U.S. Economy

encounter diseconomies of scale in which larger plants or production

sites become less efficient and more costly to operate. Usually that

happens because monitoring and managing increasingly larger production

facilities becomes more difficult. That is why most large manufacturers

have more than one factory to make their products, instead of one massive

facility where they make everything they produce. In recent years, many

steel companies have found it more efficient to build and operate smaller

steel mills than they once operated.

Specialization and International Trade

Over the past few decades, international trade has led to greater

specialization and competition among producers in the United States and

throughout the world. By selling worldwide, companies in the United

States and in other countries can reach many more customers.

Specialization is ultimately limited by the size of the market for a good

or service. In other words, larger markets always allow for greater

levels of specialization. For example, in small towns with few customers

to serve, there is often only one clothing store that carries a small

selection of many different kinds of clothing. In large cities with a

million or more potential customers, there are much larger clothing

stores with many more choices of items and styles, and even some stores

that sell only hats, gloves, or some other particular kind of clothing.

International trade is a dramatic way of expanding the size of a firm’s

market. In markets where transportation costs are low compared with the

selling price of a product, it has become possible for producers to

compete globally to take full advantage of highly specialized production.

But international trade also means that businesses must compete more

efficiently against firms from all around the world. That competition

also makes them try to take advantage of greater specialization and the

division of labor.

In many cases, products are produced and sold by firms from two or more

countries that have large production and employment levels in the same

industry. Often, however, these firms still specialize in the kinds of

products they produce. For example, though many small cars and small

pickup trucks are made in Japan and sent to the United States, large

pickups and four-wheel drive sport utility vehicles are often exported

from the United States to Japan and other nations. Similarly, the United

States exports large commercial passenger jets to most countries, but

imports many small jets from Canada, Brazil, and other nations. While

this may seem strange at first glance, it allows greater specialization

in production for particular kinds of products.

Transportation costs can also help to explain the pattern of

international production and trade. It often makes sense to produce goods

close to the markets where they will be sold, or close to where the

resources used in the production process are found or made. In recent

years, the availability of a skilled and hard-working labor force has

become more important to producers in many different industries, so new

factories are often located in areas with large numbers of well-trained

workers and good schools that provide a future supply of well-educated

workers.

Production Patterns: Past, Present, and Future

Several dramatic changes in production patterns occurred in the United

States during the 20th century. First, most employment shifted from

farming in rural areas to industrial jobs in cities and suburbs. Then,

during the second half of the century, production and employment patterns

changed again as a result of technological advances, increased levels of

world trade, and a rapid increase in the demand for services.

Technological changes in the transportation, communications, and computer

industries created entirely new kinds of jobs and businesses, and altered

the kinds of skills workers were expected to have in many others. World

trade led to increased specialization and competition, as businesses

adapted to meet the demands of international competition.

Perhaps the greatest change in the U.S. economy came with the nation’s

growing prosperity in the years following World War II (1939-1945). This

prosperity resulted in a population with more money to spend on services

and leisure activities. More people began dining out at restaurants,

taking vacations to far-off locations, and going to movies and other

forms of entertainment. As family incomes increased, a wealthier

population became more willing to pay others for services.

As a result of these developments, the closing decades of the 20th

century saw a dramatic increase in service industries in the United

States. In 1940 about 33 percent of U.S. employees worked in

manufacturing, and about 49 percent worked in service-producing

industries. By the late 1990s, only 26 percent worked in goods-producing

industries, and 74 percent worked in service-producing industries. This

change was driven by powerful market forces, including technological

change and increased levels of world trade, competition, and income.

Some observers worried that this growth of employment in service-

producing industries would result in declining living standards for most

U.S. workers, but in fact most of this growth has occurred in industries

where job skill requirements and wages have risen or at least remained

high. That is less surprising when you consider that this employment

includes business and repair services, entertainment and recreation

occupations, and professional and related services (including health

care, education, and legal services). United States consumers and

families are, on average, financially better off today than they were 50

or 100 years ago, and they have more leisure time, which is one of the

reasons why the demand for services has increased so rapidly.

During the 20th century, businesses and their workers had to adjust to

many changes in the kinds of goods and services people demanded. These

changes naturally led to changes in where jobs were available, and in

what kinds of education, training, and skills employees were expected to

have. As the base of employment in the United States has changed from

predominantly agriculture to manufacturing to services, individuals,

firms, and communities have faced often-difficult adjustments. Many

workers lost jobs in traditional occupations and had to seek employment

in jobs that required completely different sets of skills. Standards of

living declined in some communities whose economies centered on farming

or around large factories that shut down. In recent decades, populations

have decreased in some states where agriculture provides a significant

number of jobs. While high-technology industries in places such as

California's Silicon Valley were booming and attracting larger

populations, some textile and clothing factories in Southern and Midwest

states were closing their doors.

Public Policies to “Protect” Firms and Workers

Historically in the United States, the government has rarely stepped in

to protect individual businesses from changing levels of demand or

competition. There have been some notable exceptions, including the

federal government’s guarantee of $1.5 billion in loans to the Chrysler

Corporation, the nation’s third-largest automobile manufacturer, when it

faced bankruptcy in 1980.

Although direct financial assistance to corporations has been rare, the

government has provided subsidies or partial protection from

international competition to a large number of industries. Economic

analysis of these programs rarely finds such subsidies and protection to

be a good idea for the nation as a whole, though naturally the companies

and workers who receive the support are better off. But usually these

programs result in higher prices for consumers, higher taxes, and they

hurt other U.S. businesses and workers.

For example, in the 1980s the U.S. government negotiated limits on

Japanese car imports, and the price of new Japanese cars sold in the

United States increased by an average of $2,000. The price of new U.S.

cars also rose on average by about $1,000. Although the import limits did

save some jobs in the U.S. automobile industry, the total cost of saving

the jobs was several times higher than what workers earned from these

jobs. When fewer dollars are sent to Japan to buy new automobiles, the

Japanese companies and consumers also have fewer dollars to spend on U.S.

exports to Japan, such as grain, music cassettes and CDs, and commercial

passenger jets. So the protection from Japanese car imports hurt firms

and workers in U.S. export industries. Still other U.S. firms and workers

were hurt because some U.S. consumers spent more for cars and had less to

spend on other goods and services.

It is simply not possible to subsidize and protect everyone in the U.S.

economy from changes in consumer demands and technology, or from

international trade and competition. And while most people agree that the

government should subsidize the production of certain types of goods

required for national defense, such as electronic navigation and

surveillance systems, economists warn against the futility of trying to

protect large numbers of firms and workers from change and competition.

Typically such support cannot be sustained over the long run, when the

cost of protection and subsidies begins to mount up, except in cases

where producers and workers represent a strong special interest group

with enough political clout to maintain their special protection or

subsidies.

When the special protection or support is removed, the adjustments that

producers and workers often have to make then can be much more severe

than they would have been when the government programs were first

adopted. That has happened when price support programs for milk and other

agricultural products were phased out, and when policies that subsidized

U.S. oil production and limited imports of oil were dropped in the 1970s,

during the worldwide oil shortage.

For these reasons, if public assistance is provided to a particular

industry, economists are likely to favor only temporary payments to cover

some of the costs of relocation and retraining of workers. That policy

limits the cost of such assistance and leaves workers and firms free to

move their resources into whatever opportunities they believe will work

best for them.

Most producers in the United States and other market economies must face

competition every day. If they are successful, they stand to earn large

returns. But they also risk the possibility of failure and large losses.

The lure of profits and the risk of losses are both part of what makes

production in a market economy efficient and responsive to consumer

demands.

CORPORATIONS AND OTHER TYPES OF BUSINESSES

Three major types of firms carry out the production of goods and services

in the U.S. economy: sole proprietorships, partnerships, and

corporations. In 1995 the U.S. economy included 16.4 million

proprietorships, excluding farms; 1.6 million partnerships; and about 4.3

million corporations. The corporations, however, produce far more goods

and services than the proprietorships and partnerships combined.

Proprietorships and Partnerships

Sole proprietorships are typically owned and operated by one person or

family. The owner is personally responsible for all debts incurred by the

business, but the owner gets to keep any profits the firm earns, after

paying taxes. The owner’s liability or responsibility for paying debts

incurred by the business is considered unlimited. That is, any individual

or organization that is owed money by the business can claim all of the

business owner’s assets (such as personal savings and belongings), except

those protected under bankruptcy laws.

Normally when the person who owns or operates a proprietorship retires or

dies, the business is either sold to someone else, or simply closes down

after any creditors are paid. Many small retail businesses are operated

as sole proprietorships, often by people who also work part-time or even

full-time in other jobs. Some farms are operated as sole proprietorships,

though today corporations own many of the nation’s farms.

Partnerships are like sole proprietorships except that there are two or

more owners who have agreed to divide, in some proportion, the risks

taken and the profits earned by the firm. Legally, the partners still

face unlimited liability and may have their personal property and savings

claimed to pay off the business’s debts. There are fewer partnerships

than corporations or sole proprietorships in the United States, but

historically partnerships were widely used by certain professionals, such

as lawyers, architects, doctors, and dentists. During the 1980s and

1990s, however, the number of partnerships in the U.S. economy has grown

far more slowly than the number of sole proprietorships and corporations.

Even many of the professions that once operated predominantly as

partnerships have found it important to take advantage of the special

features of corporations.

Corporations

In the United States a corporation is chartered by one of the 50 states

as a legal body. That means it is, in law, a separate entity from its

owners, who own shares of stock in the corporation. In the United States,

corporate names often end with the abbreviation Inc., which stands for

incorporated and refers to the idea that the business is a separate legal

body.

Limited Liability

The key feature of corporations is limited liability. Unlike

proprietorships and partnerships, the owners of a corporation are not

personally responsible for any debts of the business. The only thing

stockholders risk by investing in a corporation is what they have paid

for their ownership shares, or stocks. Those who are owed money by the

corporation cannot claim stockholders’ savings and other personal assets,

even if the corporation goes into bankruptcy. Instead, the corporation is

a separate legal entity, with the right to enter into contracts, to sue

or be sued, and to continue to operate as long as it is profitable, which

could be hundreds of years.

When the stockholders who own the corporation die, their stock is part of

their estate and will be inherited by new owners. The corporation can go

on doing business and usually will, unless the corporation is a small,

closely held firm that is operated by one or two major stockholders. The

largest U.S. corporations often have millions of stockholders, with no

one person owning as much as 1 percent of the business. Limited liability

and the possibility of operating for hundreds of years make corporations

an attractive business structure, especially for large-scale operations

where millions or even billions of dollars may be at risk.

When a new corporation is formed, a legal document called a prospectus is

prepared to describe what the business will do, as well as who the

directors of the corporation and its major investors will be. Those who

buy this initial stock offering become the first owners of the

corporation, and their investments provide the funds that allow the

corporation to begin doing business.

Separation of Ownership and Control

The advantages of limited liability and of an unlimited number of years

to operate have made corporations the dominant form of business for large-

scale enterprises in the United States. However, there is one major

drawback to this form of business. With sole proprietorships, the owners

of the business are usually the same people who manage and operate the

business. But in large corporations, corporate officers manage the

business on behalf of the stockholders. This separation of management and

ownership creates a potential conflict of interest. In particular,

managers may care about their salaries, fringe benefits, or the size of

their offices and support staffs, or perhaps even the overall size of the

business they are running, more than they care about the stockholders’

profits.

The top managers of a corporation are appointed or dismissed by a

corporation’s board of directors, which represents stockholders’

interests. However, in practice, the board of directors is often made up

of people who were nominated by the top managers of the company. Members

of the board of directors are elected by a majority of voting

stockholders, but most stockholders vote for the nominees recommended by

the current board members. Stockholders can also vote by proxy—a process

in which they authorize someone else, usually the current board, to

decide how to vote for them.

There are, however, two strong forces that encourage the managers of a

corporation to act in stockholders’ interests. One is competition. Direct

competition from other firms that sell in the same markets forces a

corporation’s managers to make sound business decisions if they want the

business to remain competitive and profitable. The second is the threat

that if the corporation does not use its resources efficiently, it will

be taken over by a more efficient company that wants control of those

resources. If a corporation becomes financially unsound or is taken over

by a competing company, the top managers of the firm face the prospect of

being replaced. As a result, corporate managers will often act in the

best interests of a corporation’s stockholders in order to preserve their

own jobs and incomes.

In practice, the most common way for a takeover to occur is for one

company to purchase the stock of another company, or for the two

companies to merge by legal agreement under some new management

structure. Stock purchases are more common in what are called hostile

takeovers, where the company that is being taken over is fighting to

remain independent. Mergers are more common in friendly takeovers, where

two companies mutually agree that it makes sense for the companies to

combine. In 1996 there were over $556.3 billion worth of mergers and

acquisitions in the U.S. economy. Examples of mergers include the

purchase of Lotus Development Corporation, a computer software company,

by computer manufacturer International Business Machines Corporation

(IBM) and the acquisition of Miramax Films by entertainment and media

giant Walt Disney Company.

Takeovers by other firms became commonplace in the closing decades of the

20th century, and some research indicates that these takeovers made firms

operate more efficiently and profitably. Those outcomes have been good

news for shareholders and for consumers. In the long run, takeovers can

help protect a firm’s workers, too, because their jobs will be more

secure if the firm is operating efficiently. But initially takeovers

often result in job losses, which force many workers to relocate,

retrain, or in some cases retire sooner than they had planned. Such

workforce reductions happen because if a firm was not operating

efficiently, it was probably either operating in markets where it could

not compete effectively, or it was using too many workers and other

inputs to produce the goods and services it was selling. Sometimes

corporate mergers can result in job losses because management combines

and streamlines departments within the newly merged companies. Although

this streamlining leads to greater efficiency, it often results in fewer

jobs. In many cases, some workers are likely to be laid off and face a

period of unemployment until they can find work with another firm.

How Corporations Raise Funds for Investment

By investing in new issues of a company’s stock, shareholders provide the

funds for a company to begin new or expanded operations. However, most

stock sales do not involve new issues of stock. Instead, when someone who

owns stock decides to sell some or all of their shares, that stock is

typically traded on one of the national stock exchanges, which are

specialized markets for buying and selling stocks. In those transactions,

the person who sells the stock—not the corporation whose stock is

traded—receives the funds from that sale.

An existing corporation that wants to secure funds to expand its

operations has three options. It can issue new shares of stock, using the

process described earlier. That option will reduce the share of the

business that current stockholders own, so a majority of the current

stockholders have to approve the issue of new shares of stock. New issues

are often approved because if the expansion proves to be profitable, the

current stockholders are likely to benefit from higher stock prices and

increased dividends. Dividends are corporate profits that some companies

periodically pay out to shareholders.

The second way for a corporation to secure funds is by borrowing money

from banks, from other financial institutions, or from individuals. To do

this the corporation often issues bonds, which are legal obligations to

repay the amount of money borrowed, plus interest, at a designated time.

If a corporation goes out of business, it is legally required to pay off

any bonds it has issued before any money is returned to stockholders.

That means that stocks are riskier investments than bonds. On the other

hand, all a bondholder will ever receive is the amount of money specified

in the bond. Stockholders can enjoy much larger returns, if the

corporation is profitable.

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