C H A P T E R 1UNDERSTANDING THE U.S. BUSINESS SYSTEM

CHAPTER OVERVIEW

Businesses are organizations that produce or sell goods or services to make a profit. Profits are the difference between revenues and expenses. The prospect of earning profits encourages individuals and organizations to open and expand businesses, whose benefits also extend to wages paid to workers and to taxes that support government functions.

An economic system is a nation’s system for allocating its resources among citizens. Economic systems differ in terms of who owns or controls the five basic factors of production: labor, capital, entrepreneurs, physical resources, and information resources. In planned economies, the government controls all or most factors. In market economies, individuals and businesses control the factors and exchange them through input and output markets. Most countries today have mixed market economies that are dominated by one of these systems but include elements of the other. Privatization is an important means by which many planned economies are moving toward mixed market systems.

The U.S. is a market economy, based on the principles of capitalism, and propelled by the forces of demand and supply. Demand is the willingness and ability of buyers to purchase a good or service. Supply is the willingness and ability of producers to offer goods or services for sale. Demand and supply work together to set a market or equilibrium price at which the quantity of goods demand and supplied are equal.

Fundamentally, the U.S. economy is a private enterprise system, incorporating four key elements: private property rights, freedom of choice, profits, and competition. Degrees of competition vary because not all industries are equally competitive. Under conditions of pure competition, numerous small firms compete in a market governed entirely by demand and supply. An oligopoly involves a handful of sellers only. A monopoly has only one seller.

The rise of the factory system during the Industrial Revolution brought with it mass production and specialization of labor. During the entrepreneurial era in the 19 th century, huge corporations and monopolies emerged.

During the production era of the early 20th century, companies grew by emphasizing output and production. During the marketing era of the 1950s and 1960s, businesses began focusing on sales staff, advertising, and the need to produce what consumers wanted.

The global perspective of business emerged in the 1980s and continues today. The most recent developments are pointing toward an Internet era as perhaps the next major period in the evolution of business.

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CHAPTER OUTLINE

OPENING CASE: MEGAWATT LAUNDERING AND OTHER BRIGHT BUSINESS IDEAS

1. THE CONCEPT OF BUSINESS AND PROFIT

2. ECONOMIC SYSTEMS AROUND THE WORLDa. Factors of production

i. Labor or Human Resourcesii. Capital

iii. Entrepreneursiv. Physical resourcesv. Information resources

b. Types of economic systemsi. Planned economies

1. Communism2. Socialism

ii. Market economies1. Input and output markets2. Capitalism

iii. Mixed economies1. Privatization

3. THE ECONOMICS OF A MARKET SYSTEMa. Markets, demand, and supply

i. Laws of demand and supplyii. Demand and supply schedules

iii. Demand and supply curvesiv. Market or equilibrium pricev. Surpluses and shortages

b. Private enterprisei. Private property rights

ii. Freedom of choiceiii. Profitsiv. Competition

c. Competitioni. Perfect competition

ii. Monopolistic competitioniii. Oligopolyiv. Monopoly

4. HISTORY OF BUSINESS IN THE UNITED STATESa. The factory system and the industrial revolutionb. Laissez-faire and the entrepreneurial erac. The production era

i. Countervailing powersd. Marketing erae. Global eraf. Internet era

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LEARNING OBJECTIVES

1. Define the nature of U.S. business and identify its main goals and functions.2. Describe different types of global economic systems according to the means by which they

control the factors of production through input and output markets.3. Show how demand and supply affect resource distribution in the U.S.4. Identify the elements of private enterprise and explain the various degrees of competition in the

U.S. economic system.

LECTURE OUTLINE FOR POWERPOINT USERS

1. THE CONCEPT OF BUSINESS AND PROFITJerry Yang and David Filo of Yahoo! chose to start a new business—a profit-seeking activity that provides goods and services that consumers want. The driving force behind most businesses is the prospect of earning a profit, what remains after all expenses have been deducted from business revenue. While some businesses can weather short-term losses, successful businesses must earn long-term profits in order to survive. Businesses provide society with necessities:

They provide people with jobs and a means to prosper. They pay taxes that are used by the government to provide services for citizens.

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They reinvest their profits in the economy, thereby increasing a nation’s standard of living and quality of life for society as a whole.

Organizations such as schools, museums, public universities, and symphonies exist to provide society with a social or educational service and are known as not-for-profits. It is just as important for them to run effectively and efficiently to achieve their goals. Although there are differences between businesses and non-profit organizations, in particular, their goals are quite different, the same skills (management, marketing, finance, etc.) are needed to be successful in both arenas.

2. ECONOMIC SYSTEMS AROUND THE WORLD,How a business operates depends largely on the economic system of its home country. An economic system is essentially how a country chooses to allocate the resources that it uses to produce goods and services. These resources are referred to as the factors of production.

a. Factors of Productioni. Labor: The people who work for businesses. Labor includes both physical and

mental contributions. A country with a highly educated workforce is considered rich in this resource.

ii. Capital: The funds needed to create and operate a business. Sources include personal investment by owners, loans, sale of stock and bonds, and revenue from the sale of product.

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iii. Entrepreneurs: People who are willing to accept the risks that are part of creating and operating businesses, in return for the potential profits.

iv. Physical resources: Tangible things organizations use in the conduct of their business. Possibilities include natural resources, raw materials, office equipment and facilities, computers, transportation and communication infrastructure, etc.

v. Information resources: Data and other information used by business. This factor has become increasingly important in the last decade, as many businesses are not only using information in their production process, but also creating or repackaging information as their end product.

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b. Types of Economic SystemsDifferent types of economic systems manage the factors of production in different ways. Regardless of how they operate, all economic systems must answer the same basic questions. (1) How should resources be used to satisfy society’s needs? (2) What goods and services should be produced? (3) Who should produce them? (4) How should these goods and services be divided among the population? The three major categories are planned economies, market economies, and mixed economies.

i. Planned economy: An economy in which the government owns and operates all sources of production exists in countries that are communist. Communism is the planned system that allows individuals the least degree of economic freedom. The degree to which communism is practiced varies from one country to another. During the 1990s communism was renounced as both an economic and political system by most countries that practiced it. The only remaining communist systems are North Korea, the People’s Republic of China, Cuba, and Vietnam.

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ii. Market economy: An economic system in which buyers and sellers interact based on freedom of choice. In a free-market, or capitalist system, individuals are free to choose where to work, what to buy, and how much to pay. Producers are free to choose who to hire, what to produce, and how much to charge.

According to Adam Smith, an eighteenth-century philosopher, the market serves as a self-correcting mechanism—an “invisible hand” to ensure the production of goods that society wants, in the quantities wanted, without regulation of any kind. Examples of other countries with capitalist economies are Canada, Germany, and Japan.

1. Input and Output MarketsOne way of understanding a pure market economy is through the idea of input and output markets.

a. Input market: Market in which resources flow to firms from supplier households. Resources include labor, capital (e.g. some

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households invest in mutual funds, which in turn purchase stock, which in turn provide capital for companies), entrepreneurs, information (e.g. consumer buying patterns).

b. Output market: Market in which firms supply goods and services in response to demand from households.

2. Capitalism—Market economy that provides for private ownership of production and encourages entrepreneurship by offering profits as an incentive.

iii. Mixed Market EconomiesCapitalism is a fundamentally market based economy in which the government supports private ownership, and encourages entrepreneurship by offering after-tax profits as an incentive. In the real world, most economies are neither fully planned nor fully market, but rather they include elements of each—a mixed market economy.

1. Socialism—The worldwide trend continues to be toward the market end of the spectrum. Countries in the mid-range of the spectrum are typically socialist, embracing an economic system in which the government owns and operates only selected sources of production. As in a communist system, there is a high level of government planning and ownership of vital industries such as transportation, utilities, and steel. The government provides such social services as medical care, education, and subsidized housing. As in capitalist systems, socialism allows private ownership in industries not considered vital, and individuals may benefit from their own efforts. Examples of socialist countries are Great Britain, France, and India.

a. Privatization—Like communism, socialism has been embracing elements of capitalism in the past decade. Private ownership of basic industries is on the rise. For instance, Mexico and Chile are selling off state-owned enterprises such as national airlines and telephone companies. As many of these countries have moved more towards a market economy (e.g. England), they have engaged in privatization, the process of converting government enterprises into privately owned companies. However, many planned systems are finding that moving toward a free-market system and converting state-owned enterprises into world-class corporations is a formidable task.

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3. THE ECONOMICS OF A MARKET SYSTEMIn looking more closely at the U.S. economic system, we should start with the forces of demand and supply, which drive our market-based economy.

a. Demand and Supply in a Market EconomyThe forces of supply and demand combine with the profit motive in a free-market system to regulate what is produced and in what amounts.

i. The Laws of Demand and SupplyDemand refers to the quantity of a good or service that consumers will buy at a given time at various prices.Supply refers to the quantities of a good or service that producers will provide on a particular date at various prices.

1. The law of supply states that the higher the price, the more producers are willing to supply.

2. The law of demand says that the lower the price, the more consumers are willing to buy.

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ii. The Demand and Supply Schedule—Assessment of the relationships among different levels of demand and supply at different price levels.

iii. Demand and Supply CurvesDemand Curve—Graph showing how many units of a product will be demanded (bought) at different prices.Supply Curve—Graph showing how many units of a product will be supplied (offered for sale) at different prices.The equilibrium price, or market price, is the price at which the quantity of goods demanded is the same as the quantity supplied. This is the price that maximizes profits. Why?

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iv. Surpluses and ShortagesIf the actual price of a good were below the market price, demand would be higher than supply, creating a shortage. Producers would be leaving "money on the table" that they could be collecting if they simply increased the supply. Example: When PT Cruisers were introduced to the U.S. market, demand far outstripped supply. Poor sales projections cost DaimlerChrysler the opportunity to earn profits on all the additional PT Cruisers that it could have sold. If the actual price of a good were above the market price, supply would be higher than demand, creating a surplus. Producers would need to sell excess goods at a steep discount, dramatically reducing profitability.

However, in real life it is more complicated than that. To a large degree, it depends on the type of product being sold. For instance, when the price of gasoline or milk goes up, consumers won’t stop buying, although they may cut back. In broad terms, the theory of supply and demand regulates a free-market system by determining what is produced and in what amounts.

b. Private Enterprise and Competition in a Market EconomyPrivate enterprise is an economic system that allows individuals to pursue their own interests with minimal government restricts. It requires the presence of four elements:

i. Private property rights—Ownership of the resources used to create wealth is in the hands of individuals. Private property rights include both real and intellectual property.

ii. Freedom of choiceiii. Profits

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iv. Competition

c. Degrees of CompetitionCompetition motivates businesses to produce their products better or cheaper. Companies that don’t compete effectively will be forced out of business. While competition is a fundamental element of free enterprise, not all industries are equally competitive. Economists have identified four basic degrees of competition within a private enterprise system:

i. Perfect competition: Characterized by many competitors with virtually identical products, and few barriers to entry. No single firm has control over prices. The agricultural industry is a classic example of perfect competition. However, some groups of farmers within this industry have managed to differentiate their products, which has allowed them to exercise some control over price (e.g. California cheese, Chiquita bananas, Dole pineapples, Sunkist oranges).

ii. Monopolistic competition: Characterized by slightly fewer competitors with somewhat differentiated products, and modest barriers to entry. Individual firms have limited control over prices. Examples include fast food, detergent, clothing manufacturers, etc.

iii. Oligopoly: Characterized by few competitors and high barriers to entry. Product can be either similar or differentiated. Each firm has some control over prices. Examples include the automobile industry, the airline industry, the steel industry, etc.

iv. Monopoly: Characterized by one producer dominating the industry to the point of completely controlling prices. Monopolies are illegal in the U.S. because they undermine the competition that drives our economy (e.g. the recent Microsoft lawsuit). In the past, the government has sanctioned (and closely regulated) some natural monopolies, industries in which one producer can most efficiently supply all needed goods or services (e.g. natural gas, electricity, local phone service). But even these natural monopolies are gradually being deregulated to allow for competition. One natural monopoly that will never be deregulated: U.S. defense forces!

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4. A SHORT HISTORY OF BUSINESS IN THE UNITED STATESa. The Factory System and the Industrial Revolution

The Factory System and the Industrial Revolution, which began during the middle of the eighteenth century, forced hundreds of cottage workers to enter a centralized factory environment, and launched an era of mass production. This form of production reduced duplication of equipment and allowed firms to purchase raw materials at better prices. It also encouraged specialization of labor.

A number of developments made possible the transportation of products to distant markets. Among the most important of these developments was improved financing through the U.S. banking system, and improved transportation through the opening of the Erie Canal and the development of the railroads.

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b. Laissez-Faire and the Entrepreneurial EraAlso contributing to the rise in entrepreneurship in this country was the Laissez-Faire principle. This principle states that the government should not interfere in the economy but should let business function without interference. A number of laws were passed during this era that helped improve business practices. These included the Sherman Antitrust Act and the Clayton Act.

c. The Production EraMass production and the assembly line are ascribed to the genius of Henry Ford (1863-1946). In the early 1900s, Ford used the principles of mass production to build the Model T, and used an army of workers to keep up with the moving assembly line. Mass production and specialization continued into the twentieth century. These factors, along with the focus on scientific management and the moving assembly line, helped usher in the Production Era.

The management thinker behind scientific management is Frederick Winslow Taylor. Beginning in 1881, he used a stopwatch to break down every step in the production process. He wrote: “In the past the man was first. In the future the system must be first.”

i. The Concept of Countervailing PowersThe Production era also saw the rise of labor unions and collective bargaining, referred to as countervailing powers. In addition, the Great Depression of the 1930's and World War II prompted the government to intervene in commerce more so than it had done in the past.

d. The Marketing EraAfter World War II, the 1950's and 1960's were prosperous times. Production increase,

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technology advanced, and the standard of living rose. A new philosophy called the marketing concept emerged during this marketing era. This concept states that a business must focus on identifying and satisfying consumer wants in order to be profitable.

e. The Global EraIn the 1980s, the continuation of technological advances in production, computer technology, information systems, and communications capabilities created the emergence of a global economy. The global economy emerged during this era, as more Americans began to purchase foreign products, and American firms sold their products in more and more countries.

f. The Internet EraThe beginning of the twenty-first century marked what experts call the Internet Era. Approximately 450 of 1,000 people in the year 2000 used the Internet. Projections estimate that by the year 2005 that figure will increase to 750 users per 1000 people. The growth of the Internet has affected businesses in at least three different ways: (1) giving a dramatic boost to trade in all economic sectors, (2) leveling the playing field between larger and smaller enterprises, (3) building a networking mechanism among businesses

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