U.S. Economy

                           United States (Economy)

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

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

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

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

                            U.S. ECONOMIC SYSTEM

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

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

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

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

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

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

                            Factors of Production

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

                              Natural Resources

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

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


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

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


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


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

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

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

                     Acquiring the Factors of Production

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

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

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

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

                     Markets and the Problem of Scarcity

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

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

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

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

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

                              What Are Markets?

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

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

                          How a Single Market Works

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

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

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

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

               A System of Markets for All Goods and Services

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

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

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

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

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

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

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

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

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

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

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

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

                      How and Why Market Prices Change

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

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

                              Changes in Demand

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

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

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

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

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

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

                              Changes in Supply

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

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

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

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

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

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

                            Creative Destruction

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

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

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

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


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

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

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

                  Specialization and the Division of Labor

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

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

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

                        Advantages of Specialization

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

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

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

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

                   Specialization and International Trade

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

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

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

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

               Production Patterns: Past, Present, and Future

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

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

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

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

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

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

               Public Policies to “Protect” Firms and Workers

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

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

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

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

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

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

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


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

                      Proprietorships and Partnerships

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

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

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


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

                              Limited Liability

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

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

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

                     Separation of Ownership and Control

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

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

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

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

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

                 How Corporations Raise Funds for Investment

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

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

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

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

                          Entrepreneurs and Profits

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

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

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

                             Calculating Profits

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

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

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

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

                               Return on Sales

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

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

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

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

                              Return on Equity

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

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

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

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

                      CAPITAL, SAVINGS, AND INVESTMENT

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

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

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

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

                 Providing Funds for Investments in Capital

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

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

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

             Matching Borrowers and Lenders in Financial Markets

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

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

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

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

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

                         U.S. Household Savings Rate

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

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

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

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

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

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

                        Borrowing from Foreign Savers

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

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

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

                         MONEY AND FINANCIAL MARKETS

                     A     Money and the Value of Money

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

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

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

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

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

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

               The Federal Reserve System and Monetary Policy

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

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

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

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

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

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

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

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

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

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

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

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

               Effect of Monetary Policies on the U.S. Economy

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

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

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

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

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

                           LABOR AND LABOR MARKETS

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

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

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

                           Labor Supply and Demand

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

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

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

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

                       Factors Affecting Labor Markets

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

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

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


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

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

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


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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

                              Income Inequality

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

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

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

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

                         GOVERNMENT AND THE ECONOMY

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

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

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

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

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

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

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

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

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

                         Correcting Market Failures

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

                           Providing Public Goods

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

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

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

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

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

                  Adjusting for External Costs or Benefits

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

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

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

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

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

                           Maintaining Competition

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

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

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

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

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

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

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

                Promoting Full Employment and Price Stability

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

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

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

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

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

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

                     Limitations of Government Programs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

      A     U.S. Imports and Exports  

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

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

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

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

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

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

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

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

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

      C     World Trade Organization (WTO) and Its Predecessors  

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

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

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

      D     Exchange Rates and the Balance of Payments  

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

      A     Natural Resource Sector  

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

      A1    Agriculture  

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

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

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

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

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

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

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

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

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

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

      A2    Forestry  

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

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

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

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

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

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

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

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

      A3    Fishing  

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

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

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

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

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

      A4    Mining  

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

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

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

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

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

      B     Manufacturing and Energy Sector       B1    Manufacturing  

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

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

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

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

      B1a   International Manufacturing  

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

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

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

      B1b   Principal Products  

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

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

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

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

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

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

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

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

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

      B2    Energy Production  

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

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

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

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

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

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

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

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

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

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

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

      C1a   Banking and Financial Services  

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

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

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

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

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

      C1b   Travel and Tourism  

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

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

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

      C1c   Transportation   

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

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

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

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

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

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

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

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

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

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

      C1d   Government   

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

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

      C1e   Entertainment  

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

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

      C2a   Domestic Trade   

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

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

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

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

      C2b   Foreign Trade  

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

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

      D     Information and Technology Sector  

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

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

      D1    Communications  

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

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

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

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

      D2    Technology

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

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

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