An Outline of the
American Economy

Part 1
Introduction

PART 4

A dominant theme in American history is the importance of economic opportunity for the individual. In the 17th and 18th centuries this took the form of public admiration of the pioneer, the individual or family that overcame great hardships to carve a home out of the wilderness. Combining all the moral qualities of the sturdy yeoman, the pioneer typically enjoyed the wide open spaces found in the vast American heartland. It is reported that Daniel Boone, legendary as an early American frontiersman, claimed that when he could see smoke from his neighbor's chimney, it was time for him to move farther west.

In 19th- and 20th-century America, the economic individualist was envisioned in rural settings as a homesteading farmer. As a city dweller, he was seen as a small merchant, independent craftsman or self-reliant professional.

But just what does entrepreneurship -- the formation of independent business -- mean in the United States?

The American frontier fostered the notion that "everybody is an entrepreneur," or that everybody has the right to try his hand. On the frontier, families could homestead their land, take it simply through "squatters' rights," or purchase it on credit and make payment over many years. Its huge expanse permitted the United States to become a nation of agricultural entrepreneurs. The dream of "being in business for oneself" evolved as the nation shifted from rural to urban and from farming to other types of business.

For many people, entrepreneurship retains the significance that 19th- and 20th-century Americans attached to "having a store," "being a plumber," or "having a medical practice." Tales of door-to-door peddlers becoming successful merchants are common in many U.S. families.

Many visitors from abroad are surprised to discover that the U.S. economy is by no means one dominated by giant corporations. The Internal Revenue Service, the tax-collecting agency of the federal Treasury Department, reported that in 1989 there were 13.5 million nonfarm sole proprietorships, 1.8 million partnerships and 4.2 million corporations in the United States -- a total of 19.5 million firms. The vast majority of these were small, having business receipts under $100,000 a year.

There are various ways of defining small and medium businesses, but according to the U.S. Small Business Administration (SBA), if a small business is defined as one employing fewer than 500 persons, then there are roughly as many people employed in small businesses in the United States as there are in large ones. (If small business is defined more narrowly, as employing fewer than 100 employees, about 36 percent of all workers are employed in small business.) Furthermore, small businesses (employing fewer than 500 employees) accounted for 60 percent of all new jobs created in the years between 1976 and 1988, according to the SBA. During the decade of the 1980s, there was a net growth of 7 million new businesses in the United States, about half of which were self-employed businesses. Self-employed businesses are famous for being able to respond almost instantly to changes in demand; for example, the SBA notes that the number of self-employed part-timers "took off like a rocket" in the 1970s, partly as a result of the energy crisis which caused large numbers of Americans to get into such sideline activities as cutting up trees in rural areas to sell as firewood in cities.

A notable trend of recent years has been the increase in numbers of women in small business activities. According to the SBA, the number of women-owned sole proprietorships more than doubled over the 1977-87 period, from 1.9 million to 4.4 million.

THE SOLE PROPRIETOR

Many businesses are sole proprietorships, firms owned and operated by a single person. When a person decides to open an independent business, that person is then entirely responsible for its success or failure. Any profits go to the owner; any losses are his or her responsibility as well. If the losses prove to be greater than the investment, the individual is responsible for paying them, even if this depletes all personal assets.

One of the advantages of a sole proprietorship is that an owner can make decisions quickly and decisively without having to consult others. And an individual proprietor, by law, pays fewer taxes and at a lower rate than does a corporation.

There are disadvantages to this form of business organization, however. A sole proprietorship ends with the incapacity or death of the owner. The assets can be inherited by a person who may then become the operator, but legally the business dies with its owner. Also, since it is dependent upon the amount of money the owner has saved or can borrow, usually it does not develop into a large-scale enterprise.

In spite of its limitations, the sole proprietorship is well adapted to many kinds of small businesses and suits the temperament of many persons who like to exercise initiative and be their own bosses. Some economic contributions of small business are:

• A small business is often the starting point for developing a new product or service. One person tries out an idea. If it is successful, the business grows, or the product may be bought by a larger firm.
• The small business can give an individual a chance to gain experience, which the person may use later on a larger scale.
• Small businesses are particularly well suited for meeting specialized local needs.
• Artisans can provide individualized products for customers who have grown weary of mass-produced goods.
• Small businesses provide a service where knowing one's customers is important.
• Sole proprietors are reassuring to customers who believe an individual who is accountable will do a good job.

Small businesses often grow into large ones, adding to the economic vitality of the nation. Small business advocates contend that 55 percent of American technical innovation comes from small- and medium-size businesses. Certainly, many of the creative innovators in the American computer industry, including those who built successful companies in what is now known as Silicon Valley, California, started out as "tinkerers" working on hand-assembled machines in their garages. They have become part of American business lore. By any measurement, small businesses are an important part of the ferment, the creativity, and the competition that provide new strength to the American economy.

Of course, it is true that small businesses often fail. But in the United States "failure" of a small business venture does not carry with it the social stigma or opprobrium for the failed entrepreneur that it does in some countries. Often, failure of a small business venture turns out to be a valuable learning experience for the entrepreneur, who may be more successful the second or third time. Unsuccessful attempts to start a business become part of the larger process of sorting out the market and making it more efficient, according to small business experts.

THE BUSINESS PARTNERSHIP

When a proprietor wants to expand a business, one way to do so is to form a partnership, a business formed for profit by two or more co-owners. The rights and duties of a partnership are regulated by laws of the state where it is formed and by a legal agreement entered into by the co-owners. Usually an agreement specifies the amount of money each is investing and the duties each partner assumes. A partnership agreement also may provide for a "silent partner" who does not take part in the management, but who invests money in the business.

The partnership has the advantage of pooling managerial talent. One partner may be qualified in production, another in marketing. The partnership, like individual ownership, is exempt from most of the reporting that the government requires of corporations. Furthermore, it has a favorable tax position when compared with the corporation. Federal taxes are paid by individual partners on their share of earnings; beyond that the business is not taxed.

A major disadvantage of the partnership is that each member is liable for all the debts of the partnership; the act of any partner is legally binding upon all the others. If one partner takes a large amount of money from the business and squanders it, the others must pay the debt. Partnerships suffer another major disadvantage: decision-making is shared. If partners have serious and constant disagreements, the business is bound to suffer.

Nonetheless, the partnership remains a vital part of the overall business economy. The Internal Revenue Service reported that between 1970 and 1982, there were approximately half as many business partnerships as corporations.

SMALL BUSINESS

Analysts of small business recognize that several economic factors tend to thwart this business form. To offset these factors, legislation was enacted creating the Small Business Administration, an independent federal agency. In Washington, D.C., and in regional offices around the country, trained specialists provide professional expertise and financial assistance to those wishing to form small businesses or to those already operating such businesses.

In a typical year, the SBA guarantees about $3.5 thousand-million of bank loans made to small businesses. These loans usually are for the purchase of plant, equipment and inventory.

A unique feature of the SBA is the management assistance that is offered to new or faltering businesses. In the SCORE program, successful entrepreneurs who are retired volunteer their services to help others. Working in conjunction with individual state agencies and universities, the SBA also operates about 700 Small Business Development Centers that provide technical and management assistance to new and existing small businesses.

The SBA makes a serious effort to fund programs for minorities, especially African-, Asian- and Hispanic-Americans. The agency also administers an aggressive program to identify international markets and joint venture opportunities for small businesses that have export potential.

In addition, the SBA is well known for its disaster relief program. Ever since its inception, the SBA has offered assistance to homeowners and business firms suffering physical damage as a result of floods, hurricanes, tornadoes and other natural disasters.

FRANCHISING AND CHAIN STORES

Franchising, a practice adaptable to small business, has increased greatly in recent years. A common practice in the restaurant business, franchising combines the economic efficiencies of the large corporation with the benefits of local ownership. In this transaction, a large company allows an individual or small group of entrepreneurs to use its name (often a distinct advertising advantage) and sometimes its products in exchange for a percentage of the profits. The entrepreneur, who is usually not an employee of the parent company, is responsible for the management and operation of one or several units of the larger chain. The individual owner or owners must also assume most of the risks connected with the enterprise.

Franchising has costs as well as benefits for the economy. The rise of the chain store has inhibited the development of single proprietorships and partnerships. Chain stores use mass methods -- buying in large quantities, selling a high volume and stressing self-service -- that make it possible to sell goods at lower prices than small-owner stores. Chain supermarkets, for example, using lower prices to attract customers, have driven out many independent small grocers.

Nonetheless, many independents do survive. Some individual proprietors join forces with others to form chains of independents or cooperatives. They pool their buying power or become independent franchises, and they often serve specialized or "niche" markets.

LARGE CORPORATIONS

Although there are many small- and medium-size corporations, bigger business units are needed to perform certain services in the vast American economy. Large corporations can supply goods and services to a greater number of people across a wider geographic area than small businesses. They serve consumers across the nation and across the world. Corporate products tend to cost less because of the large volume and small overhead costs per unit sold. Moreover, consumers benefit from the availability of corporate "brand names," which they recognize as guaranteeing a certain level of quality wherever purchased.

Large corporations also have the financial strength to research, develop and produce new goods. Their scientific know-how, innovation and technical capability are critical to maintaining the nation's competitiveness and productivity.

In the United States, a corporation is a specific legal form of organization of persons and resources chartered by one of the 50 states for the purpose of conducting business. When people and resources are brought together to form a corporation, the result -- in the eyes of the law -- is a person. (indeed, the Latin word corpus means "body" or "person.") A U.S. corporation, distinct from any individual human being, may own property, sue or be sued in court and make contracts. For this reason, a corporation is an ideal vehicle for the conduct of business by many smaller enterprises as well as larger ones.

Some 500 major corporations occupy an important role in American business, although in some respects it has been a declining one. From 1978 to 1990, the profits of these 500 firms taken together have risen from $61.5 thousand-million to $93.3 thousand-million and assets have risen from $898.5 thousand-million to $2,298.6 thousand-million. In 1990 some 12.4 million people were employed by these firms, 1 million fewer than in 1986.

HOW CORPORATIONS RAISE CAPITAL

The large corporation has grown to its present size in part because it has found innovative ways to raise new capital for further expansion. Five primary methods used by corporations to raise new capital are:

ISSUING BONDS
A bond is a written promise to pay a specific amount of money at a certain date in the future or periodically over the course of a loan, during which time interest is paid at a fixed rate on specified dates. Should the holder of the bond wish to get back his money before the note is due, the bond may be sold to someone else. When the bond reaches "maturity," the company promises to pay back the principal at its face value.

Bonds are desirable for the company because the interest rate is lower than in most other types of borrowing. Also, interest paid on bonds is a tax deductible business expense for the corporation. The disadvantage is that interest payments ordinarily are made on bonds even when no profits are earned. For this reason, a smaller corporation can seldom raise much capital by issuing bonds.

SALES OF COMMON STOCK
Holders of bonds have lent money to the company, but they have no voice in its affairs, nor do they share in profits or losses. Quite the reverse is true for what are known as "equity" investors who buy common stock. They own shares in the corporation and have certain legal rights including, in most cases, the right to vote for the board of directors who actually manage the company. But they receive no dividends until interest payments are made on outstanding bonds.

If a company's financial health is good and its assets sufficient, it can create capital by voting to issue additional shares of common stock. For a large company, an investment banker agrees to guarantee the purchase of a new stock issue at a set price. If the market refuses to buy the issue at a minimum price, the banker will take them and absorb the loss. Like printing paper money, issuing too much stock diminishes the basic value of each share.

ISSUING PREFERRED STOCK
This stock pays a "preferred" dividend. That is, if profits are limited, the owners of preferred stock will be paid dividends before those with common stock. Legally, the owners of this stock stand next in line to the bondholders in getting paid. A company may choose to issue new preferred stock when additional capital is desired.

BORROWING
Companies can also raise short-term capital -- usually working capital to finance inventories -- in a variety of ways, such as by borrowing from lending institutions, primarily banks, insurance companies and savings-and-loan establishments. The borrower must pay the lender interest on the loan at a rate determined by competitive market forces. The rate of interest charged by a lender can be influenced by the amount of funds in the overall money supply available for loans. If money is scarce, interest rates will tend to rise because those seeking loans will be competing for funds. If plenty of money is available for loans, the rate will tend to move downward.

If the corporate borrower finds that it needs to raise additional money, it can refinance an existing loan. In this transaction the lender is essentially lending more money to its debtor. But if interest rates have gone up during the period since the original loan was secured, borrowers pay a higher rate in order to hold additional funds. Even if the rate has gone down, the lender benefits by having increased the size of its original loan at a lower rate of interest.

USING PROFITS
Some corporations pay out most of their profits in the form of dividends to their stockholders. Investors buy into these companies because they want a high income on a regular basis. But some other corporations, usually called "growth companies," prefer to take most of their profits and reinvest them in research and expansion. Persons who own such stocks are content to accept a smaller dividend or none at all, if by rapid growth the shares increase in price. These persons prefer to take the risk of obtaining a "capital gain," or rise in value of the stock, rather than be assured a steady dividend.

The typical corporation likes to keep a balance among these methods of raising money for expansion, frequently plowing back about half of the earnings into the business and paying out the other half as dividends. Unless some dividends are paid, investors may lose interest in the company.

ADVANTAGES AND DISADVANTAGES OF CORPORATIONS

The corporate form of business is a more flexible instrument for large-scale economic activity than the sole proprietorship or partnership.

First, because the corporation itself has legal standing, it safeguards its owners, relieving them of individual legal responsibility when they act as agents of the business.

Second, the owners of shares of stock have limited liability; they are not responsible for corporate debts. If a shareholder paid $100 for 10 shares of stock and the corporation goes bankrupt, he or she can only lose the $100 invested.

Third, corporate stock is transferable. Thus, the corporation is not damaged by the death or disinterest of a particular person. An owner of stock can sell his or her holdings at any time or pass the stock along to heirs.

Yet the corporate business organization has drawbacks as well as benefits.

One disadvantage relates to taxation. As a separate legal entity, the corporation must pay taxes. Unlike the treatment of interest on bonds, dividends paid to shareholders are not a tax deductible business expense for the corporation. When the corporation passes along profits to individuals in the form of dividends, the individuals are taxed again on these dividends. This is known as "double taxation."

Another cost results from the fact that ownership becomes separated from management. While this makes management easier, some managers are tempted to act more in their own interests than those of the stockholders.

SEPARATION OF OWNERSHIP AND CONTROL

Perhaps the most striking feature of the large corporation is its great number of shareholders (in effect, owners). A major company may be owned by a million or more people, many of whom own fewer than 100 shares. Typically, corporation directors and managers own less than 5 percent of the common stock. Blocks of stock often are owned or controlled by individuals, banks, or retirement funds, but these holdings usually account for only a fraction of the total. By the mid-1980s more than 40 million persons in the United States owned common stock.

With shareholders living in all parts of the country, it is impossible for them to know all details about their business and to manage it wisely. In this situation, effective direct control is in the hands of the corporation's board of directors.

Beyond making policy, the board places operational control in the hands of a chief executive officer (CEO). This person, who may be the chairman or president, usually supervises a number of vice presidents who manage various aspects of the corporation and report to the CEO. The chairman of the board is often an experienced executive who, together with the executive committee of the board, gives advice and approval to the president and many vice presidents. As long as the CEO has the confidence of the board of directors, he or she is permitted a great deal of freedom in the operation of the company.

The makeup and role of the board of directors varies from one company to another. Increasingly, only a minority of board members are internal officers of the corporation. Some directors are selected to give prestige to the board, others to provide certain skills or to represent lending institutions. It is not unusual for the same person to serve concurrently on several different corporate boards.

The board meets monthly or quarterly to consider policy related to operational decisions and to review accomplishments. At annual meetings new directors are added as needed and major policy decisions are made.

Until recent years only a few people would normally attend the annual corporation meetings. They would vote on the election of directors and certain other highly important matters by "proxy," that is by filling out a form and mailing it in. Now, it is not unusual for several hundred to attend. Often they ask management penetrating questions. In recent years the Securities and Exchange Commission (SEC) has ruled that every corporation must send a written notice of the annual meeting to each stockholder. Also, groups that challenge management must be permitted access to mailing lists of stockholders so that all sides can present their views.

When acting in concert, individual and institutional stockholders can have tremendous power over corporate management by selling or buying their shares to drive the price of the stock down or up. Sometimes, by backing dissidents, they can force a change in management.

THE THREAT OF MONOPOLY

In the late 19th century, the corporation was viewed by many as the chief instrument of monopoly. It was commonly argued that, by raising vast amounts of capital, corporations could combine or collude with competitors to control prices and inhibit genuine competition.

A monopoly exists in theory when one firm controls production and sale of total output of a commodity. In practice, however, a definition based on control of a specified percentage (often 33 percent) of total sales is often used.

In both theory and practice, large companies can become monopolies by absorbing smaller ones through stock purchases on the open market. The giants then raise prices, causing people who need their products to pay a larger amount than before.

U.S. companies are getting bigger -- current corporate giants with some $1 thousand-million of assets dwarf the giants of the late 19th century -- but it cannot be assumed that monopolistic conditions are increasing.

To be sure, in the last 100 years, many persons have been concerned about what is viewed as breakdown of domestic competition and control of basic industries by a few large corporations. Many basic industries -- the automotive and steel-producing industries, for example -- traditionally were "oligopolies" dominated by a few major corporations.

At the same time, in recent years, many large U.S. corporations have been shown to be vulnerable to new forms of competition. U.S. consumers can buy goods from foreign producers; in the case of automobile, they can purchase products made by Honda, Toyota, Hyundai or Volvo, to name a few. In many cases, consumers or producers can switch to substitutes; for example, they can use aluminum, glass, plastics or concrete instead of steel. In the newer industries, such as computers, small companies have shown themselves capable of moving faster to exploit new technologies than have giant corporations.

Some people argue that a concentration of economic power is dangerous because it may lead managers to put personal or corporate gain above public welfare. The U.S. government has tried to reap the advantages of large-scale organization while minimizing the dangers through legislation, such as the Interstate Commerce Act and the Sherman Antitrust Act. The Federal Trade Commission and the Antitrust Division of the Justice Department are mandated to watch for potential monopolies and to prevent mergers, or take steps to break up companies when a lack of competition can be demonstrated to hurt the consumer.

Anti-monopoly efforts will long be measured against the Justice Department's success in forcing the breakup of American Telephone and Telegraph Co. (AT&T), the world's largest and most prosperous telecommunications network. In 1974 the Justice Department sued AT&T for attempting to monopolize the telephone industry. In 1982 an agreement was announced whereby AT&T would divest itself of its 22 local operating companies, effective January 1, 1984. AT&T was allowed to retain the Western Electric Company (its manufacturing subsidiary), the Bell Telephone Laboratories (its research subsidiary) and its long-distance telephone business. In addition, it was allowed to expand into previously prohibited areas including data processing, telephone and computer equipment sales and computer communication devices. AT&T rapidly moved into the computer business; after some halting and mostly unsuccessful efforts, in 1991 it took over NCR Corp., one of the major American computer companies.

As a demonstration of the vigorous enforcement of U.S. antitrust laws and the effort to safeguard competition, the AT&T breakup was an unqualified success. Although AT&T continued to have about two-thirds of the long-distance telephone market in the early 1990s, it no longer held a monopoly. Vigorous competition was coming from such rivals as MCI Communications and U.S. Sprint Communications, neither of which had existed two decades earlier. Still, the breakup of AT&T remained a subject of controversy well into the 1990s, as divested parts of the corporation -- the so-called "Baby Bell" companies -- sought to enter entirely new businesses, and many residential and business telephone users worried about rising prices and what some regarded as less reliable telephone service. Still others, however, enthusiastically embraced expected benefits of rapid technological change in the traditional telephone system. The question of how much regulation was optimal -- for meeting producer and consumer needs -- was still being hotly debated in the 1990s.

GROWING LARGER, GROWING LEANER

In the 1980s U.S. industry underwent a wave of restructuring as corporations tried to position themselves to better compete. Mergers, takeovers, divestitures, joint ventures -- firms rushed to use these and other procedures, usually to discard unrelated product lines, to marry or buy up competitors and to rearrange finances in response to changing economic conditions (including new and more formidable foreign-competitors) and in hopes of restoring growth and prosperity.

The tools of restructuring can be used to diversify or concentrate product lines. A merger is the fusion of two or more companies into one when both the merging companies wish to join together, as distinct from a takeover which occurs against the wishes of one company. Management's rationale when moving to diversify is that it is unwise to have "all its eggs in one basket." If the demand for one product slackens, another line of business can provide balance.

A firm becomes a conglomerate when it expands into the production and sale of products quite different from those with which it was initially involved. A conglomerate is a business organization generally consisting of a holding company and a group of subsidiary companies engaged in dissimilar activities.

In recent years, a number of conglomerates have found that they have over-extended themselves, financially or by moving into fields where they lack competency. As a result, they have moved to divest themselves of losing acquisitions.

Much of this corporate activity is a response to the diversification trend that swept U.S. corporations in the late 1960s and early 1970s. At that time many ambitious companies acquired unrelated businesses at least in part in response to the strict enforcement of antitrust laws, which tended to make mergers between companies in the same field difficult. Over time however, business leaders found that managing such diverse enterprises was often difficult, less productive and less profitable than corporations with more narrowly defined product lines.

Many recent mergers are concentrated within specific industries, particularly in retailing, airlines and communications. In 1986 alone, May Department Stores acquired the Associated Dry Goods Corporation; General Electric Company purchased the RCA Corporation, and the Burroughs Corporation purchased the Sperry Corporation (a combination that was renamed Unisys).

Many firms also have tried to improve the competitiveness of their products through joint ventures with competitors. A joint venture between rivals does not involve a complete consolidation of their operations. Because joint ventures eliminate competition between firms in the field in which they decide to cooperate, it poses some of the same problems of potential monopoly. But joint ventures also yield benefits. For example, when the Federal Trade Commission voted to allow General Motors (GM) and Toyota to carry out a joint venture, part of its reasoning rested on the idea that the joint venture would enable GM to observe and absorb Japanese manufacturing technology and therefore to become a stronger competitor.

In addition, many American companies are joining together to cooperate in joint research and development activities. In the past, cooperative research, usually conducted through trade organizations, concentrated on ways of meeting environmental and health regulations. But now product development and manufacturing processes are being examined. Many U.S. firms are beginning to think they cannot afford the time and money to do all the research themselves, especially when manufacturers in other nations are cooperating with each other. Some of the major research consortiums include Semiconductor Research Corporation (33 members) and Software Productivity Consortium (14 members). A spectacular example of cooperation among fierce competitors occurred in 1991 when IBM Corporation, the world's largest computer company, agreed to work with Apple Computer, Inc., one of the leading producers of "personal" computers to create a new computer software operating system that could be used by a variety of different computers.

Despite all of the mergers and consolidations that have taken place in American business in recent years, the size of the average company has been declining. The reason is the huge number of new businesses formed each year, particularly those with fewer than 20 employees. Many fail, especially in times of recession, but others take their place.

DEVELOPMENT OF SERVICE AND INFORMATION INDUSTRIES

Over time the U.S. economy has become increasingly involved in the production of services, rather than goods. Service industries do not produce tangible objects, such as automobiles or refrigerators. Rather they provide services such as transportation, banking, insurance, tourism, communications, entertainment, data processing and consulting. In fact, many services -- such as computer, engineering, legal, accounting and advertising services -- are used in the production of goods.

Between 1950 and 1990, total U.S. employment grew from 48.5 million workers to 118 million workers. Most of the increase was in services; in the decade of the 1980s alone the service-producing sector had a net increase of 20 million jobs, which exceeded the net 19 million job increase in the overall economy. The two industries adding the most jobs were business services, including the advertising and computer and data processing industries, and health services. Twenty-seven percent of the net employment gain during the 1980s was in those two categories. Computer and data processing industries added nearly half a million jobs during the 1980s.

The growth in service-sector employment has absorbed labor resources freed by rising manufacturing productivity. Manufacturing productivity increased at an average rate of 4.5 percent from 1982 to 1990, which allowed manufacturing to retain a roughly constant share of U.S. gross national product (slightly over 20 percent), even though only about half of the 3 million manufacturing jobs lost during the severe recession of 1981-1982 were regained by 1990.

Most experts now dismiss the idea of a rapidly eroding U.S. industrial base. Instead they believe the statistics demonstrate that the structural shift in the U.S. economy, from goods-producing to service-producing industries, has been a relative one, which has occurred primarily in employment. For example, the goods-producing sector accounted for 41 percent of nonfarm employment in 1946, 28 percent in 1980, and only 23 percent in 1990. Of course, many of the new service jobs did not pay as highly as did manufacturing jobs, nor did they carry the same benefits. This put a squeeze on many family incomes and forced large numbers of women into the work force during the 1980s. This trend is likely to continue.

An Outline of the American Economy