U.S. Economy

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.

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.

economy.

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

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