a higher quality of life forconsumers and more opportunity for businesses by trading with other nations.Foreign, or international, trade enables the United States to specialize inproducing those goods that it is best suited to make given its availableresources. It then imports products that other nations can make moreefficiently, lowering prices of these goods for U.S. consumers.

Nonagricultural products usually account for 90percent of the yearly value of exports, and agricultural products account forabout 10 percent. Machinery and transportation equipment make up the leadingcategories of exports, amounting together to one-third of the value of allexports. Other leading exports include electrical equipment, chemicals, precisioninstruments, and food products. Beginning in the mid-1970s, the nation’simports 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 technologicalinnovations had been introduced in the United States. Communications satellitesorbited 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 manyaspects of daily life in the United States, from improvements in kitchenappliances to advances in medical treatment to television broadcasts that aretransmitted live via satellite from around the world.
An increasing number of jobopportunities are opening in fields related to the research and application ofnew technology. Entirely new industries have emerged, such as companies thatbuild the equipment used in space explorations. In addition, technology hasopened new opportunities for investment and employment in establishedindustries, such as those that manufacture medicines and machines used in thedetection and treatment of diseases and individuals who market and sellproducts via the Internet.
    D1          Communications  
The communications systems in the United States are among the most developed in the world. Television, radio, newspapers, andother publications, provide most of the country’s news and entertainment. Onaverage there are two radios and one television set for every person in the United States. Although the economic output of the communications industry is relativelysmall, the industry has enormous importance to the political, social, and intellectualactivity of the nation. Most communication media in the United States are privately owned and operate independently of government control.

The Federal Communications Commission must licenseall radio and television broadcasting stations in the United States. In 1997, 1,285 television broadcasters were in operation. All states hadtelevision stations, and more than 40 percent of the stations were concentratedin 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. Anestimated 98.3 percent of U.S. households had at least one television set.Telephone communication changed as cellular phones allowed people tocommunicate via telephone while away from their homes and businesses or whiletraveling. There were 69 million cellular phones in use in 1998.
There were 1,489 dailynewspapers published in the United States in 1998, 8 fewer than the yearbefore. Daily newspapers had a circulation of approximately 60.1 million copiesin 1998. The top daily newspapers in the United States according to circulationwere the Wall Street Journal (published in New York City), USA Today (publishedin Arlington, Virginia), theNew York Times, and the Los AngelesTimes, each with a circulation in excess of 1 million. Other leadingnewspapers included the Washington Post, the New York Daily News,the Chicago Tribune, the Detroit Free Press, the San FranciscoChronicle, the Chicago Sun-Times, the Dallas Morning News,the Boston Globe, and the Philadelphia Inquirer.
Nearly 21,300 periodicals werepublished in 1997. These ranged from specialized journals reaching only a smallnumber of professionals to major newsmagazines such as Time, with acirculation of 4.1 million a week, and Newsweek, with a circulation of3.2 million a week. Other mass publications with vast audiences included theweekly TV Guide, reaching 13.2 million readers, and the monthly Reader’sDigest, with a circulation of 15.1 million copies.
    D2          Technology
 One of themost far-reaching technological advances of the late 20th century took place inthe field of computer science. Computers developed from large, cumbersome, andexpensive machines to relatively small and affordable devices. The developmentof the personal computer (PC) in the 1970s made it possible for manyindividuals to own computers and allowed even small businesses to use computertechnology in their operations. The U.S. Bureau of the Census estimates thatjobs in the computer industry are growing at the fastest rate of any employmentarea, with job openings for computer specialists expected to double from 1996to 2006.
The Internet began in the 1960sas a small network of academic and government computers primarily involved inresearch for the U.S. military. Originally limited to researchers at a handfulof universities and government facilities, the Internet quickly became aworldwide network providing users with information on a range of subjects andallowing 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 andmore Americans were paying bills, shopping, ordering airline tickets, and purchasingstocks via computer over the Internet.
This article was written byMichael Watts, with the exception of the Chief Goods and Services of theU.S. Economy section, which he reviewed.