1

The American

Introduction

Welcome to the AmericanPrivate Enterprise System—a

study of how our economy works atthe national and local levels. This pro-gram includes the following contentinformation and discussion topics:• Part I: How America Is Organized

to Do Business• Part II: Our Economy—How It Works, What It

Provides• Part III: The Role of Government in Our

Economy• Part IV: How to Do Business• Part V: Sole Proprietorships and Partnerships• Part VI: Investor-Owned Corporations and Lim-

ited Liability Companies• Part VII: Cooperatives

You should enjoy your study of the AmericanPrivate Enterprise System. After all, you are a vi-tal part of the system. You will have an opportu-

GUIDE FOR PARTICIPANT AND DISCUSSION LEADERLionel Williamson, Extension Specialist in Agricultural Economics

S Y S T E MENTERPRISE

P R I V A T E

nity to meet and talk with leaders inyour community during this project,and there should be productive give-and-take time between you and thespeakers. The success of the discussionmethod used in this program dependson how well you prepare in advanceand how well you actively participatein each session.

Your discussion leaders are business and pro-fessional leaders of the community who have vol-unteered to share their knowledge and viewpointswith you as they lead you in discussing the topicsof the program. Remember to personally thankeach adult leader who works with you and othersin this project. They will appreciate your courtesy.

You are one of a number of high school jun-iors and seniors throughout the state selected toparticipate in this project at the local level. TopYouth Scholars from each program may participatein the Kentucky Youth Seminar in June at the Uni-versity of Kentucky. We hope to see you then!

Our challenge

is to use our

economic

resources

wisely to

satisfy our

needs and

wants, now

and in the

future.

AEC-90

2

• Capitalism refers to a market economy with re-sources owned primarily by private individualsand groups.

• Socialism refers to an economy that dependsheavily on the government to plan and makeeconomic decisions and to own and control im-portant economic resources.

• Communism describes a socialist economy ruledby a single political party that controls the useof all economic resources.

In some nations, including our own, individu-als are free to choose their personal goals and todecide how their work and resources will be used.In other nations, only a small group of leaders havethis power.

We have what is called a market economy. Itinvolves economic decision making by threegroups: consumers, producers, and governments.Their decisions are guided primarily by the inter-play of buyers and sellers in the marketplace. Mar-ket economies can exist in democratic politicalsystems, as in the United States, or somewhat moreauthoritarian systems, as in Spain. The same is true

How It All Started

The United States in its 200-plus years of exist-ence has grown to be the economic wonder of

the world, bringing forth a richness from its farmsand factories unprecedented in all history. Duringthis period, we have also enjoyed a unique form ofdemocratic government that has been an inspira-tion to freedom-seeking peoples around the globe.Because we have a democratic government, ourcountry goes where we (all of us together) decidewe want to take it. These decisions can be madewisely only if the choices we make are based on anadequate understanding of our economic system.

Economic SystemsEconomics is everybody’s business. An eco-

nomic system refers to a process through which la-bor, resources, and skills are brought together toproduce and distribute the enormous variety ofthings people need and want. These things includegoods (food, clothing, cars, factories, etc.) and ser-vices (transportation, education, health care, pub-lic safety, etc.).

Three Basic QuestionsSince there are limits to what can be produced,

basic choices must be made. Economies must an-swer three central questions:1. What to produce?2. How to produce it?3. For whom to produce it?

Comparing Economic and Political SystemsDifferent countries have developed different

ways of answering these three questions. Knowl-edge of economic systems in other parts of the worldcan help us understand our American economicsystem better. Although economic and politicalsystems in each country are related in importantways, we should be careful not to confuse the eco-nomic and political aspects of each political/eco-nomic system.

PART I:

How America IsOrganized to Do Business

Producer (business) Consumers (households)

Factors of production: land, labor, capital, entrepreneurship

Cost

s of p

roductio

n: rent, wages, interest and dividends, profits

Goods and

servicesConsum

er spen

ding

The circular flow of economic activity.

We have what

is called a

market

economy.

It involves

economic

decision

making by

three groups:

consumers,

producers,

and govern-

ments.

3

Three Forms of Political Economiesand How They Work Today

are managed by bureaucrats.Central planners set productionquotas.PAY: Government sets wages. Freetrade unions are taboo.GOVERNMENT: The sole politicalparty, the Communist Party, rules.SocialismPRODUCTION: Elected governmentgradually takes control of keyindustries. Authorities often planoutput for use rather than profit.PAY: Strong trade unions bargainwith management and oftenserve as the fountainheads ofsocialism.GOVERNMENT: It allocates re-sources and uses taxing power toredistribute wealth.

comes before“What ourEconomyProvides”

CapitalismPRODUCTION: Private individualsown land and businesses,operating them for profit. Themarket mainly determines whatgoods are sold at what prices.PAY: Wages are set betweenemployees and management atindividual firms, with workersoften represented by unions.GOVERNMENT: It regulates businesslargely by telling firms what notto do. It stimulates outputthrough incentives and usuallyprovides tax-supported socialbenefits.CommunismPRODUCTION: The state owns thesources of production, and these

In 1999, our GDP totaled more than $9.2 tril-lion, adjusted for inflation. Its size was greater thanthose of Russia, Germany, and the United King-dom combined. To better understand this over-whelming figure, think of it as about $32,448 worthof goods and services per American.

IncomeWe earn income by being paid for applying

our skills, efforts, and resources to some produc-tive purpose. In this activity, we produce goods andservices for others—and income for ourselves. Thisincome, in turn, allows us to buy the goods andservices we want.

If we add all of the incomes of individuals andbusinesses earned through producing goods and ser-vices during one recent year, the total is more than$5.46 trillion. As you might expect, most of thisincome went to employees in wages and benefits.

National income = GDP plus receipts or incomefrom abroad, payments abroad, consumption offixed capital, taxes, and subsidies.

World Trade: A PocketbookIssue for Everyone

More than ever before, the United States isbecoming dependent on other nations for many ofthe goods and services American consumers want.Shoes, oil, computers, cars, clothes, and DVDs arejust a few of the items foreigners are sending herein huge quantities. As a result, U.S. shoppers, re-tailers, and travelers are learning that they need toknow more about foreign economic conditions andexchange rates that affect their decisions on whatto buy or sell abroad. If Japan’s yen increases sharplyin value, consumers might see higher prices forJapanese cars. If the German mark declines, it canmean cheaper hotel rooms for tourists in Munich.

Purchase decisions are made even harder as itbecomes more difficult to determine whether aproduct is Japanese, European, or American. Atelevision set, for example, might have parts fromJapan, a speaker from Singapore, and a picture tubefrom the United States, with the assembly workdone by workers in both Mexico and the UnitedStates. One thing is certain: never again will theUnited States be as self-sufficient as it was in theyears immediately after World War II, when it hadmost of the world’s manufacturing plants, much ofthe advanced technology, and the greatest amountof capital.

of socialist economies. In the case of Sweden,democratic political processes guide a socialist-ori-ented economy; in the former Soviet Union, a so-cialist economy was ruled by a single group, theCommunist Party. In today’s world, most major in-dustrial nations are market economies, while so-cialism is common among developing nations.

What Our Economy ProvidesWe now have some familiarity with the ele-

ments of our economy, how decisions are made,and how the system works. Now we can look atthe extraordinary dimensions of our Americaneconomy—the things it provides.

How Big Is Our Economy?One way to measure the size of our national

production is to add together the value of all thegoods and services we produce in one year. Thetotal is called the Gross Domestic Product, orGDP. GDP doesn’t measure total transactions, onlyfinal output. We constantly see and hear referencesin the news to this total as a yardstick of our pro-duction. The GDP does not include do-it-yourselfactivities, such as housework or home gardening.It also does not measure expenses such as cleaningup our environment, only market activities.

4

Stronger Economies

The improved health of manycountries’ economies that

languished after World War II isbehind the growth in trade.Japan’s sales to the United Statesgenerally exceed its purchases.Western Europe sells autos, steel,and other products here in largeamounts. Small countries such asSingapore, the Philippines,Taiwan, and South Korea havebecome major manufacturers ofour textiles and home-entertain-ment devices. Purchases fromoverseas often mean lower pricesand greater variety among itemsAmericans buy, as well as the lossof thousands of real or potentialAmerican jobs, as imports takeaway sales that otherwise mighthave gone to U.S. firms.

Buying from foreignersrepresents one side of the tradepicture—the import side. To payfor imports, a country tries toexport its products to othercountries. The United States hasfound that the emerging healthof its trading partners meanstheir consumers can afford moreAmerican goods. In 1999, weimported $1,029 trillion dollars

worth of goods and exported$684 billion worth. Despite thesehuge sales, the U.S. deficit onmerchandise trade with othernations—imports compared toexports—reached $345 billion.

The trade deficit isn’t thewhole story, however. Also to beconsidered is the money theUnited States takes in from threeother major areas: sales ofservices, foreign-investmenttransactions, and profits bymultinational corporations.Increasingly, U.S. firms areperforming moneymakingservices for foreigners in theareas of banking, transportation,communications, data processing,and investments. The nation alsogets funds from foreigners in theform of vast investments. Forexample, high interest rates makeit attractive for foreigners todeposit their money in U.S.lending institutions, to buy bonds,and to make other investments.Declining interest rates, however,have the opposite effect. Profitsby U.S.-based multinationalcorporations, with branches andfactories in many countries, alsohelp offset the trade deficit.

comes before“ExchangeRates”

Example: Most cameras are now made in Japanand other Asian countries. If the U.S. dollar de-preciates against the Japanese yen from 120 to 100yen per dollar, a camera that used to cost $50 willcost more than $60. The main reason is that thosecameras are sold in yen by the Japanese manufac-turer, so it takes more dollars for a U.S. importerto obtain the necessary yen to purchase each cam-era than before the depreciation. Specifically, atU.S. $1 = 100 yen, one yen costs exactly 1 cent,but at U.S. $1 = 120 yen, one yen costs less than acent or exactly 0.83 cents per yen.

Enter the TariffThere are times when the rules break down.

When one country loses the advantage, it may de-cide to protect its own industries by imposing tar-iffs to raise the prices of imports. Tariffs are taxes agovernment places on internationally traded goodsto protect its prices. Or it may subsidize productsfor export. Especially during hard economic times,pressures mount on governments to protect work-ers and businesses that are hurt.

While trade barriers may work in the shortrun, most trade experts fear that everyone suffersin the long run. For example, tariffs placed on im-ported automobiles actually increase the cost toU.S. consumers.

The Need for ChoicesAll of our needs and desires cannot be fully

satisfied, nor will they ever be in a world of limitedresources. Throughout history, many societies haveattempted to solve this problem by dictating whatindividual needs and wants should be—and by con-trolling how these needs and wants are met. Yeteconomic freedoms and personal freedoms have away of interlocking. When individuals are told howthey must conduct their economic lives and whenthere are obstacles to such economic freedoms asspending choices and career choices, personal free-doms are inherently involved.

In the American economic system, decisionmaking is shared by consumers, producers, and gov-ernments. Our challenge—and privilege—is tomake wise choices in our use of economic resourcesto satisfy our private and public needs and wants,now and in the future.

Exchange RatesEvery year, deals between countries are affected

markedly by wide fluctuations in the value of eachcountry’s currency—the exchange rate. The ex-change rate of the American dollar, for example,is the number of dollars or cents it takes to buy aJapanese yen or other currency. When the dollar isrising against the yen, it takes fewer dollars to pur-chase the same number of yen. When the dollar isfalling, it takes more dollars to buy yen. An in-crease in the value of the dollar makes imports lessexpensive in the United States, but U.S. exportscost more abroad. If the dollar loses value, the op-posite happens: imports become more expensivehere, and U.S. businesses enjoy larger sales abroad.

Tariffs are

taxes a

government

places on

internation-

ally traded

goods to

protect its

prices.

5

Considering Alternative BenefitsWhat benefits do we gain when we make a

particular economic decision compared with thebenefits we might have gained by making another?We must always consider the alternatives. Whatwe are discussing is an economic concept knownas opportunity cost. When limited resources are used,some benefits are gained, but some are also sacri-ficed. So there is a cost involved in our choice.

This concept applies to all economic choices.For instance, in our own lives we make choices likethese:• Spending for things today or saving for the fu-

ture.• Balancing spending for food, clothing, and shel-

ter against spending for entertainment and rec-reation.

• Undertaking extra work or spending that timeon leisure.

• Comparing the potential benefits of higher edu-cation with the cost and sacrifices it normallyrequires.

Key public issues also require choices:• How much government involvement in our

economy is necessary for its continued well-be-ing? In what areas should there be less involve-ment? In what areas, more?

• How can we balance national growth with con-servation of natural resources and protection ofour environment?

• How can we evaluate the long-term economicand social costs and benefits of various govern-ment programs?

• How can we hold down inflation and yet stimu-late the economy and expand employment?

• How can we preserve the benefits of competi-tion in our American economic system and stillmeet the needs of the less fortunate?

Answers to such questions are anything butsimple. Yet these issues directly affect our own fu-ture, our children’s future, and our nation’s future.Under our American economic and political sys-tems, such answers depend on the choices we allmake.

Questions for Discussion: Part I1. Is the role of choice equally important in all

economic systems?2. When you become a member of a group such as

this one, should you be willing to give up someof your personal freedom and assume someadded responsibility? Why? What are someexamples?

3. What is an economic system? What does it do?4. What are the basic CHOICES that must be made

with regard to the production of goods andservices in any economic system, e.g., in theUnited States or in Cuba or in mainland China?

5. What kind of economic system do we have inthe United States?

6. Most major industrial nations of the world, suchas the United States, are largely MARKETECONOMIES, while socialism is more commonamong developing nations. Why is this? Is onesystem better for us, while another systemmight be better for a less developed country?

7. What three groups have important decision-making roles in our economy in the UnitedStates today? In what way?

8. Are you individually a CONSUMER or a PRO-DUCER, or are you a part of GOVERNMENT, asthe terms are used here? Are you all three?

9. How does your answer influence your perspec-tive as to your individual responsibilities inconsuming or producing or in influencing therole of government in our economy?

Ideas for Further Study and Topicsfor Talks or Demonstrations1. Pick a country and examine how it answers the

three basic questions of what to produce, howto produce it, and for whom to produce it.

2. Pick a country and see the importance of theroles of producer, consumer, and government ineconomic decision making.

3. Invite a labor leader or government representa-tive to talk to this group about his/her role inthe U.S. economy.

Purchases

from overseas

often mean

lower prices

and greater

variety

among items

Americans

buy, as well as

the loss of

thousands of

real or

potential

American

jobs, as

imports take

away sales

that other-

wise might

have gone to

U.S. firms.

6

PART II:

Our Economy—How ItWorks, What It Provides

Introduction

While members of all three groups—consum-ers, producers, and government—make de-

cisions in our economic system, the key role thatreally makes everything work is played by you inyour role as a consumer.

ConsumersToday, almost two-thirds of our nation’s to-

tal economic output consists of goods and ser-vices bought by individuals and households forpersonal use. The remaining one-third is boughtby businesses and governments. So you canclearly see the importance all of us play as con-sumers in today’s economy.

Every day we make decisions to buy or not tobuy, and these decisions directly affect oureconomy. Our willingness and ability to spend ourmoney for certain goods and services is called thedemand for these things. This demand is influencedby the prices, quality, and availability of goods andservices. If the price of something rises, we oftendecide to buy less of it or to buy something else. Ifthe price goes down, we might buy more of it.

When our incomes change, our demands areaffected. We buy less or shift to cheaper items whenour incomes go down. We tend to choose moreexpensive items or simply buy more when our in-comes go up.

Our demand for goods and services affects theefficiency of producers. Most of us look for good val-ues when we buy, and we are increasingly concernedwith product safety and reliability. We try to selectgoods and services that will serve us best and havethe highest quality for the price. This rewards effi-cient producers that keep quality up and prices downand penalizes inefficient ones. To succeed, produc-ers must continue to offer goods and services con-sumers want. The cost squeeze has set off a flurry ofchanges in the marketplace. For example, somepeople now are settling for smaller homes, such astownhouses, condominiums, and the like.

Even though the general consumer trend is tocut costs, the expanding number of working womenhas created a brisk market for convenience goods.And among working couples with no children,whose combined annual incomes are often $50,000or more, the demand for luxury goods and serviceshas remained steady even in a time of recession.

Although every household has slightly differ-ent spending priorities, about $8 of every $10 onaverage goes for necessities, such as food, clothes,shelter, and medical care. Health spending aloneaccounts for $1.50 of every $10 in total consumeroutlays. What’s left over goes mostly for nonessen-tial goods and services—a new stereo, vacationtrips, cosmetics, sporting goods, and movies, toname just a few.

Supply and DemandAmerica’s businesses are the suppliers in the

basic supply-and-demand equation that is at theheart of the free-enterprise system. In a nutshell,that’s how the U.S. economy works: The match-ing up of consumer needs and desires with the goodsand services offered by businesses at a price con-sidered fair by both parties. When buyers’ desireschange, businesses must respond or be swallowedup by the competition. The troubles of the autoindustry, when it was slow to adjust to the desirefor smaller cars, were glaring proof of this axiom.

For businesses, the best of all worlds would beto maximize profits by making or selling goods thatare most in demand because the more consumerswant an item or service, the more they are willingto pay for it. Thus, firms have an incentive to sellvideo games, for example, when consumer demandis high for that product.

Problems crop up for businesses when toomany firms enter a field to meet the consumers’demand for a product or when the price rises be-yond the point individuals consider reasonable. Inboth instances, the result is that too much of a prod-uct is produced and prices drop, putting a squeezeon business profits.

The U.S.

economy

works by

matching up

of consumer

needs and

desires with

the goods

and services

offered by

businesses at

a price

considered

fair by both

parties.

7

Wooing the Consumer

How do consumers keepabreast of what goods and

services are available—and atwhat cost? Mostly throughadvertising messages ontelevision and radio, in newspa-pers and magazines, on bill-boards, and through the mail. Inone recent year, business pourednearly $118 billion into advertis-ing, according to estimates byAdvertising Age. In addition to the

traditional methods of advertis-ing, technology has begun to playa vital role in advertising. Most, ifnot all, companies have anInternet site where consumerscan research their products andpurchase them online. Consumersenjoy the convenience of nothaving to leave their home topurchase products. Companiesare spending billions of advertis-ing dollars to get their productson the Internet to meet thedemands of consumers.

comes before “Credit and Savings”

build and modernize, thus creating more jobs forAmericans and allowing U.S. firms to competemore effectively with foreign firms.

During the last several years, the United States,France, and Italy were the only three industrial-ized countries to register a decline in the rate ofpersonal savings. During the 14-year period 1980through 1994, personal savings in the United Statesdeclined from 7.9 to 4.1 percent of disposable per-sonal income.

ProducersProducers are those who work by themselves

or in groups to provide goods and services. Theymake economic decisions based on what they be-lieve the demand will be for their products or ser-vices—and they expect to earn an income fromwhat they do.

Who are these producers in the American eco-nomic system? You might think only in terms oflarge businesses, but, in all probability, you are aproducer yourself. Workers are producers. Theyapply their basic skills and energies to change re-sources into goods and services.

Managers are producers. They produce whenthey coordinate, plan, and organize the actual pro-duction of goods and services. About one-third ofall wage and salaried employees are managers, su-pervisors, or administrators.

Investors are producers. They supply themoney, or financial capital, needed to buy and usefacilities, equipment, and raw materials.

You may well be helping to supply financialcapital without realizing it. If you have a savingsaccount, own shares of stocks, own life insurance,or are in a pension fund, you are helping to gener-ate funds for investment purposes. Banks, savingsand loan associations, and the stock markets helpput the savings of people to work. By financinghome and business investments and creating newjobs, they play a vital role in our economic system.

People who start businesses are producers.These people who start new enterprises or busi-nesses are called entrepreneurs. Their vision andoriginality have always played a key part in thegrowth of our economy by providing new goods,services, and jobs. Some of America’s famous in-ventors have been entrepreneurs.

Although you may not have thought of your-self as a producer, you can probably see at least oneway in which you are.

Credit and SavingsIn the scramble to lure the con-

sumer, U.S. industry would be at aloss without another importanttool: credit. Particularly in thepurchase of big-ticket items, suchas homes, autos, and major ap-pliances, credit enables con-sumers to buy without havingto put up all the cash at once.

If buyers can meet theirtime payments, credit serves a vital purpose by al-lowing them to enjoy goods and services now,rather than having to wait. But there’s a danger,too. Recently, personal bankruptcies were at an ex-treme high—the result, experts say, of the inabil-ity of many families to manage credit obligations.Altogether, the amount of money owed by Ameri-can consumers has been $729 billion.

The economy can suffer from such excesses,too. Retail sales stagnate or fall when consumersbecome concerned over their debts or the high in-terest rates they must pay on everything from creditcards to home mortgages. For example, outstand-ing consumer and mortgage debt as a percentageof after-tax disposable income reached record lev-els in late 1979, then declined for two years in arow. From 1980 to 1999, mortgage debt increasedfrom $1.460 billion to $5.7 billion.

Most analysts view a drop-off in consumer debtas a good omen. Rather than spend and borrow,say the economists, consumers should put more oftheir money into savings and investments. Thatwould make more funds available to companies to

Credit

enables

consumers to

buy without

having to put

up all the

cash at once.

8

How the Work Force Is BeingTransformed

Workers form the backbone of American en-terprise. White-collar and blue-collar; skilled andunskilled; merchants, farmers, and professionals—men and women in the work force do far more thanearn a livelihood. More than 116 million strong,they are both producers and consumers of goodsand services and are sources of both the supply andthe demand that drive the nation’s commerce.

Yet the nation’s labor force is undergoing im-portant changes:• Automation is eroding job opportunities in old-

line manufacturing industries while creating vastnew ones in high-technology and service fields.

• Labor unions, after decades of growth, are los-ing power.

• Women and more mature workers are playingbigger roles.

• Young people, particularly African Americansand Hispanics, are continuing to find it diffi-cult to land competitive jobs.

For most Americans, having a job is a basicrequirement for participating in the economic sys-tem. Those without jobs find themselves with littlecontrol of their own destiny, dependent on othersor the government for their welfare.

Wages and salaries earned by working peopleare the chief source of personal income in the UnitedStates, recently amounting to nearly $3.3 trillion,or 52 percent of all personal income. Virtually all ofthis is plowed back into the economy through spend-ing, savings, investments, and taxation.

But workers derive more from their jobs thanjust a paycheck. Such important items as healthinsurance, old-age pensions, and paid vacationtime are typical of the benefits that go along withmany jobs.

Just as workers need jobs to sustain their liveli-hood, industries cannot function properly withoutan adequate supply of trained workers. Matching upjobs with qualified workers is a complex process thatin a free-market economy depends on the forces ofsupply and demand. The process is not always a

smooth one. Demand for labor frequently changesmore rapidly than the supply. For example, it mighttake a company in Phoenix several months to lo-cate and hire 100 electrical engineers it needs for abusiness expansion. Finding a shortage of qualifiedpeople, the company might have to lure employeesaway from other companies by offering big salariesand other benefits. Over time, such strong demandin the field might encourage students entering col-lege to major in electrical engineering, assuring thatfuture needs will be met. Too heavy a response couldproduce a surplus.

Labor surpluses occur on a wide scale duringperiods of recession, when business activity slowsand the need for workers declines. The result ismassive layoffs. The resulting economic hardshipdoes not stop with those who are jobless. Entireregions often feel the impact as retail spending andtax revenues falter. This, in turn, can lead to stillmore unemployment.

Changing WorkplaceAbout 20 percent of the labor force hold

manufacturing jobs. Experts look for little employ-ment growth overall in this field and an outrightdecline in some industries as unskilled workers arereplaced by computerized robots.

Service occupations now account for the larg-est share of American workers—nearly 43 millionpeople, or 62 percent of the nonagricultural workforce. This broad field includes occupations suchas nurses and hospital attendants, hotel and res-taurant workers, police officers, firefighters, andjanitors.

Another important trend in the U.S. laborforce is the growing ranks of female workers. Thenumber of women holding jobs has more thandoubled during the past two decades—from fewerthan 22 million in 1960 to 56.6 million at the mostrecent count. While this increase reflects both ris-ing divorce rates and decisions of many women tostay single longer, married women who are em-ployed outside the home now account for 60.3 per-cent of all female workers.

Men and

women in the

work force do

far more than

earn a

livelihood.

They are both

producers

and consum-

ers of goods

and services

and are

sources of

both the

supply and

the demand

that drive the

nation’s

commerce.

9

Government

We have seen that consumersand producers make

decisions in the Americaneconomic system. Governmentalso gets into the decision-making process. Becauseconsumers obtain benefits fromcompetition, our government hastraditionally sought to maintain a

competitive environment forbusiness. This often takes theform of laws or regulationsintended to prevent abuse inspecific areas. Of course, manygovernment regulations also dealwith product standards, environ-mental impacts, and othermatters not directly related tocompetition. We will talk moreabout the role of government inPart III.

comes before “How Our EconomyFits Together”

There is an opposite side to this point. Con-sumers might decide a product is not worth its priceand stop buying it. The product is no longer worththe cost of producing it. When this happens, andif the situation continues very long, the product isforced off the market.

What is going on is a balancing act betweenthe supply of goods and services and the demand forthem in the marketplace. Prices play a role in thisprocess. Look around and you can see the effects.

When the auto model year is over, last year’smodels are usually reduced in price to stimulatesales. Department stores hold clearance sales to re-duce their inventories.

Food prices go up and down, depending in parton the relative supply of agricultural commodities.However, the costs of such commodities are oftena small share of the final retail price for many pro-cessed foods. For example, it was recently estimatedthat prices of farm products accounted for onlyabout 8 percent of the price of a typical loaf ofbread. The other 92 percent was for processing anddistribution.

All these transactions between buyers and sell-ers are made possible by the existence of money.Using money is a convenient way to exchangegoods and services. Also, by saving money, we canset aside some of our purchasing power for lateruse. Money makes buying and selling easy and thusmakes our economic life far more productive. Thatis why money has replaced the barter system in allmodern societies.

The marketplace is wherever these transac-tions occur, where buyers and sellers come togetherto agree on the exchange of goods and services formoney. Transactions permit buyers and sellers toinfluence each other and thereby largely determinewhat our economy produces and who produces it.

CompetitionCompetition has always been of key impor-

tance in the American economic system. The vi-tality of the American economy is based on com-petition between producers. Those who supply thebest goods and services at the best prices generallyare the most successful. Competition is one of thefactors that causes our economy to change con-stantly. Producers tend to move to activities whereearnings apparently are higher and leave thosewhere earnings are lower. This means workers, fa-cilities, and raw materials shift to these new areasfrom former ones.

Competition

has always

been of key

importance in

the American

economic

system. The

vitality of the

American

economy is

based on

competition

between

producers.

How Our Economy Fits TogetherOur economy can be thought of as a gigantic

machine. So far we have looked at the differentparts and what they do. Now, in order to under-stand the economy more fully, it will be helpful tolook at how the whole machine fits together andworks. The concept of supply and demand is cen-tral to this understanding.

Supply, Demand, and PricesWe touched on the subject of supply and de-

mand briefly in Part I. It is something we come incontact with every day.

For example, supply and demand affect thewages we are paid; our wages are actually the priceswe charge for performing work. Supply and demandalso affect the prices of goods and services, theprices of raw materials, and the price, or interest,paid when we borrow money.

Two factors work together to determine thesupply of a product, service, or resource: the costof producing it and the selling price.

Suppose buyers are willing to pay more for aproduct than it costs to produce it. Businesses usu-ally increase their production to increase their prof-its (or their return over and above productioncosts). This profit margin, if it is large enough, en-courages new businesses to enter this field. Nowthere’s more competition among sellers, and thistends to reduce prices or improve products, or both.And it means a larger supply.

10

In any discussion of competition, the subjectof productivity is likely to come up. Productivitydescribes how well producers (and governments)use resources—people, facilities, and raw materi-als. The most important factors influencing pro-ductivity are:• People—their skills, efforts, and motivations.• Capital resources—the availability and effi-

ciency of factories and equipment.• Technology—the application of science to in-

dustrial needs, involving new materials, newmethods, and advanced processes.

• Organization—the effectiveness of managementin combining resources.

• Government regulation—the imposition ofstandards or restrictions.

• Working environment—as it relates to bothhealth and work attitudes.

Improvement of productivity in business andindustry is essential if we are to maintain competi-tiveness in selling goods and services both at homeand abroad. Since our various governments nor-mally have no competition in providing many oftheir services, improving productivity in govern-ment should be a matter of special interest and con-cern to us all. How do we as producers remain com-petitive? And how do businesses and industries in-crease productivity? Investments in new factoriesand equipment and improved technology are theanswers in many cases.

Balancing the EconomyAs you probably realize by now, an important

factor making the American economic system workis the law of supply and demand. It is not really alaw, of course; it is an explanation of the factorsdetermining how much of each product and ser-vice is produced and how those goods and servicesare distributed.

Remember that when we buy less than oureconomy is producing, eventually production goesdown and unemployment increases. When our pur-chases increase, this demand results in businessexpansion and higher employment.

Supply and demand forces ultimately deter-mine the levels of production and employment inour economy. But as we shall see, certain steps canbe taken to influence what these levels will be. Itis now a responsibility of the federal government,as established by the Employment Act of 1946, topromote maximum employment, production, and pur-chasing power.

Maintaining both stable prices and high em-ployment, however, is difficult in a free society.Wages tend to increase when available workers arein short supply, and prices of goods tend to risewhen demand outstrips supply. Over the years, oureconomy has grown at a remarkable rate. But inthis process, there have been periods of expansionand periods of recession. These alternating ups anddowns mean our national goal of high employmentis not always achieved.

The economy expands and contracts as a re-sult of changes in our total spending. Many factorscan cause this, including the introduction of newtechnologies, the availability of investment funds,changing national economic policies, crop failures,wars, and public confidence in our economic fu-ture. There are many more. All these factors di-rectly affect the economy.

Let’s consider this matter of public confidencea little further. When economic times are good,individuals, businesses, and many governments feelmore confident about the future, and they spendmore. An individual might buy a new car or de-cide to buy a home. A company might decide thetime is right to build a new factory or install newequipment. A local government might build a newschool. Expenditures like these are not made ev-ery day. When spending occurs in surges of in-creased public confidence, this stimulates theeconomy for a period of time. When such spend-ing decreases, it normally slows down the economy.

Questions for Discussion: Part II1. Why is the role of the CONSUMER said to be the

key role that makes everything work in oureconomic system? Do you agree?

2. How are the concepts of SUPPLY and DEMANDimportant to our understanding of oureconomy in the United States?

3. What is the role of the PRODUCER in making oureconomy work?

4. Who are the PRODUCERS in our society? What isPRODUCTION in the economic sense? AreGOVERNMENTS producers?

5. How is GOVERNMENT involved in our economytoday? How does it get into the decision-making process? Is the role of governmentmore important today than earlier in the historyof our country? Why?

Over the

years, our

economy has

grown at a

remarkable

rate. But in

this process,

there have

been periods

of expansion

and periods

of recession.

11

PART III:

The Role of Governmentin Our Economy

There are five major areas in which governmentunits (on the federal, state, and local levels)

are involved in the economy.1. Protection of the rights and freedoms—

economic, political, and religious—of in-dividuals through our courts and the ad-ministration of our laws.

2. Providing goods and services in the in-terest of all of us—such as highways, nationaldefense, and education.

3. Regulation—the promotion of fair economiccompetition and the protection of publichealth and safety.

4. Promotion of economic growth and stabiliza-tion—through various economic policies andprograms.

5. Direct support to individuals—programs to re-duce hardships for individuals who cannotmeet their minimum needs because of specialcircumstances or lack of employment.

Before we discuss the role of government inour economy, some definitions are in order. Weshould know the meaning of these important terms.

Supply of MoneyThe supply of money has an important influ-

ence on spending and production, and banks play acentral role in this process. By changing the moneysupply, the Federal Reserve affects the amount ofmoney banks can lend to individuals and businessesto spend. In simplest terms, the Federal Reserve gen-erally makes money more available when totalspending is considered too low and less availablewhen total spending is too high. These actions di-rectly influence interest rates throughout oureconomy. The federal government does not directlycontrol the supply of money in the United States.The Federal Reserve Board, appointed by the presi-dent and confirmed by Congress, controls the Fed-eral Reserve System, which controls our money sup-ply. Terms for members of the Board do not coin-cide with presidential elections and are not supposedto be political appointments.

InflationInflation means a continual rise in the general

level of prices. Nobody wants inflation, but it hasbecome all too familiar in the world today. Prices ofmost goods and services have increased significantlyover recent years. Prices often go up as the qualityof the goods and services we buy improves. But, in

6. What factors determine the SUPPLY of a productor service?

7. If buyers are willing to pay more for a productthan it costs to produce it, will producers likelyincrease their production? Might this result inmore competition? What might this then do toprices? To quality? To product differentiation?

8. How is COMPETITION important in the MARKET-PLACE of our American economic system? Whatis it? How does it operate?

9. Is PROFIT good or bad? Why or why not?10. In what industries is our nation strongly

competitive in the world markets? Why?

Ideas for Further Study and Topicsfor Talks or Demonstrations1. Select one natural resource or raw product and

find all the final consumer goods which use thatraw product.

2. Help your group plan a visit to a local business.3. Examine the changes in one product over time.

For example, how has one car changed overtime? What changes have occurred in orangejuice during the last 30 years?

4. Discuss the intermediate (value-added)processes the raw product goes through.

Ask your program leader to have yourExtension agent tell you about relatedcommodity marketing projects.

The supply of

money has an

important

influence on

spending and

production,

and banks

play a central

role in this

process.

12

Fiscal Policies

The taxing and spendingpolicies of the federal

government are called fiscalpolicies.

Federal spending can beincreased to keep overall demandat a high level if private spendingis low. And federal spending canbe restrained to reduce overalldemand when demand is higherthan our total production.

Government tax policies canalso be changed to help balancethe economy. Federal tax cuts andrebates can be used to stimulatethe economy in a recession—ortax increases may be used to helpdampen excessive demand.

Whether the federal govern-ment has a surplus (spending lessthan taxes) or a deficit (spendinggreater than taxes) depends onhow fiscal policy is used to meetthe needs of the economy andhow the economy performs.

comes before “Monetary Policy”

Monetary PolicyThe Federal Reserve System has responsibil-

ity for controlling our nation’s money supply—thetotal of all coins and currency in circulation, pluschecking accounts held by individuals and busi-nesses. This control is called monetary policy,which is another way to lessen the adverse effectsof economic swings.

EmploymentThe American economy has shown an impres-

sive ability to create new jobs. However, the natu-ral growth and development of the economy hasbrought major shifts in employment. Some regionsof the country grow faster than others. The pat-tern of available jobs keeps changing, and the workforce must continually adjust to these changes.

Of course, the total demand for goods and ser-vices changes during swings in the economy. Thischange in demand, combined with the regional andoccupational shifts in employment just described,causes part of the work force to be unemployed forvarious periods of time.

Reducing unemployment and the personalhardships associated with it involves efforts by busi-ness, labor organizations, government, and indi-viduals themselves. Retraining programs, incomeassistance, and employment services can all helppeople adjust to changing job conditions.

The Ever-Present Hand ofGovernment

The U.S. government has far-reaching powerover the American economy. It influences virtu-ally every economic decision made by businessmanagers and their employees, by savers and con-sumers, by investors and retirees.

To begin with, the government makes possiblethe working of the capitalistic economy. It providesthe basics: money and credit for economic trans-actions, the judicial system that protects privateproperty and enforces contracts, and regulators whokeep competition on the up and up.

general, price increases not accompanied by im-proved quality are called inflationary.

When inflation occurs, each dollar we havebuys fewer goods and services. In the years between1950 and 1975, the ability of our dollar to pur-chase these things went down by about 50 percent.However, from 1950 to 1994 the overall rate ofinflation declined from 4.2 to 0.68 percent.

Inflation has at least three basic causes. Whenconsumers, businesses, and governments spend tooheavily on available goods and services, this highdemand can force prices up. If costs of productionrise and producers try to maintain profit levels,prices must increase. The lack of competitionamong producers also can contribute to inflation.

The burdens of inflation tend to fall moreheavily on those who live on incomes that remainthe same or rise more slowly than prices. This caninclude many workers and retired persons. The onlyway these people can cope with rising prices is tobuy less, reducing their living standards.

These economic ups and downs have variedwidely in the past, and federal government poli-cies often have attempted to moderate their ad-verse impacts. However, there are so many com-plex forces at work in our economy, and the tim-ing of government policies is so critical, that un-expected results can occur.

13

Beyond that, the Washington bureaucracy op-erates America’s biggest business. It employs morepeople, buys more products, owns more real estate,constructs more buildings, insures more invest-ments, and borrows more money than any otherorganization in the non-Communist world. Addin the state and local governments and you havean enormous machine that directly affects thewhole economy.

Of equal importance, the government inter-venes in the market by setting the rules underwhich all businesses compete. Through the tax sys-tem, the budget process, and control of the moneysupply, the government has great leverage in push-ing the level of economic activity up or down.

Overall, the supply-side policies of the early1980s had the effect of emphasizing the short runover the long run and eroding the foundation ofthe economy. At the core of these supply-side eco-nomic theories lies the key assumption that thestimulus given to the economy from tax cuts isstrong enough for the tax cuts to pay for them-selves. But most experts believe otherwise, and ex-perience has proved them to be right. While theshort-term improvement in living standards can-not be denied, the long-lasting effect has been aballooning of the federal budget deficit which leadsultimately to a deterioration of the long-termstrength of the economy.

The economic power of the government, how-ever, will never shrink to its original level, whichwas simply to coin money, regulate internationaland some interstate trade, and provide a few basicservices, such as protection, roads, and defense.Generally, the economic activities assumed by gov-ernment were those that could not be carried outby private business.

The first major interventions by governmentinto the economy were pushed by businessmen tomake more commerce possible. In the 1800s, forexample, federal investments were made in rail-roads, canals, and roads to make it easier to trans-port products to markets and to help build andpopulate new communities on the frontiers. Theeconomies of the western territories were given abase by the federal government when it offered land

to homesteaders, encouraging families to settle andfarm there. At the same time, big business, inter-ested in making the marketplace operate in a ra-tional manner, pushed for government regulationof banks, credit, and the circulation of paper money.

Starting in the late 1880s, Americans becamemore and more convinced that the free working ofthe market system was an insufficient guaranteethat there would be no abuse. Complaints of farm-ers about unreasonable shipping rates, of workersabout the employment of children, and of smallbusinesses about ruthless, unfair competition bylarge firms all prompted government to step in.

As long ago as 1890, Congress passed a majorpiece of legislation regulating business—theSherman Anti-Trust Act. The objective was to pre-vent two or more persons from getting together torestrain trade. This could involve forming a mo-nopoly, where a single producer dominates an in-dustry so that it can set prices or control supplywithout regard to competition. It also could involveprice fixing, the agreement among several firms toset prices to avoid competition.

There are some cases where competition maynot be in the public interest. An example is a pub-lic utility that supplies electricity, natural gas, orwater. Duplication of local power, gas, or water linescould result in higher rates. But if there is no com-petition, how should prices be determined? In suchcases, state or local governments regulate the pricesof the services, keeping in mind the interest of thepublic and the costs involved.

Still, until the Great Depression of the 1930s,the feeling remained strong that the capitalisticsystem generally was self-adjusting: given time,companies that sold shoddy merchandise at exor-bitant prices would lose their markets; firms thatmistreated workers would find poor morale cuttingproductivity and profits in their factories. The harddays of the Depression, however, prompted increas-ing political demands for regulations. Now morethan 60 federal agencies include some kind of regu-latory activity involving agriculture, food process-ing, consumer safety, worker welfare, or other ac-tivities closely related to agribusiness. Seventy-fiveyears ago, there were just six.

Washington

bureaucracy

employs

more people,

buys more

products,

owns more

real estate,

constructs

more build-

ings, insures

more invest-

ments, and

borrows more

money than

any other

organization

in the non-

Communist

world.

14

Today, government rules cover deceptive busi-ness practices; the ingredients of foods, drugs, andcosmetics; the air Americans breathe; and the wa-ter we drink. State commissions usually set ratesfor electricity and natural gas. Local boards estab-lish fares for taxis and public-transit systems.

There are federal regulations detailing eligi-bility requirements for government-sponsoredmedical care and outlining how depressed areas areto be rebuilt. They specify minimum wages and tellemployers how safe factories and offices must be.They limit agricultural production and set floorprices for commodities to bolster farm income.There are rules for insuring banks, distributing en-ergy, overseeing radio and television, and mediat-ing labor disputes.

All of these rules have costs far beyond theamounts needed simply to administer them. TheCenter for the Study of American Business at Wash-ington University in St. Louis estimates the totalannual price tag at $130 billion. Most of that ex-pense is picked up by consumers. For instance, whenindustry spends $20 billion a year to meet clean airrequirements, that shows up in higher utility bills aselectric companies act to recover their costs as wellas in more expensive household cleaning productsand higher prices for processed food, etc.

The climate of change toward deregulation hasmade little reduction in the overall cost of federalintervention so far, according to the WashingtonUniversity center. But it seems certain to alter theway the economy works in affected industries. Themajor example to date is the airline industry. In1980, the rules for entry of new companies, sched-uling, and ticket costs were relaxed. More low-costcarriers jumped into the field, ticket prices dropped,and a new competitive era opened up.

The biggest, most powerful tool for influenc-ing the economy came with the passage of the fed-eral income tax law in 1913. To some extent, thisprogressive tax redistributes wealth, because thosewith higher incomes are taxed at a steeper rate thanthose down the income scale. Changes in tax rateshave been used to fine-tune economic activity.Lowering tax rates puts more spending money in

consumers’ pockets, increasing demand for goodsand services during periods of sluggish growth orrecession. At the same time, the governmentpumps money into the economy through the fed-eral budget, trying to keep business expanding fastenough to provide jobs for all who want them butnot so fast as to ignite an inflationary binge. WhenWashington buys something or hands out money,recipients have that many additional dollars tospend, thus increasing the demand for goods.

The federal government gives tax credits tocompanies to induce them to invest in new plantsand equipment and to persuade them to trainthe unemployed. It uses tax deductions to en-courage such industries as home building and topromote such social and economic goals as en-ergy conservation.

Uncle Sam also is in the lending business in agigantic way. Billions are dispensed in loans to farm-ers, small businesses, and foreign buyers of U.S. ex-ports. Additional billions of loans are guaranteedby the government.

Through Social Security, income mainte-nance, and other aid to the aged, the ill, and thepoor, the government is a major source of funds formillions of Americans. For example, in 1991 ap-proximately 20 percent of gross domestic productwas allocated for Social Security. In 1994 SocialSecurity payments totaled $320 billion. Do youknow what it was last year? If changed, what doyou attribute this to?

The federal government also is the largest singlecustomer for America’s industrial products and ser-vices. The Pentagon alone spent more than $269billion in 1994, with many billions going to buyeverything from aircraft carriers to kitchen pots.

Directly or indirectly, the government supportsmuch of the research done in the country.

Most of the money these activities take is sup-plied through taxes. Federal, state, and local gov-ernments use revenues amounting to more than11 percent of the country’s total production ofgoods and services.

15

Effects of Debt

Most often, with the excep-tion of recent years, the

federal government has spentbillions more than it takes in. Tomake up the difference, theTreasury will borrow—which iswhy the national debt keepsgoing up. To cover this deficit, thegovernment sells securities tobanks or individuals, thus takingfor public use funds the lenders

could have used to buy or investelsewhere. In the past, this processhas tended to increase thecountry’s money supply. When themoney supply increases at a pacefaster than the output of goodsand services, the result is likely tobe inflation, with prices rising andwages racing to keep up. Themajor burden falls on personswhose incomes do not go up asfast as inflation and who therebylose purchasing power.

comes before “Economic Theoriesthat Vie for Dominance”

Economic Theories That Vie forDominance

For some 40 years, the theories of Britisheconomist John Maynard Keynes dominated thepolitical economies of the United States and manynations of the non-Communist world. Over thepast decade, those theories, which hold that theactive use of government taxing and spending pow-ers can bring full employment and price stability,have come under increasing challenge. The rea-son is that they didn’t work well during the decadeof the 1970s when inflation persisted during reces-sion. That wasn’t supposed to happen. In theKeynesian world, inflation should have droppedsharply during recession.

As a result of this unexpected development,other economic theorists have come into promi-nence. They include:• Monetarists, who believe that a steady, re-

strained growth of the money supply is far moreinfluential than budget policy on economic per-formance, inflation, and unemployment.

• Supply-siders, who favor restoring incentives tothe economy by cutting taxes to stimulate work,savings, and investment.

• Post-Keynesians, who now acknowledge thepotent effect that money and finance, as well asfederal fiscal policy, have on the economy.

Let’s take a closer look at the schools of eco-nomic thought now vying in the United States andsome of their leading lights:

KeynesiansThe early interpreters of Keynes adopted bud-

get activism as the way to manage the economy.To pull out of a recession, the government shouldcreate deficits, either by increasing spending or low-ering taxes. Conversely, to cool down inflation, thegovernment should accumulate surpluses, either bycutting spending or raising taxes. The originalKeynesians believed in a predictable trade-off be-tween unemployment and inflation. A higher in-flation rate must be accepted to keep unemploy-ment down, and vice versa.

Franklin Delano Roosevelt’s New Deal em-braced the Keynesian philosophy to lift Americafrom the Great Depression when 25 percent un-employment was the nation’s concern. During the1960s, the Keynesians thought they could managefiscal policy (government taxation and spending)to moderate, if not eradicate, the boom-bust swingsof the business cycle.

But the Keynes formula ran into trouble in the1970s when unemployment stayed high and infla-tion rose—a condition known as stagflation.

Critics now believe that the Keynesian em-phasis on spending and taxation through the fed-eral budget overlooked the powerful effect moneyand credit have on economic performance, particu-larly in coping with inflation.

Out of this criticism have come various post-Keynesian schools, which acknowledge that mon-etary policy (levels of interest rates and growth inthe supply of money) matters as much as fiscalpolicy in managing the economy’s ups and downs.

In addition, many post-Keynesians favor somesort of an incomes policy—using the tax systemrather than direct federal controls—to moderatewages and prices in the fight against inflation.

MonetaristsMilton Friedman is the recognized leader. He

contends that stable monetary policy, rather thanactivist budgetary policy, is the key to a smooth-running economy. Inflation, Friedman argues, canbe controlled only by maintaining a firm grip onthe growth of the nation’s money supply.

It is largely on the basis of this theory that theFederal Reserve Board in October, 1979, switchedfrom a policy of managing interest rates to one ofcontrolling money-supply growth, letting rates findtheir own level.

As inflation is tamed, the monetarists contend,the economy will surge forward if it is unleashedfrom what they consider the shackles of govern-ment. That requires lower taxes, less regulation,and a reduction in the federal budget as a share ofthe total economy.

16

Unlike the Keynesians, Friedman and his fol-lowers do not believe fiscal policy (federal taxesand spending) should be used to counteract theturns of the business cycle. These monetarists wantto contain federal spending and balance the bud-get over the course of a business cycle. The govern-ment cannot fine tune the economy to eliminate everyup and down, Friedman says. Its attempts to do sohave made the ups and downs worse, not better.

Supply-SidersThese are divided into political and academic

advocates.Representative Jack Kemp (Republican from

New York) has been the leading proponent of sup-ply-side economics in the political arena. He hasargued that deep cuts in personal and business taxeswould produce such a strong recovery that the bud-get could be balanced with rising revenues andwithout substantial spending cuts.

Rational ExpectationistsAnother current development in economic

analysis, one that is influencing both monetaristsand Keynesians, is known as rational expectations.Economists doing research on this theory attributethe failures of past government policy, in part, tothe erroneous assumption that people would be-have under new policies as they did under old ones.

The government was assumed to be systematicallysmarter than people, explains Thomas Sargent, a pro-fessor at the University of Minnesota. When peoplebehaved in unexpected ways, he adds, the objec-tives of government policy often were frustrated.

Now these academics are attempting to in-clude in their statistical models of the economyestimates of the rational expectations of people inreaction to policy. Though this effort is far fromcomplete, the hunch among the theorists is thatthe results will tend to support stable economicpolicies over activist ones. Says Robert Lucas, aUniversity of Chicago professor: The best climatewe know how to provide is stability.

This section has set forth some of the mostimportant economic questions facing our nationtoday. How can we best encourage competition?How can we best deal with the problems of infla-tion? In what ways can we broaden employmentopportunities for those in need? Each deserves se-rious thought because our future progress dependson the answers we provide.

Questions for Discussion: Part III1. While ours is basically a CAPITALISTIC system

with resources owned primarily by individualsand businesses rather than government, insome important respects ours is a MIXEDeconomy existing within a democratic politicalsystem. What are some examples?

2. Are PRIVATE PROPERTY RIGHTS important in ourbusiness system? What are these? How are theyestablished and maintained? What are some ofthe challenges to them today?

3. The allegation is sometimes made that govern-ment doesn’t produce anything; only individu-als and businesses engage in production. Is thistrue? Is it helpful in understanding the role ofgovernment in a society?

4. Should government insist on every businesssurviving or perishing on its own merits, so longas it does not violate the laws of the land? Arethere any exceptions to this? What are theconsiderations?

5. Can you recall recent examples of governmentBAILING OUT some large business or busi-nesses? What circumstances are said tosometimes justify this? Do you agree?

6. Should government ever SUBSIDIZE or PROTECTbusiness development? Has this been done toany considerable extent in the United Statesover the years? What about the great landgrants to the railroads? What about importquotas or tariffs to protect infant industries inthis country? What about special tax breaks?What about provisions for accelerated deprecia-tion and others?

7. In general, there seems to be some feelingagainst BIG government and against BIGbusiness in the country today. Why? Is it likelythat we shall see a reduction of government’sinvolvement in the future? Why? How big is toobig—in government and in business?

8. The charge is sometimes made that in Americawe are more concerned with PROPERTY RIGHTSthan with personal rights or human rights. Howdo you respond to this statement? Do you agreeor disagree? What is the evidence on each sideof the question?

9. Do you feel that the government and itsemployees have any ethical responsibilities tothe general public?

10. What do you feel the government’s role shouldbe in the health care debate and other specialissues?

17

PART IV:

How to Do Business

Ideas for Further Study and Topicsfor Talks and Demonstrations1. Trace the history and activities of a U.S. govern-

ment agency, such as USDA, OMB, or OSHA.2. Develop your own criteria for how one of our

government agencies should function. For

Ways of Doing BusinessIntroduction

After studying Parts I, II, and III, you should have some idea of how our economy works—in a

broad sense. You should be aware of how the U.S.private enterprise system resembles other economiesand how it is different. The different roles you playas consumer, producer, and the voice of governmentalso should be apparent to you now. The remainderof our project on the American Private EnterpriseSystem is devoted to examination of the producer,concentrating on the four different ways of doingbusiness: the individually owned business, the partner-ship, the corporation, and the cooperative.

An overview will be presented first; then thenext three units will be devoted to each method oforganizing as a business. Table 1 on page 21 is acomparison of the methods used by these four typesof businesses.

OverviewBusiness Organizations. Businesses are orga-

nized to (a) produce or manufacture, (b) distrib-ute, or (c) sell goods and services. Sometimes abusiness combines more than one function. For ex-ample, storekeepers buy, store, and sell goods. Theymay also sell a service, such as fixing television sets.Storekeepers seldom produce or manufacture.

Production of Basic Commodities. Some busi-nesses produce basic commodities. Basic commodi-ties are raw goods or materials. Consumers use somecommodities, like coal and oranges, directly. Farm-ing, fishing, lumbering, and mining are businessesthat produce raw products.

Processing or Manufacturing. Typewriters,tractors, bread, canned peas, baby bottles, radios,and televisions are made from basic commodities.Processors make basic commodities more useful to

consumers. Cooking peas and canning them is pro-cessing. Manufacturers use basic commodities tomake other things. Radios are manufactured.

Marketing. Products that are processed ormanufactured must get to us as consumers. Mar-keting involves selling and transporting products.Sometimes products are sold to wholesale firmsfirst. Then wholesale firms sell products to retailfirms, and retail firms sell them to consumers.

Business Services. Many businesses sell ser-vices instead of products to people or other busi-nesses. Banks, law firms, doctors, bowling alleys,and repair shops sell services.

How Does Business Produce?Business produces using two or more of the

following elements:• natural resources,• labor,• capital,• management,• government.

As an example, consider a gas station and autorepair shop. No matter who owns it, it needs:

Basic Natural Resources. The land for a gasstation and repair shop must be in a good spot. Itshould be easy for cars to drive to it. A good supplyof water is necessary. In addition to these two natu-

example, what should the EPA do? Or howshould we handle food stamps?

3. Conduct a survey of your community to seehow many government agencies there are andwhat businesses, if any, they relate to. Draw achart to show these relationships.

18

ral resources, other services such as electricity andtelephone must be available.

Capital. The land, money, buildings, ma-chines, and tools used in a business represent thecapital used or owned by the business.

Labor. Businesses need labor to keep themfunctioning. For example, a full-service gasolinestation needs a skilled mechanic, a gas pump at-tendant, and a bookkeeper. The working condi-tions and the abilities, skills, and attitudes of own-ers and employees determine in part how well thebusiness will operate.

Management. Even with good capital, labor,and natural resources, someone must run the busi-ness. That is called management. Managers (orentrepreneurs) solve problems, decide who doeswhat, and plan. Management at a gas station maysolve a problem of long lines of customers by buy-ing more land, adding more pumps, or hiring morepeople. It is poor management, for example, touse a skilled mechanic to wash cars. Managementmust also see that gasoline, tools, and other ma-terials are available.

Government. Businesses need police and fireprotection, mail delivery, and other services. Lo-cal governments furnish some services such as po-lice protection. State or federal government fur-nishes services such as inspecting buildings andequipment for safety.

Capital Goods. Factories and machineryneeded to convert raw materials into the goods andservices we want are called capital goods. Facto-ries and equipment wear out or become out of dateand noncompetitive. Besides replacing these items,more capital goods are needed if production is toexpand. Without a continuing supply of new capi-tal, the economy cannot produce the goods, ser-vices, and jobs required now and in the future. Andthis means large capital investments must continu-ally be made.

In addition to replacing, modernizing, and ex-panding existing industrial capacity, our nation willbe challenged in the next decade to provide morejobs, expand housing, develop major new energyresources, continue improvements in the qualityof our environment, and improve our transporta-tion networks. It has been estimated that our totalcapital requirements for the next 10 years will atleast double those of the past decade.

Capital goods are important to jobs. The in-vestment in equipment and facilities is many thou-sands of dollars for each production worker inAmerican industry. Millions of new jobs will beneeded in the near future for workers entering the

labor market for the first time. Here we face somevery important questions. How can business andgovernment best work together to provide thesejobs? And how will the necessary capital goods beprovided?

What Business Does For a CommunityBusiness provides our basic needs:

Food. The food in a grocery store comes frommany business organizations. Milk, for example, isproduced on farms. Then it must be processed andput into containers before it can be delivered tostores. Farmers also buy cows, feed, and many otherthings from different businesses to help producethe milk.

Shelter. Many materials are used in buildinghouses. For example, nails are manufactured frommetal. First, ore is taken from the mine to thesmelter for processing. Metal is then taken to a fac-tory where the nails are made. Nails are marketedby factory representatives to wholesale firms.Wholesale firms sell nails to retail stores.

Clothing. Ready-to-wear clothes and cloth formaking clothes are bought in stores. Tailors pro-vide a service in making or fixing clothes.

Transportation. Transportation services movepeople or products from place to place.

Communication. Communication takes manyforms, a number of which involve business: televi-sion, radio, newspaper, telephone, computer, andon and on.

Services. Personal services make a communitysafer and more comfortable. Banks, insurance com-panies, law offices, churches, schools, and hair sa-lons are examples.

Successful local businesses offer two benefits tothe local community: (1) they serve the commu-nity and (2) they generate income. Successful busi-nesses are necessary for a prosperous community.

Local businesses usually trade with organi-zations outside the community, just as local gov-ernment works with county, state, and federalgovernments.

Starting a BusinessNo matter what its present size, chances are

that an enterprise traces its roots to an entrepre-neur—a person with a new idea who took a risk inthe hope of making a profit.

The examples are endless. In 1976, two col-lege dropouts—Steven Jobs and StephenWozniak—raised $1,500 by selling an oldVolkswagen van and setting to work in a garage todesign the first line of personal computers. Now,

No matter

what its

present size,

chances are

that an

enterprise

traces its

roots to an

entrepre-

neur—a

person with a

new idea who

took a risk in

the hope of

making a

profit.

19

return on investment, or profit, inrelation to the net amountinvested in the firm.

Thus, while annual reportsmight show rising profits in dollarterms over several years, a look atthese other two measures mayshow a slowdown or even adecline.

In recent years, profits of manycompanies have been squeezedtightly by rising wages, soaringenergy costs, and overseascompetition. Furthermore,inflation has pushed up dramati-cally the cost of buying rawmaterials and new machineryneeded to modernize, a furtherdrain on profits.

comes before “Problems ofProductivity”

Making a Profit

In order to stay alive, a businessmust have profits to pay for

future expansion, unexpectedevents, and as incentive to theowner to keep going. In acorporation, profits also are thesource of dividends paid to theindividual owners—the stock-holders.

While there are many ways tomeasure profits, investorsfrequently look at two. One—theprofit margin—is the amount abusiness clears on each dollar ofsales. A supermarket, for example,typically has a profit of a littleover one cent on each dollar ofsales. The second measure is the

their company (Apple Computers) isone of the leaders in the field.

Others build their businessaround existing ideas combined in anew way. For decades, many Americanspaid consultants to figure their incometaxes, but it took Henry and RichardBlock of Kansas City in the mid-1950s todevelop a lucrative nationwide chain oftax-preparation offices aimed at indi-viduals of all income levels.

Even in these risky times, entrepreneurialspirits seem to thrive. During a recent recession,a record 582,000 businesses were started in oneyear.

Some experts blame this problem on the floodof inexperienced workers into the labor market.Others cite the failure of many U.S. firms to investin enough modern equipment and plants, a prob-lem that often can be traced to inflation and thehigh cost of borrowed funds.

With more money to invest, companies are ex-pected to move more rapidly into such innovationsas industrial robots, which can speed production,improve quality, and relieve people of tedious anddangerous jobs.

In addition, more and more computers, wordprocessors, and other automated equipment areappearing in factories, offices, banks, departmentstores, and even supermarkets. Many firms also aresetting up quality-control circles in which smallgroups of employees give their ideas on how to trimcosts and boost production.

Together, these efforts are designed to producean item for less, thus allowing companies to makemore profits and be more competitive with foreignfirms.

A Topsy-Turvy Investment WorldNowhere is American capitalism in greater tur-

moil today than at its core—the financial system thatputs money to work to make more money.

Persistent inflation during the past decadeturned the nation’s money markets topsy-turvy; es-calating prices eroded corporate earnings, discour-aging thousands of investors from acquiring sharesin corporations. Many would-be entrepreneurs wereunable to form new companies, while existing firmshad to shelve plans to expand operations. In today’seconomy many of these trends have been reversed.

Also during that period, double-digit interestrates pushed credit out of the reach of home buy-ers and small businesses. Even large companiesscrambled to find less costly ways to borrow thefunds needed to keep factories running or to buildnew ones.

Wide swings in values of traditional invest-ments such as stocks and bonds make it harder forsecurities firms, banks, and other financial institu-tions to attract savings. The result: an explosionin investment opportunities tailored to inflation-savvy investors.

Why are these changes so important? Put sim-ply, our economy relies on the financial markets tofunnel people’s savings into industrial expansion.Without an efficient investment process, economicgrowth would be impossible.

The Problems of ProductivityIn the struggle to boost profits and trim costs,

companies are focusing more and more on produc-tivity—usually output per worker per hour.

Historically, the productivity rate has risen byalmost 3 percent per year in the United States. Butbeginning in the mid-1960s, the rate in this coun-try began to slow dramatically. At the same time,other nations, Japan in particular, have shownsteady jumps in productivity.

20

Raising the Money

All these steps—starting a business, making a profit, and

increased productivity—takemoney, which in today’s market-place is becoming ever moredifficult to raise, especially withthe government’s tremendousdemand for borrowed funds.

Traditionally, corporationshave relied on the sale of stocksto raise money for growth andexpansion. Perhaps a good placeto start this discussion is torespond to a few basic questions.What is stock? Why does acompany issue stock? Why doinvestors pay good money forlittle pieces of paper called stockcertificates? What about bonds?As stated above, a company mayneed money for growth andexpansion. One option is for thecompany to issue stock. There areother methods too, such as

issuing bonds and getting a loanfrom a bank. However, stock raisescapital (money) without creatingdebt: without creating a legalobligation to repay these funds.Buyers of the stock becomeshareholders in the corporation—the company’s owners. From theirinvestment, these shareholdersexpect to make a good return ontheir investment. Bonds, too, arean important capital source forcorporations. In normal years, theaggregate value of new bondissues may be five times greaterthan the value of new stockissues. In fact, in the modern era,American business has raisedlittle more than 5 percent of themoney it has needed through thesale of stocks. It has raised mostof the balance by selling bonds.This is why the bond market ismany times larger than the stockmarket.

comes before “In the Driver’s Seat”

regulations, consumer demands, environmentalrules, and competition from overseas.

Yet companies are beginning to realize thatsuch issues—and the added costs they bring withthem—should not be allowed to keep managersfrom their mission of putting out a product or ser-vice that people will want to buy.

Stock MarketThe stock market is the hub of the invest-

ment world. More than 40 million individualsown shares in U.S. corporations valued at morethan $1 trillion dollars and representing one-fourth of all household assets.

Some 150 million Americans indirectly ownstocks held in huge portfolios managed by insti-tutional investors such as bank trust departments,life-insurance companies, and pension plans.When people purchase a company’s stock, theyactually become part owners, entitled to a shareof the firm’s profits.

Stocks can provide two sources of income forthe investor. The first is the dividend—profits afirm distributes to its shareholders. The second isthe capital gain an investor reaps when a stock issold for more than its original price. However, in-vestors have no guarantee that a stock will pay anydividends, and a share’s value can easily decline.

Stock prices are influenced by many factors,including the value of a firm’s assets, earnings pros-pects, and investor demand. That’s why investorspay close attention to such developments aschanges in a company’s product line. Even rumorscan have dramatic impact.

Stock prices are a key barometer of the busi-ness outlook. A bear market—when prices are fall-ing—indicates investors are worried that theeconomy is slipping and that corporate earningswill decline. In contrast, the rising stock prices ofa bull market signal that investors think businessconditions and profits will improve.

Corporations could not sell a single share, how-ever, if there were no stock market where investorsin need of cash can easily sell their holdings.

On a typical business day, approximately 500million shares change hands. More than half ofthese trades take place at the New York Stock Ex-change. Called the Big Board, it lists the stocks formore than 3,275 of the country’s oldest, largest,and best-known corporations. The American StockExchange, also in New York and the second-larg-est trading floor, lists more than 900 additionalfirms. Shares in more firms are listed at the country’sseven regional exchanges. The stocks of 12,000generally small- and medium-sized firms are soldover the counter by securities dealers.

In the Driver’s Seat—the Board of DirectorsWhile thousands of individual investors may

own a piece of a large public firm, its real control isin the hands of a board of directors.

Board members often include officers of thecompany, major stockholders or their representa-tives, and outsiders who can provide useful con-nections with law firms, banks, investment houses,and customers.

In recent years, some firms have broadenedtheir boards beyond the typical white, wealthy,male membership to include women and minori-ties. The Chrysler Corporation added the presidentof the United Auto Workers to its board, markinga dramatic shift in U.S. business-labor relations.

Although the board sets overall policies, theday-to-day decisions are made by professional man-agers trained in law, business management, engi-neering, finance, and other fields. Beyond theirsalaries, these managers may have no ties or loy-alty to the organization, unlike the entrepreneurscrambling to make a firm a success.

Increasingly, top management is spendingmore time on outside issues that can have a bigimpact on the firm. Among them: government

21

For an idea of how a stock exchange works,note what happens when an investor decides tobuy 100 shares of, say, the Widget Company for $5a share. The investor first asks a brokerage firm tohandle the purchase. At the stock exchange whereWidget shares are traded, the broker’s representa-tive locates another broker whose client wants tosell 100 shares of Widget at the same price. Oncethe trade is executed, the buyer has five businessdays to come up with the $500 for the stock andthe seller has five days to deliver the shares.

Some firms issue preferred stock that pays in-vestors a fixed dividend. Dividends on this specialclass of stock must be paid before any earnings aredistributed among other shareholders.

Buying and Selling BondsWhen the stock market looks risky, many

people prefer to invest their savings in debt secu-rities, which usually provide a dependable flowof income.

Many companies and government agenciesborrow money by selling bonds, typically in de-nominations of $1,000. A bond certificate is an IOUthat promises to pay the holder a certain rate ofinterest and to redeem the full face value of thenote when it matures. Terms of new issues typi-cally range from five to 40 years.

Bonds are considered less risky than stocks,since any interest obligations must be met before adividend is paid. In addition, bondholders get firstcrack at the assets of a bankrupt firm.

Still, the price of a bond can vary greatly overits lifetime, depending on the course of interestrates. When rates fail, bond sellers can demand apremium.

In general, higher yields are offered on longer-term bonds, since investors must commit funds for20 years or longer. But when interest rates becomeextremely volatile, as in recent years, investors maydemand higher rates for short-term issues.

Independent firms, such as Standard & Poor’sor Moody’s, evaluate an organization’s ability to carryits debt burden before assigning a rating, which canvary from the top-quality triple-A rating to a singleC or D for companies in default. To offset low-qual-ity ratings, issuers must offer higher yields.

The taxing power of the federal governmentassures that its debt securities are virtually risk-free,so that the U.S. Treasury borrows more cheaplythan do private corporations. However, the lowestbond rates are offered by state and local govern-ments. While they don’t share Uncle Sam’s impec-cable bond rating, the interest they pay is exemptfrom federal income taxes.

Hedging BetsSoaring interest rates encourage the creation

of various devices enabling investors to hedgetheir bets.

Today, investors can protect themselvesagainst adverse movements in stock values by writ-ing options to buy or sell a stock at the currentmarket price prior to a future date. For example,an investor who fears that the price of his/her sharein Company A will fall in the coming months canbuy an option to sell the stock to another investorat the present price.

If the price falls before the option expires inthe next nine months, the investor is able to sellthe stock at the higher price. If the market pricerises, the investor just lets the option expire.

Table 1. Comparison of Methods of Doing Business in America by Different Types of Businesses

Features Compared

Type of Business

Individual Partnership

Corporate Form

Regular Corporation Cooperative Corporation

Who uses the services? Nonowner customers

Generally nonowner customers

Generally nonowner customers

Chiefly the member-patrons

Who owns the business? The individual The partners The stockholders The member-patrons

Who votes? Not necessary The partners Common stockholders The member-patrons*

How is voting done? Not necessary Usually by partner’s share in capital

By shares of common stock

One member one vote orproportional to patronage

Who determines policies? The individual The partners Common stockholders and directors

The member-patrons anddirectors

Are returns on ownershipcapital limited?

No No No Yes, 8 percent or less*

Who gets the net operating proceeds?

The individual The partners in proportionto interest in business

The stockholders inproportion to stock held

The patrons on a patronagebasis*

* Basic cooperative characteristics

22

PART V:

Sole Proprietorships and Partnerships

The Individually Owned Business

Individual ownership is the oldest form of business. Individually owned businesses include farms, lo-

cal stores, repair shops, barbershops, restaurants,dental practices, and others.

The sole proprietorship remains the most com-mon type of company, accounting for about 77 per-cent of all firms. Here, an individual stands alone,bearing full responsibility for the success or failureof the venture, such as permits and licensing. On asmall scale, sole proprietorship illustrates many ofthe activities common to all business.

For example, perhaps your neighbor—ateacher—tires of the classroom. She knows fromexperience that private tutors are in demand. So,after sizing up her market, she quits school andopens a tutoring service.

At first, she does everything alone. Start-upmoney, or capital, for an office in her home and forstudy materials comes from her savings.

Through trial and error, she discovers what feesstudents are willing to pay, and she eventually earnsenough to cover expenses and have some funds leftover—a profit.

Profits might go to improve the business, per-haps to purchase a home computer. Or she mighttake the extra money and hire another teacher ifbusiness is booming or spend more on advertisingif it is slowing. Another portion of the profits maybe set aside for future expansion or for unforeseenevents. Some she keeps as a personal reward forthe risks of establishing the business.

Later, a big injection of cash might be neededto open another office or add staff. She may decideto find partners to share costs and profits, or shemight go to the bank or other sources of capital.Lenders usually demand a successful track recordbefore they will make a loan to an individual.

In some cases, too, lenders or venture-capitalfirms that invest in growing businesses will demanda share of ownership. The result is that the entre-preneur gets money to expand but gives some ofthe control and profits to others.

1. The individual owner serves the public. Theowner buys and sells goods or provides servicesto whoever wants them.

2. Little legal help is needed to start this kind ofbusiness. The owner may only need to buy alicense or apply for a permit. For example, alicense to operate a barbershop or hair salon isall that is needed.

3. The owner provides or borrows capital to starta business and has the liability for all debtsthe store owes. If the store loses money, theindividual still must pay the bills.

4. Management is the responsibility of the owner,although someone can be hired to operate thebusiness.

5. The individual owner can make all decisionsand determine business policies.

6. The owner receives the net margins, themoney left after all bills are paid.

7. When the owner retires or dies, heirs may keepthe business, sell it, or close it.

Below are some characteristics of individuallyowned businesses. Are they advantages or disad-vantages?• The business can be started quickly. Decisions

may be made quickly, policies changed. Theowner is responsible for management.

• Business credit is only as good as the credit ofthe owner.

• Large amounts of capital are difficult to obtainfor business expansion.

The individually owned business is more domi-nant in farming than in any other segment of oureconomy. The most common type of farm businessstructure is the one in which the owner-operatormakes the decisions and assumes the risk; the farmeris the entrepreneur and usually performs the physi-cal labor.

Despite the growth in size of farms and theincreased use of farm machinery, the division oflabor now typical in so many other industries isstill not characteristic in agricultural production.A farmer is often engaged in manual work, account-ing, bookkeeping, management decisions, and fi-nancial planning. The farmer is a combined owner,manager, and laborer.

23

Although somefarms, even the family-type ones, are now in-corporated, the predominanttype of farm business is still an indi-vidual operation.

The individually owned business has these ad-vantages: (1) it is easy to control—the owner’s judg-ment is final, and (2) any profits are the sole prop-erty of the owner—they need not be shared.

But it has these disadvantages: (1) any lossesare borne by the owner—they cannot be shared,and (2) capital is limited by what the owner canput up or borrow—which often limits the size ofthe business.

The Business PartnershipA partnership is a voluntary association of two

or more persons, as co-owners, to carry on a busi-ness for profit. Property used in the business maybe leased, but the business as an enterprise must beowned by all the partners. Partnerships are gov-erned by a code of rules called the Uniform Part-nership Act, and additional rules may be adoptedin the partnership agreement.

For federal income tax purposes, the term“partnership” includes a syndicate, group, pool,joint venture, or similar organization carrying outa trade or business and is not classified as a trust,estate, or corporation. A joint undertaking merelyto share expenses is not a partnership. Mere co-ownership of property maintained and leased orrented is not a partnership. However, if the co-owners provide services to the tenants, a partner-ship exists.

Creating a Partnership. A partnership is cre-ated by an oral or written agreement. In some in-stances, a partnership may be implied without anagreement if the business is being carried on as apartnership. Several characteristics define a part-nership: (1) each person involved participates inmanagement decisions; (2) assets are owned jointly;(3) profits are shared; (4) losses are shared; (5) theparties operate under a firm name; (6) the partieshave a joint bank account for doing business trans-actions; and (7) the parties keep a single set of busi-ness records.

Legal Considerations. Listed below are somelegal factors that partners, or potential partners,should consider. (1) Unless otherwise specified in

the Agreement, each partner legally hasan equal voice in management control, anda majority of the partners must controlbusiness decisions. (2) Both real and per-sonal property may be owned in the part-nership name. (3) Profits and losses are di-vided according to the specific agreement;partners do not normally draw compensa-

tion for their services, and any withdrawals or wagesshould usually be treated as advances on their shareof the profits. Profits do not have to be distributedon the basis of the relative amount of capital con-tributed to the partnership by respective partners.(4) A partnership must have its own records, espe-cially for income tax purposes. Although the busi-ness pays no income taxes, a return showing part-nership income tax information must be filed. Thepartners then pay individual taxes on their shareof the partnership income, as specified in the part-nership agreement.

Family Partnership. Members of a family canbe partners. However, family members (or anyother person) will be recognized as partners only ifone of the following requirements is met: (1) if capi-tal is a material income-producing factor; they ac-quired their capital interest in a bona fide transac-tion; actually own the partnership interest; and ac-tually control the interest or (2) if capital is not amaterial income-producing factor, they must havejoined together in good faith to conduct business.In addition, they must have agreed that contribu-tions of each entitle them to a share in the profits.Some capital or service must be provided.

General Partnership. There are two types ofpartnerships: general partnerships and limited part-nerships. A general partnership is created when twoor more individuals agree to create a business andto jointly own the assets, profits, and losses. Thereis no limit on the number or types of partners. Ageneral partnership can be formed by an oral agree-ment. Even so, it is better for the general partnersto have a written agreement that addresses a num-ber of key issues, including the following: (1) howmuch time and/or money the partners will con-tribute to the business; (2) how business decisionswill be made; (3) how profits and losses will beshared; (4) what will happen if a partner dies, be-comes disabled, or stops working or contributingto the business; and (5) when the partnership willmake payments to its partners.

A farmer is

often

engaged in

manual work,

accounting,

bookkeeping,

management

decisions,

and financial

planning.

24

In a general partnership, each partner is indi-vidually as well as jointly liable for all of the obli-gations of the partnership. It is important that gen-eral partners carefully evaluate the financial statusof each other before forming a general partnership.

Limited Partnership. A limited partnershipmay be created by following specific steps set outin each state’s statutes. Limited partners do nothave personal liability for the business of the part-nership. Limited partners are at risk only to theextent of the contributions that they agreed to inthe partnership agreement.

Taxes in the Partnership. The partnership it-self is not responsible for paying taxes on the in-come generated by the business. A partnership taxreturn is filed but for informational purposes only.Each partner individually pays taxes on his or hershare of the business income. The profits and losses“flow down” from the partnership to the individualpartners. Partners must also pay self-employmenttax on their partnership income.

Partnership Advantages. There are four realadvantages in organizing as a partnership. First,partnerships are relatively easy to create withoutmuch legal expense. Second, a partnership permitsownership by more than one individual. Third, apartnership pays no income tax since profits aredistributed to partners as ordinary income. Fourth,a partnership is easy to dissolve and has few legalformalities for its maintenance.

Disadvantages of a Partnership. First, part-nerships succeed only if each partner has faith andtrust in the other partners’ business abilities. Sec-ond, each partner is individually and fully respon-sible for all debts owed by the partnership; how-ever, this does not extend to personal debts of theother partners. Third, the partnership ends withdeath, bankruptcy, or incapacity of a partner.Fourth, general partnership interest may not be soldor transferred.

Terminating a Partnership. A partnership ter-minates when: (1) all of its operations are discon-tinued, and no part of any business, financial op-eration, or venture is continued by any of its part-ners in the partnership; or (2) at least 50 percentof the total interest in partnership capital and prof-its is sold or exchanged within a 12-month period,including a sale or exchange to another partner.Any partner may terminate the partnership at will.Although a partnership is easy to terminate, care-ful thought should be given to this area at the timethe partnership begins.

Questions for Discussion: Part V1. What are some businesses in your own commu-

nity that are individually owned or partner-ships?

2. How does the number of such businesses inyour community compare with the number ofcorporations or cooperatives? Check withothers.

3. If you had information as to the rate of failureamong single-owner businesses and corpora-tions, which would you think might have theHIGHEST rate of failure? Why?

4. What are some of the ADVANTAGES of theINDIVIDUALLY OWNED BUSINESS? DISADVAN-TAGES?

5. What are some of the ADVANTAGES of thePARTNERSHIP BUSINESS? DISADVANTAGES?

6. If most farming operations in the United Statestoday are conducted as individually ownedbusinesses, why are some farms incorporated?

7. How does an individual get enough capital tobegin a single-owner business? What are someof the limitations? Why?

8. How many persons must be involved in orderfor there to be a LEGAL limit to the number ofpartners in a business partnership? What aresome of the practical considerations involved indeciding on the number of partners in abusiness partnership?

9. If there are profits resulting from the operationsof a business partnership, to whom do theseprofits belong? How are they divided?

10. Would you be as willing to invest in a partner-ship business in some distant city as in acorporation in some distant city? Why or whynot?

Ideas for Further Study and Topicsfor Talks and Demonstrations1. Invite a lawyer to tell your group how one starts

an individual business or partnership in yourcounty.

2. Look at the yellow pages of your telephonebook and try to determine how many individualbusinesses and partnerships are listed there. Tryto categorize the businesses listed by types ofbusiness. Are individual businesses andpartnerships usually among certain types ofbusiness activity? Can you think of reasons foryour findings?

25

Forming a Corporation

Forming a corporation involvesthe transfer of money,

property, or both by prospectiveshareholders in exchange forcapital-stock in the corporation.Perhaps the first step in organiz-ing a corporation is to clearlydefine the goals the corporationis expected to meet. The nextstep is to retain the services of anexperienced attorney. Theattorney will be instrumental indeveloping the Articles ofIncorporation and other legaldocuments. A third step in

forming a corporation is toengage a certified publicaccountant to set up recordaccounts. The remaining steps areto obtain a state charter; issuedividend stock as prescribedwhen goals were established;issue stock certificates; hold thefirst meeting of stockholders;elect a board of directors andadopt the bylaws of the corpora-tion; elect officers; set wages andsalaries and settle on remunera-tion for assets leased to thecorporation; and establish a fiscalyear.

comes before “Corporation’s LegalFoundation

PART VI:

Investor-Owned Corporations andLimited Liability Companies

Corporations

A third business organization, the corporation, is defined as a legal entity separate and dis-

tinct from the shareholders who own it, from theindividuals who manage it, and from its employ-ees. There are two major kinds of corporations–one is the investor-owned corporation, and theother is the cooperative. Both are state-charteredbusinesses, usually organized under the laws of thestate in which they have their main office.

The corporation is considered a separate legalentity and, as such, shareholders in the corporationare not personally responsible for the losses of thebusiness. As a separate legal entity, the corporationhas most of the legal rights and duties of an indi-vidual. For example, the corporation can enter intocontracts, transact business, hold property, sue, andbe sued. It should be noted that it is the concept oflegal separateness that sets the corporation apartfrom the partnership and sole proprietorship.

Most states will also recognize non-stock cor-porations, which are commonly used for non-profitorganizations. There are no owners in a non-stockcorporation, although there may be members.

Corporations’ Legal FoundationAn investor-owned corporation is established

by the founders according to the laws of the statewhere the corporation is headquartered. Articles ofIncorporation or a certificate of incorporation ex-plain the activities and purposes of the corporation.Information in the Articles of Incorporation in-cludes: the name of the business, the total numberof shares of stock the corporation can sell or issue,the number of shares of stock each of the ownerswill buy, the amount of money or other propertyeach owner will contribute to buy his or her sharesof stock, the business in which the corporation willengage, and who will manage the corporation.

Usually bylaws are adopted specifying howbusiness will be conducted. Bylaws are really a setof rules of procedure by which the corporation isrun. Such rules will include information on howto conduct the stockholder meetings and directors’meetings, the number of officers in the corpora-tion, and the responsibility of each officer.

Who Owns the Corporation?Corporations are owned by their shareholders

or stockholders. Such corporations are commonlyreferred to as “investor-owned corporations.” Aninvestor-owned corporation is operated as a profit-keeping enterprise. Individuals are motivated topurchase shares of stock in the corporation to makea profit on their investment. The corporation de-rives capital funds by issuing shares of stock. Theprice of each share may vary from day to day.

Stock of many investor-owned corporations isbought and sold daily on stock exchanges, the larg-est being the New York Stock Exchange. Becausewe live in a global economy, stock markets in othercountries such as Japan are of special interest tomany stockholders.

Stocks and Non-Stock Corporations. Stockcorporations, as the name implies, are corporationsthat raise a large percentage of their capital throughthe sale of stock to stockholders. A stock corpora-tion may elect sub-chapter S status for tax purposes.Once such an election is made, the corporation isreferred to as a Sub-chapter Corporation.

26

Advantages of theCorporate Structure

The major advantages oforganizing a business as an

investor-owned corporation are:(1) liability is limited to assets ofthe same legal rights as anindividual; (2) the corporation canoperate in perpetuity (continuityof operation); and (3) it is easy toadd additional owners/investors.

Limited Liability. A corpora-tion is treated as a separate entityfrom its owners. This suggeststhat creditors of the corporationmay look only to the corporationand the business assets forpayment. Individual stockholdersare not personally liable for thelosses of the business if thecorporation is establishedproperly. The extent of sharehold-

ers’ risk is their investment in thecorporation.

Continuity of Operation. Acorporation exists for any lengthof time the shareholders desire,as long as it continues to fulfillthe requirements of law. In otherwords, a corporation does notcease to exist if one or more of itsowners dies. Ownership of acorporation can also be trans-ferred by sale of all or a portion ofthe stock.

Easy to Add AdditionalInvestors. Additional owners canbe added either by selling stockdirectly from the corporation orby having the current ownerssell some of their stock. Thistransaction can occur withoutany negative effects on thecorporation.

comes before “Taxing the Corpora-tion”

Capitalizing the CorporationCorporations need long-term capital for build-

ings, facilities, and equipment and short-term capi-tal to cover the day-to-day expenses. Some capitalfunds are obtained by issuing shares of stock to in-vestors who are looking to make a profit. Corpora-tions supplement this capital by borrowing frombanks, other financial institutions, and individuals.

Controlling the CorporationThe corporation is controlled by the

stockholder(s) who own the majority of shares inthe corporation. Stockholders’ wishes are reflectedby the actions of a board of directors who areelected by the stockholders. The board of direc-tors is responsible for the major decisions of thecorporation. The board will meet a minimum ofonce each year. Typically each director has onevote, and usually a majority vote of the directors issufficient to approve a decision of the board. Oncethe board of directors is determined by stockhold-ers, the officers of the board (president, vice-presi-dent, secretary, and treasurer) are elected by thedirectors from among their ranks.

The officers are responsible for running theday-to-day business of the corporation.

Taxing the CorporationThe corporation must file its own income tax

returns and pay taxes on its profits. The corpora-tion must report all income it has received from itsbusiness and may deduct certain expenses it haspaid in conducting its business.

Dividends paid to shareholders by the corpo-ration are taxed to each shareholder individually.This process is often referred to as “double taxa-tion.” This is true because the corporation paystaxes on its profits, and shareholders must pay taxeson the dividends paid to them from the profits.

How Corporations HandleRisk and Uncertainty

One way an enterprise can survive in thisriskier era is to become a larger and more diversi-fied corporation. When one part of its operationfalters, other parts may do very well, thus ensuringthe overall health of the firm.

Corporations play the largest role in theAmerican economy. They account for about 88percent of all business sales receipts, while singleproprietors account for 8 percent and partnershipsa mere 4 percent.

What’s behind this trend to bigness? For onething, many of the products and services sold topeople now are too complex to be produced bysmall enterprises. Size can also mean savings andgreater efficiency than are possible on a small scale,from buying raw materials by the ton to mountinga mass sales-and-delivery campaign.

The corporate form of ownership also worksbetter for ventures involving large amounts ofmoney because of its limited risk. Legally, if a cor-poration goes bankrupt, the owners usually can-not be required to make good on unpaid debts.

What characterizes today’s giant corporationsis the constant search for the right mix. By movingquickly into the most profitable fields and phasingout products that offer little opportunity, a companycan do very well, despite economic downturns.

This trend is reshaping countless firms. Gen-eral Electric, for example, was known traditionallyfor its electrical and electronic equipment. Duringthe early 1970s, 80 percent of its earnings camefrom such equipment. At latest report, this type ofproduct, including consumer and lighting goods,was responsible for less than 50 percent of earn-ings. The remaining profits came from such thingsas information services, financial activities, aero-space, medical systems, power systems, transporta-tion equipment, and energy exploration.

27

Investor-owned corporations have these char-acteristics:1. Like the individually owned business and part-

nership, the investor-owned corporation servesthe general public.

2. Capital for investor-owned corporations is usu-ally provided by selling stock or by borrowing.Corporations may borrow from lending insti-tutions. They can also issue bonds and payback the people who buy the bonds. The cor-poration is responsible for debts. If the busi-ness fails, each owner of stock can lose onlythe amount paid for the stock. The corpora-tion can lose its property or assets.

3. Business decisions and matters of policy aredecided by the board of directors and officers,who are elected by stockholders. If stockhold-ers wish to change policies, they can elect otherdirectors at the next annual meeting. Eachstockholder has as many votes in these elec-tions as the number of shares he or she owns.Those who own the largest number of sharesof stock control the corporation.

4. Management of the corporation is by the of-ficers, who are selected by the board of direc-tors in accordance with the charter.

5. Net margins are either divided among thestockholders on the basis of the amount ofstock owned or used to expand the business.The board of directors decides how net mar-gins will be used.

6. When a stockholder dies, his or her stock goesto heirs, who may keep or sell it. Business op-erations are usually not affected.

Below are some characteristics of investor-owned corporations. Are they advantages or dis-advantages?• The purpose of investor-owned corporations is

to make money for stockholders. The financialresponsibility of each investor-owner is limitedto the amount he/she has invested in stock.

• The investor-owned corporation is structuredto continue in business indefinitely. Long-rangeplanning and research can be conducted.

• Often, many owners of stock do not attendmeetings. They can vote by proxy. Some own-ers of stock pay little attention to business op-erations. They are primarily interested in thedividends earned by the stock they own.

Limited Liability CompaniesA limited liability company (LLC) is a type of

company authorized only in certain states, whoseowners and managers have limited liability and taxbenefits. An LLC is a blend of some of the bestcharacteristics of corporations, partnerships, andsole proprietorships. It is a separate legal entity likea corporation, but it is entitled to be treated as apartnership for tax purposes. Because it is a sepa-rate entity, none of its members are personally li-able for its debts. But, like a partnership, the LLCis not a tax-paying entity. Profits, losses, etc. flowdirectly through and are reported on the individualtax return. It is very flexible and simple to run and,like a sole proprietorship, there is no statutory ne-cessity to keep minutes, hold meetings, or makeresolutions that can trip up many corporations.

Forming an LLCThe formation of an LLC is not a difficult pro-

cess. An LLC is formed by filing a form, usuallycalled Articles of Organization, with the Secretaryof State. Most states require that an annual reportbe filed to keep them up to date on the LLC’s cur-rent status, but other than that, there are no otherongoing reports or forms. Most states require thatthe LLC have an Operating Agreement. The Op-erating Agreement is the agreement between themembers as to how the LLC will be managed, andit contains provisions that will qualify it for thebeneficial partnership tax treatment.

Who Owns the LLC?The owners are called members and can be vir-

tually any entity, including individuals, corporations,other LLCs, trusts, pension plans, etc. Unlike a cor-poration, which is not required to have more thanone shareholder, most states require that an LLC con-sist of two or more members. Management and con-trol of an LLC are vested in its members, and no onecan become a member of an LLC without the con-sent of members having a majority in interest unlessthe Articles of Organization state otherwise.

By moving

quickly into

the most

profitable

fields and

phasing out

products that

offer little

opportunity,

a company

can do very

well, despite

economic

downturns.

28

Type of Company Liability Operations Management Raising Capital

Sole Proprietorship Unlimited Simple Proprietor Difficult

Partnership Partners Simple Partners ----

LLC NO Medium Members Possible

Corporations NO Difficult Board Stock

LLCs’ Legal FoundationThe existence of an LLC begins upon the fil-

ing of the Articles of Organization with the Secre-tary of State. The articles must be on the form pre-scribed by the Secretary of State. Among the re-quired information on the form is the latest date atwhich the LLC is to dissolve and a statement as towhether the LLC will be managed by one man-ager, more than one manager, or by the members.To validly complete the formation of the LLC,members must enter into an Operation Agreement.This operating agreement may come into existenceeither before or after the filing of the Articles ofOrganization and may be either oral or in writing.The Articles of Organization must specify the dateon which the LLC’s existence will terminate. Un-less otherwise provided in the Articles of Organi-zation or a written operating agreement, an LLCgoes out of business at the death, withdrawal, res-

ignation, expulsion, or bankruptcy of a member(unless the remaining members attain a majorityvote within 90 days to continue the LLC).

Advantages vs. DisadvantagesAdvantages of an LCC• Its owners, managers, and officers are not per-

sonally liable for the company’s debts.• It does not pay taxes.• It does not require as much paperwork or record

keeping as a corporation.

Disadvantages of an LCC• It is not widely accepted since this is a relatively

new form of company.• It is difficult to transact business in states not

allowing this form of business.• Its filing fee is usually much higher than for cor-

porations.

Questions for Discussion: Part VI1. What are the ADVANTAGES of INCORPORATING

a business? DISADVANTAGES?2. How does one become a part owner in a

corporation? How is OWNERSHIP usuallyrepresented? How does common stock usuallydiffer from preferred stock? Which kind wouldYOU prefer to own in a company? Might thisdiffer for different people? Why?

3. Are corporations usually set up or charteredunder state laws or under federal laws?

4. Are stocks of all corporations traded on thesecurities markets? What are the two majorsecurities markets? Are there local brokeragefirms in your community through which you canbuy or sell stocks on these two major stockexchanges? What is meant by OVER THECOUNTER?

5. Does the owner of COMMON STOCK in acorporation usually have any vote in the affairsof the corporation? On what basis, usually?

6. Where would you expect to find the statementas to the duties of the board of directors for anyparticular corporation?

7. When the investor-owned corporation makes aprofit from its operations, to whom does thePROFIT BELONG? To whom are PROFITSDISTRIBUTED, and on what basis?

8. Is it necessary for a corporation to makedistribution of its profits each year after payingcorporation income taxes? Explain.

9. If you were considering a career in a type ofbusiness in which there were single-ownerfirms, partnerships, and also corporations, wouldyour education and training necessarily besignificantly different depending on which kindof business organization you were to consideras a career opportunity? Explain.

10. How do corporations compare in size topartnerships and single-owner businesses onthe average? How would you measure SIZE forthis kind of comparison? Total capital required?Amount of capital invested? Dollar volume ofbusiness per year? What would you EXPECT tofind usually?

Ideas for Further Study and Topicsfor Talks and Demonstrations1. Try to determine how many corporations there

are in your county. Then call some of them tofind out how big they are. How much variationis there in their sizes?

2. Have your group discuss starting a corporation.What kind of corporation would you form? Howwould you go about forming it?

29

PART VII:

Cooperatives

Introduction

A cooperative corporation is also a state-chartered business, but it exists to perform specific ser-

vices for and provide economic benefits to its mem-bers rather than to make a profit for investor-own-ers. Also, it obtains a portion, or all, of its capitalfunds from the members it serves rather than fromoutside investors.

Some cooperatives raise a portion of their capi-tal needs by charging a membership fee; others bythe sale of shares of stock. Cooperative stock, how-ever, is not traded on the stock exchanges. There isno active market because net operating marginsbelong to patrons rather than to investors.

The fundamental difference between coopera-tives and other types of businesses is in objective.A cooperative seeks to realize economic benefitsfor its members from services that reduce costs, in-crease members’ income, improve quality, providean improved service, and develop the best use ofmembers’ resources.

Cooperatives thus exist to meet members’needs economically and efficiently. Other types ofbusinesses are motivated by prospective profits oninvested capital. Their entire pattern of opera-tions—commodities handled, services performed,operating procedures—is planned and executedwith profits as the goal. Actual operations may besimilar or comparable, but the motive is different.

The difference in motive is evident in who re-ceives the net margins. In an individually ownedbusiness, it is the owner; in a partnership, the part-ners; in an investor-owned corporation, the stock-holders; in a cooperative, the member-patrons.

Cooperatives (like investor-owned firms) arenearly always incorporated to provide their mem-ber-patrons the shelter of limited liability if thebusiness should fail. In relatively rare instances,small cooperatives providing a limited number ofservices may choose to operate as an unincorpo-rated business. Under these circumstances, the co-operative has a legal status not unlike that of a part-nership. There, liability is unlimited, and the death,entry, or withdrawal of a member makes it neces-sary to restate, usually in writing, the nature of therelationship between members.

Cooperative corporations have these characteristics:1. The cooperative corporation operates as an

agent. It either buys and sells goods for itsmembers or provides some service for them.Some manufacture and process products.Farmer marketing and purchasing cooperativesact as business agents for farmers. Consumercooperatives buy for and distribute goods toindividual members. Credit unions and orga-nizations, like group health associations, pro-vide services for members.

2. Capital for cooperative corporations may beprovided by the sale of stock that has, by law,a limited return, interest rate, or dividend. Innon-stock cooperatives, capital may be ob-tained from membership fees. Additional capi-tal may be borrowed from members as well asother lenders. The cooperative is responsiblefor debts to the limit of its assets. Members areresponsible only for money each has invested.

3. Cooperatives are managed by officers who arehired by the board of directors. Boards of di-rectors are elected by the cooperative mem-bers from their membership. Directors act formembers, making policies and employing per-sons to transact business. Unlike the investor-owned corporation, each person or member ofa cooperative usually has only one vote, nomatter how many shares of stock the personowns.

4. Policies are decided at the annual meeting ofmembers. Directors are elected at this meet-ing to make policy decisions between the an-nual meetings.

5. Cooperatives usually charge enough for goodsand services to cover costs. Net margins leftover at the close of the business year are re-turned to members according to the amountof business each did with the cooperative.These returns are often called patronage re-funds.

6. The ownership of a member of a cooperativebecomes an asset of the member’s estate atdeath. Cooperative operation is not affected.

A cooperative

seeks to

realize

economic

benefits for

its members

from services

that reduce

costs,

increase

members’

income,

improve

quality,

provide an

improved

service, and

develop the

best use of

members’

resources.

30

percent per year, or restrictvoting rights to one member,one vote. Each state has itsown laws that regulate theformation and operation ofcooperatives.

3. A cooperative normallyreturns to its members anyexcess of gross proceedsover expenses. In aninvestor-oriented firm, thisexcess is called profits. In thecooperative, it is margin.

This procedure has importantfederal income tax implications. Ifexcess funds are not retained asprofits by the cooperative, theycannot be taxed as corporateincome.

Many people form and joincooperative corporations. Theyform cooperative corporationsfor stores in urban communities,credit unions, mutual insurancecompanies, and many otherbusinesses. For example,Associated Press is a cooperativeservice that gathers news fromaround the world for membernewspapers.

comes before “How Cooperativesare Organized”

Distinctive Principles

Cooperatives have three distinctive principles: (1)

democratic control, (2) limitedreturns on invested capital, and(3) operation on a cost-of-doing-business basis.1. Control of a cooperative rests

with the members, whonormally exercise their votesto elect a board of directorsat an annual meeting. Mostcooperatives allow one voteper member.

2. Consumer cooperativesusually limit rate of interestpaid on member investment.Returns to members ofagricultural cooperatives aremore definite. The Capper-Volstead Act gives legalsanction to the right offarmers to formally organizeand act together withoutfear of antitrust actionagainst them for actingtogether. To qualify for theprotection of this act, acooperative must either limitdividends on stock ormembership capital to 8

How Cooperatives Are OrganizedArticles of incorporation under which a co-

operative functions are normally approved by theSecretary of State in the state in which thecooperative’s corporate headquarters are located.

These articles specify the name of the coop-erative, its authority, its place of business, the num-ber of directors, and whether the capital is stock ornon-stock. In this respect, the cooperative does notdiffer from the investor-owned corporation.

All corporations must have bylaws, and thesetell how the corporation is going to operate. Typi-cally, these contain provisions for membership eligi-bility, election of directors, annual meetings, officers’duties, voting rights, dues and assessments, and rateof dividends, if any, to be paid on member capital.

A marketing cooperative may also have a mar-keting agreement with its members. This agreementmay require the member to deliver and marketthrough the cooperative his/her entire marketableproduction. It might be only a specified commod-ity produced on a specified block or blocks of land.It might require production in a specified manner.

The relationship between a cooperative andits members often depends on the type of servicethe cooperative performs. Some associations, par-ticularly marketing associations, require a formalapplication for membership and issue a member-ship certificate. Payment of a membership fee, usu-ally refundable on termination of membership, mayalso be required.

Cooperatives normally fall within three clas-sifications: local associations, which serve needswithin a fairly confined area; regional organizations,which encompass a much wider area; and feder-ated cooperatives, which actually are a coopera-tive of cooperatives.

The Cooperative as a Business FirmFour groups are involved in the operation of a

cooperative: the member-patrons, the directors, thegeneral manager, and the operating employees.

Member-patrons are the owners, the founda-tion upon which a cooperative is built. Their voicemay be heard on any issue brought before the gen-eral membership at the annual membership meet-ing. In most cooperatives, the one-vote rule is fol-lowed for each member regardless of the scope ofthat member’s participation in cooperative services.

Directors are elected by the member-patronsat the annual membership meeting. Directors arecharged with establishing policies of operation, andthey employ a general manager to oversee the en-actment of these policies.

31

The general manager, in turn, employs a staffand serves as the intermediary between employeesand the board of directors.

Employees answer to the manager, the man-ager answers to the directors, and the directors an-swer to the general membership.

FinancingCooperatives use all the standard methods

employed by other business corporations to fi-nance their operation, plus a few that are uniqueto cooperatives.

If the association (cooperative) is a capitalstock organization, it issues stock certificates asevidence of ownership interest. If the associationis a noncapital stock organization, it issues somekind of certificate to show capital contributionsof members.

Capital needs are generally obtained from twosources: members who invest in the cooperative toget needed services, and loans that are obtainedfrom lending agencies such as a bank for coopera-tives, a commercial bank or, in certain cases, a gov-ernment agency.

Funds for day-to-day operation of a coopera-tive are obtained through day-to-day services pro-vided by the organization. Long-term credit for theconstruction of buildings and other major needscomes through loans obtained from lending agen-cies such as a bank for cooperatives, Farmers HomeAdministration, Rural Electrification Administra-tion, and others.

Revolving-capital financing, widely used by co-operatives, is peculiarly suited to cooperative op-erations. Here is the way it works:

As members do business through a coopera-tive, they authorize the cooperative to use a por-tion of the money it has accumulated or savedthrough their patronage. Or the members may fur-nish capital based on the dollar value or physicalvolume of products sold or bought through the co-operative. In either case, this money is identifiedas a capital investment of the members and is usedfor capital purposes only.

The money thus collected by the cooperativefrom patronage is credited to each member on thecooperative’s books. At the end of the year, themember is notified or issued some evidence of thetotal amount he/she has invested in cooperativecapital for the year.

The capital accumulated in this manner maybe treated as a revolving fund. The funds may beused for repayment of debt, expansion, or for suchother capital purposes as authorized by the boardof directors. As such funds continue to be accumu-lated, the board authorizes the repayment of fundsto those members who contributed in the past.

Repayment goes first to members whose con-tributions are the oldest in the revolving fund.Normally each year’s contributions are issued in anumerical series. Thus, the oldest of the numberedseries comes up for repayment first.

As a general rule, the member’s evidence ofrevolving fund contributions does not have a speci-fied repayment date (due date). Rather, the boardestablishes revolving fund periods after taking intoaccount the association’s financial requirements.Some cooperatives revolve funds at intervals of five,seven, or 10 years. These time periods are not legalrequirements, but they are considered as moralcommitments on the part of the cooperative.

The revolving-capital plan allows members tobuild up equity in their association in proportionto the amount of business they do. It ensures thatcurrent investment in the cooperative is largely bythe current patrons. It provides an orderly processfor returning or withdrawing a member’s invest-ment without impairing the total capital structure.And it gives the business flexibility to meet chang-ing conditions that may cause financial needs tochange.

Discuss the following statements about themember/user-owned cooperative corporation. Arethey advantages or disadvantages?• Cooperatives are part of the American tradi-

tion of private enterprise. People may pool theirefforts and funds and solve business problemsthat would be beyond the ability of any personalone.

• Cooperatives are used by businesses like farms,newspapers, railroads, florists, pharmacies, hard-ware stores, as well as by individuals.

• Control of policies is achieved through meet-ings of members or the directors they elect.Members are encouraged to participate in de-ciding the future of their cooperative.

• Members benefit from the cooperative accord-ing to how much they use it.

Over the

years,

American

farmers have

learned many

new tech-

niques for

increasing

yields and

reducing

manual labor.

At the same

time, finding

satisfactory

markets for

their prod-

ucts has

become an

increasing

problem.

32

Cooperative ServicesThere are four basic areas in which agricul-

tural cooperatives operate: (1) marketing, (2) pur-chasing, (3) providing services, and (4) providingcredit.

All cooperatives have the same objectives—to provide services not otherwise provided, to pro-vide these services at the lowest possible cost, orto upgrade productivity.

Marketing CooperativesOver the years, American farmers have learned

many new techniques for increasing yields and re-ducing manual labor. At the same time, findingsatisfactory markets for their products has becomean increasing problem.

Many farmers are more effective in producingthan in marketing. Frequently they lack the timeor frame of reference to understand and satisfy thedemands of today’s mass markets. Cooperatives pro-vide them with the marketing tools they need. Forone thing, they furnish an increasing variety of off-farm marketing services. In response to the marketdemand for high-quality and standardized products,they have pioneered in assembling products frommany producers.

By paying producers on the basis of grade andquality, cooperatives encourage farmers to producethe kind and quality of product most in demand.

Cooperatives transport, store, advertise, andpromote products for their members. They ex-plore or develop new trade channels—domesticand foreign.

Through research they develop new productsor find new uses for what they produce.

Cooperatives have become a valuable bargain-ing tool for farmers. Compared with producers inother industries, agricultural producers typicallylack bargaining power. Why? Because individualfarmers produce relatively small volumes and be-cause they lack the bargaining advantage that isassociated with product differentiation. (A differen-tiated product, i.e., a brand-name product, is onewith distinctive characteristics that can be empha-sized in advertising and that give it special desir-ability for users who value such characteristics.)

During recent decades, business firms that buyagricultural products have steadily grown in size.For example, many food processors and packersare large corporations with great bargainingstrength. Similarly, chain food stores that buyfresh produce and other products in large amountspossess commensurate bargaining power. Coop-eratives help farmers match the bargainingstrength of other firms.

Marketing cooperatives benefit consumers aswell as producers. Because they emphasize gradeand quality, they have made producers more qual-ity conscious. Standardized packs of food and foodproducts help consumers shop more efficiently.

Purchasing CooperativesFarmers characteristically have sold their out-

put at wholesale prices while paying retail pricesfor many of their input needs. They gained littleadvantage from product differentiation; they pur-chased in relatively small amounts and conse-quently paid high prices for products with namebrands such as feeds, farm equipment, and petro-leum products.

To overcome these problems, farmers turnedto the cooperative as an economic tool. In somecases, wholly new cooperatives were organized tomanufacture ready-mixed feeds, to purchase, clean,and distribute high-quality seed to members, or toprovide other related production services.

Major objectives of purchasing cooperatives are:(1) to effect savings for member-patrons throughquantity purchasing and manufacturing and efficientdistribution methods; (2) to procure the type andquality of supplies best adapted to the members’farms and needs; and (3) to provide related servicesthat meet the needs of member-patrons.

Service CooperativesIn discussing cooperatives, we usually pay the

most attention to ways in which they contributeto our income. But some cooperatives provide ser-vices only indirectly related to the way we makeour living. These cooperatives help make our livesa little more comfortable in one way or another.These include health, rural electric, telephone, in-surance, irrigation, and grazing co-ops, as well asnonfarmer credit unions.

Credit CooperativesAnother important source of loans, which is

only available to farmers and fishery operators, isthe Farm Credit system. Here farmers do not savemoney, as in credit unions, but they may borrowfrom local credit cooperatives. The Farm CreditSystem will be briefly discussed here because of itsimportance to agriculture.

The Farm Credit System is a nationwide finan-cial cooperative that lends to agriculture and ruralAmerica. Congress created the system in 1916 toprovide American agriculture with a dependablesource of credit.

Today, the system provides about $63 billionin loans to more than a half million customers, in-cluding farmers, rural homeowners, and

Marketing

cooperatives

benefit

consumers as

well as

producers.

Because they

emphasize

grade and

quality, they

have made

producers

more quality

conscious.

33

agribusinesses. Overall, more than 25 percent ofthe credit needs of U.S. agriculture are met by sys-tem institutions. They also provide other value-added services like leasing, insurance, and finan-cial consulting.

Unlike commercial banks such as Bank Oneor Central Bank, system institutions do not takedeposits. In other words, they do not have savingsor checking accounts. Instead, loanable funds areraised through the sale of bonds and notes on WallStreet. The funds are channeled back to ruralAmerica through a nationwide network of morethan 200 Farm Credit lending institutions.

More specifically, the Farm Credit System ismade up of six regional Farm Credit Banks; onebank for cooperatives, the St. Paul Bank; and oneAgricultural Credit bank, CoBank. These banksprovide funds and support services to 203 locallyowned Farm Credit associations and numerous co-operatives nationwide.

Typical services offered by the regional FarmCredit banks and associations to eligible borrowersinclude real estate loans, operating loans, ruralhome mortgage loans, credit-related life insurance,and various financially related services such as farmrecord keeping and financial planning. All FarmCredit banks and associations are governed as co-operatives by boards of directors elected by mem-ber-borrowers/stockholders.

There are two banks with national charters inthe Farm Credit System. One is the St. Paul Bank,a bank for cooperatives offering a complete line ofcredit and related financial services to agriculturalcooperatives, rural utilities, and other eligible cus-tomers nationwide. Based in St. Paul, Minnesota,the bank finances a broad array of agribusinesses,including marketing and processing cooperativesthat add value to agricultural production. The sec-ond bank is CoBank, which finances agriculturalcooperatives, rural utility systems, and other ruralbusinesses throughout the United States. Headquar-tered in Denver, Colorado, CoBank also providescredit to the Farm Credit associations serving agri-cultural producers in the New England states, NewYork, and New Jersey.

CoBank, which has banking centers across theUnited States and representative offices in MexicoCity and Singapore, also finances U.S. agriculturalexports and provides international banking servicesfor the benefit of farmer-owned cooperatives andAmerican agriculture.

The Farm Credit System also has two nationalservice entities, Farm Credit Leasing and the Fed-eral Farm Credit Banks Funding Corporation. FarmCredit Leasing provides equipment-leasing services

to eligible agricultural producers, cooperatives, andrural utilities. Headquartered in Minneapolis, Min-nesota, it is owned by the system banks and has 11sales offices nationwide.

Questions for Discussion: Part VII1. How is a cooperative corporation like an

ordinary business corporation? DIFFERENT?2. How does the PURPOSE of a cooperative

corporation DIFFER from that of an ordinarybusiness corporation? Does this make it a betterorganization?

3. How is the SYSTEM OF CONTROL throughvoting in a cooperative corporation differentfrom that in an ordinary business corporation?Why?

4. What is the reason that laws governingcooperative corporations prescribe legal limitsas to the returns (dividends) that can be paid oninvested capital?

5. What is the meaning of NONPROFIT in acooperative corporation? Is this not in conflictwith what we believe to be some of theadvantages of the capitalistic system ofbusiness in the United States?

6. Does the government exercise any CONTROLover cooperative corporations?

7. If a group of farmers organizes a cooperativeand raises a substantial part of the neededmoney themselves, what are some of thesources from which they may be able to borrowmoney?

8. Are shares of capital stock in cooperatives, ingeneral, traded as freely as shares of stock inordinary business corporations?

9. What are three commonly accepted principlesof cooperatives?

10. What is the Capper-Volstead Act? How does itaffect cooperatives?

Ideas for Further Study and Topicsfor Talks and Demonstrations1. Go to your library and find what you can about

the Roachdale Cooperative in England.2. Trace the history of the cooperative. What were

the first cooperatives, and what country (orcountries) were they located in?

3. Suppose your group wanted to organize andbe responsible for an organization to keepyour school room clean. What type of organiza-tion would you form? Have a group discussionabout this.

34

Bibliography

The following publications were used, in part,as a basis for the information in the American Pri-vate Enterprise System project:

Business in Our Community, American Institute ofCooperation, Washington, D.C.

Cooperatives in Agribusiness, Agricultural Coopera-tive Service, Cooperative Information Report5, September, 1993

U.S. Bureau of Census, Statistical Abstract of theUnited States: 1995 (115th edition) Washing-ton, D.C., 1995

Board of Governors of the Federal Reserve Sys-tem, Federal Reserve Bulletin, monthly; and an-nual Statistical Digest, 1980-1994

U.S. Federal Deposit Insurance Corporation, Sta-tistics on Banking, annual and FDIC QuarterlyBanking Profile, 1990-1994

U.S. Bureau of Economic Analysis, National Incomeand Product Accounts of the United States, Vol-ume 2, 1959-88, and Survey of Current Business,July 1992, August 1993, July 1994, and March1995.

35

Educational programs of the Kentucky Cooperative Extension Service serve all people regardless of race, color, age, sex, religion, disability, or national origin. Issued in furtherance ofCooperative Extension work, Acts of May 8 and June 30, 1914, in cooperation with the U.S. Department of Agriculture, C. Oran Little, Director of Cooperative Extension Service, Universityof Kentucky College of Agriculture, Lexington, and Kentucky State University, Frankfort. Copyright © 2000 for materials developed by the University of Kentucky Cooperative ExtensionService. This publication may be reproduced in portions or its entirety for educational or nonprofit purposes only. Permitted users shall give credit to the author(s) and include this copyrightnotice. Publications are also available on the World Wide Web at: http://www.ca.uky.edu. Issued 11-2000, 2000 copies.