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statement often has been ridiculed, he was largely right. When we peer inside the eco-
nomic machine that turns inputs into outputs, we see mainly private companies. Aston-
ishingly, the United States has more than 25 million business firms”about one for every
12 people!
The owners and managers of these businesses hire people, acquire or rent capital
goods, and arrange to produce things consumers want to buy. Sound simple? It isn™t. Over
80,000 businesses fail every year. A few succeed spectacularly. Some do both. Fortunately
for the U.S. economy, however, the lure of riches induces hundreds of thousands of peo-
ple to start new businesses every year”against the odds.
A number of the biggest firms do business all over the world, just as foreign-based
multinational corporations do business here. Indeed, some people claim that it is now
impossible to determine the true “nationality” of a multinational corporation”which
may have factories in ten or more countries, sell its wares all over the world, and
have stockholders in dozens of nations. (See the box “Is That an American Com-
pany?” on the next page). General Motors and Ford, for example, generate more prof-
its abroad than they do at home, and the Toyota you drive was probably assembled in
the U.S.
Firms compete with other companies in their industry. Most economists believe that
this competition is the key to industrial efficiency. A sole supplier of a commodity will find
it easy to make money, and may therefore fail to innovate or control costs. Its management
is liable to become relaxed and sloppy. But a company besieged by dozens of competitors
eager to take its business away must constantly seek ways to innovate, to cut costs, and to

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Part 1
32 Getting Acquainted with Economics

Is That an American Company?
Robert Reich, who was Secretary of Labor in the Clinton adminis- panel parts fabricated by Nissan at its Tennessee factory, and
tration, argued some years ago that it was already nearly impossi- then marketed by both Ford and Nissan in the United States and
ble to define the nationality of a multinational company. Although in Japan. Who is Ford? Nissan? Mazda?
many scholars think Reich exaggerated the point, no one doubts
that he had one”nor that the nationalities of corporations have
become increasingly blurred since then. He wrote in 1991:

What™s the difference between an “American” corporation that
makes or buys abroad much of what it sells around the world
and a “foreign” corporation that makes or buys in the United
States much of what it sells? . . . The mind struggles to keep the
players straight. In 1990, Canada™s Northern Telecom was sell-
ing to its American customers telecommunications equipment

SOURCE: © AP IMAGES/Greg Campbell
made by Japan™s NTT at NTT™s factory in North Carolina.
If you found that one too easy, try this: Beginning in 1991,
Japan™s Mazda would be producing Ford Probes at Mazda™s plant
in Flat Rock, Michigan. Some of these cars would be exported to
Japan and sold there under Ford™s trademark.
A Mazda-designed compact utility vehicle would be built at a
Ford plant in Louisville, Kentucky, and then sold at Mazda deal-
erships in the United States. Nissan, meanwhile, was designing
a new light truck at its San Diego, California, design center. The SOURCE: Robert B. Reich, The Work of Nations (New York: Knopf, 1991), pp.
trucks would be assembled at Ford™s Ohio truck plant, using 124, 131.

build a better mousetrap. The rewards for business success can be magnificent. But the
punishment for failure is severe.

Thus far, we have the following capsule summary of how the U.S. economy works:
More than 25 million private businesses, energized by the profit motive, employ about
150 million workers and about $30 trillion of capital. These firms bring their enormously
diverse wares to a bewildering variety of different markets, where they try to sell them
to over 300 million consumers.
It is in markets”places where goods and services are bought and sold”that these
millions of households and businesses meet to conduct transactions, as depicted in
Figure 11. Only a few of these markets are concrete physical locations, such as fish mar-
kets or stock exchanges. Most are more abstract “places,” where business may be
conducted by telephone or the Internet”even if the commodity being traded is a physical
object. For example, there are no centralized physical marketplaces for buying cars or com-
puters. But there are highly competitive markets for these goods nonetheless.
As Figure 11 suggests, firms use their receipts from selling goods and services in the
markets for outputs to pay wages to employees and interest and profits to the people who
provide capital in the markets for inputs. These income flows, in turn, enable consumers
to purchase the goods and services that companies produce. This circular flow of money,
goods, and factors of production lies at the center of the analysis of how the national
economy works. All these activities are linked by a series of interconnected markets,
some of which are highly competitive and others of which are less so.

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Chapter 2 33
The Economy: Myth and Reality

The Circular Flow of Goods and Money

Markets for Sale
es s re
it u r cei
d s
rvic e pts
en se
p s an
Ex and ds
s erv
Go ice


bo .
r, c c.
a pi et
t a l,
e tc.
In c e
, in
es Markets for ges

All very well and good. But the story leaves out something important: the role of
government, which is pervasive even in our decidedly free-market economy. Just what
does government do in the U.S. economy”and why?
Although an increasing number of tasks seem to get assigned to the state each year, the
traditional role of government in a market economy revolves around five jobs:
• Making and enforcing the laws
• Regulating business
• Providing certain goods and services such as national defense
• Levying taxes to pay for these goods and services
• Redistributing income
Every one of these tasks is steeped in controversy and surrounded by intense political
debate. We conclude this chapter with a brief look at each.

The Government as Referee
For the most part, power is diffused in our economy, and people “play by the rules.” But,
in the scramble for competitive advantage, disputes are bound to arise. Did Company A
live up to its contract? Who owns that disputed piece of property? In addition, some un-
scrupulous businesses are liable to step over the line now and then”as we saw in many
cases of fraud that helped bring on the debacle in sub-prime mortgages in 2007“2008.
Enter the government as rule maker, referee, and arbitrator. Congress and state and
local legislatures pass the laws that define the rules of the economic game. The executive
branches of all three governmental levels share the responsibility for enforcing them. And
the courts interpret the laws and adjudicate disputes.

The Government as Business Regulator
Nothing is pure in this world of ours. Even in “free-market” economies, governments
interfere with the workings of free markets in many ways and for myriad reasons. Some
government activities seek to make markets work better. For example, America™s
antitrust laws are used to protect competition against possible encroachment by monop-
oly. Some regulations seek to promote social objectives that unfettered markets do not
foster”environmental regulations are a particularly clear case. But, as critics like to
point out, some economic regulations have no clear rationale at all.

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Licensed to:
Part 1
34 Getting Acquainted with Economics

We mentioned earlier that the American belief in free enterprise runs deep. For this
reason, the regulatory role of government is more contentious here than in most other
countries. After all, Thomas Jefferson said that government is best that governs least.
Two hundred years later, Presidents Reagan, Bush (both of them), and Clinton all
pledged to dismantle inappropriate regulations”and sometimes did. But the financial
crisis of 2007“2008 has led to many calls for new and tighter regulations.

Government Expenditures
The most contentious political issues often involve taxing and spending because those
are the government™s most prominent roles. Democrats and Republicans, both in the
White House and in Congress, have frequently battled fiercely over the federal budget.
In 1995 and 1996, such disputes even led to some temporary shutdowns of the federal
government. Under President Bill Clinton, the government managed to achieve a
sizable surplus in its budget”meaning that tax receipts exceeded expenditures. But it
didn™t last long. Today the federal budget is back in the red, and prospects for getting
it balanced are poor.
During fiscal year 2008, the federal government spent over $2.9 trillion”a sum that is
literally beyond comprehension. Figure 12 shows where the money went. Over 34 percent
went for pensions and income security programs, which include both social insurance pro-
grams (such as Social Security and unemployment compensation) and programs designed
to assist the poor. About 21 percent went for national defense. Another 23 percent was ab-
sorbed by health-care expenditures, mainly on Medicare and Medicaid. Adding in interest
on the national debt, these four functions alone accounted for over 86 percent of all federal
spending. The rest went for a miscellany of other purposes including education, trans-
portation, agriculture, housing, and foreign aid.
Government spending at the state and local levels was about $2.1 trillion. Education
claimed the largest share of state and local government budgets (34 percent), with health
and public welfare programs a distant second (18 percent). Despite this vast outpouring of
public funds, many observers believe that serious social needs remain unmet. Critics claim
that our public infrastructure (such as bridges and roads) is adequate, that our educational
system is lacking, that we are not spending enough on homeland defense, and so on.
Although the scale and scope of government activity in the United States is substan-
tial, it is quite moderate when we compare it to other leading economies, as we will
see next.

The Allocation of Government Expenditures

Federal State and Local
SOURCE: Economic Report of the President, 2008 (Washington, DC: U.S.

All other
Interest 13.6%
8.3% All other
Government Printing Office, February 2008).

Pensions and
and Public


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