jones: introduction to i. the environment of 2. the

Jones: Introduction To Business: How Companies Create Value for People

I. The Environment of Business

2. The Evolution of Business

© The McGraw−Hill Companies, 2007

C H A P T E R

2Learning ObjectivesAfter studying this chapter you should be able to:

The Evolution of Business

WHY IS THIS IMPORTANTFrom the beginning of time, individuals have wantedthe things that would give them security, comfort,and beauty. A family needs a variety of goods to sur-vive, so those with special talents, abilities or re-sources trade with others. How should society’sresources be allocated? Who will get what and howmuch of it? Political and economic systems haveevolved to answer these questions. What is it aboutthose systems that make it possible for an individuallike Andrew Carnegie to accumulate great wealth,but results in poverty for others?

This chapter will help you understand why capi-talism and corporations were crucial to the IndustrialRevolution and mass production in factories andhow entrepreneurs are able to raise the capitalneeded to grow companies like FedEx or Microsoft.

?1. Understand how property rights affect theway productive resources are used insociety.

2. Define the system of feudalism and howcombining land and labor speeds theaccumulation of capital.

3. Appreciate the functions of money inbusiness and how the development ofmoney promoted the rapid development ofcapital and enterprise.

4. Describe the system of mercantilism andappreciate how merchants and bankershastened the development in global trade.

5. Explain the causes of the IndustrialRevolution and the development ofcapitalism, unionization, and the classsystem as we know it today.

6. Explain how and why the form of businessorganization used to manage businesscommerce has changed over time.





spare time he became a telegraph messenger

and learned telegraphy. He began to deliver

telegrams to Tom Scott, a top manager at the

Pennsylvania Railroad, who came to appreciate

Carnegie’s drive and talents. Scott made him

his personal telegrapher for an astonishing sum

of $35 a week. Carnegie was now 17; only

seven years later when he was 24 he was pro-

moted to Scott’s job, as superintendent of the

railroad’s western division. At 30, he was

offered the top job of superintendent of the

Andrew Carnegie was born in Scotland in

1835. Carnegie was the son of a master hand-

loom weaver who, at that time, employed four

apprentices to weave fine linen tablecloths. His

family was well to do, yet ten years later they

were living in poverty. Why? Advances in weav-

ing technology had led to the invention of

steam-powered weaving looms that could pro-

duce large quantities of cotton cloth at a much

lower price than was possible through hand-

loom weaving. Handloom weavers could not

compete at these low prices and Carnegie’s

father was put out of business.

In 1848 Carnegie’s family, like hundreds of

thousands of other families in Europe at the

time, decided to emigrate to the United States

to find work and survive. The Carnegies settled

near Pittsburgh, where they had relatives, and

Carnegie’s father continued to weave table-

cloths and sell them door-to-door for around $6

a week. His mother, who had come from a fam-

ily of cobblers, repaired shoes and made

around $4 a week. Carnegie found a job as a

“bobbin boy,” replacing spools of thread on

power looms in a textile factory. He took home

$1.20 for working a 60-hour week.

Once his employer found out he could read

and write, a rare skill at this time, Carnegie

became a bookkeeper for the factory. In his

A Question of Business Andrew Carnegie and the U.S. Steel IndustryHow did Carnegie change the nature of business commerce?





36 Chapter Two

whole railroad! Carnegie had made his nameby continually finding ways to use resourcesmore productively to reduce costs and increaseprofitability. Under his oversight, his company’sstock price had shot up—which explains why hewas offered the railroad’s top job. He alsoinvested cleverly in railroad stock and was nowa wealthy man with an income of $48,000 ayear, of which only $2,800 came from his rail-road salary.

Carnegie had ambitions other than remainingin his top railroad job, however. He had noticedU.S. railroads’ growing demand for steel rails asthey expanded rapidly across the country. At thattime, steel was made by the method of small-batch production, a labor-intensive process inwhich small groups of employees worked togetherto produce quite small quantities of steel. Thismethod was expensive and the steel producedcost $135 a ton.

As he searched for ways to reduce the cost ofsteelmaking, Carnegie was struck by the fact thatmany different companies performed each of thedifferent operations necessary to convert ironore into finished steel products. One companysmelted iron ore into “pig iron.” Another companythen transported the pig iron to other companiesthat rolled the pig iron into bars or slabs. Manyother companies then bought these bars andslabs and made them into finished products suchas steel rails, nails, wire, and so on. Intermedi-aries who bought the products of one companyand then sold them to another connected theactivities of these different companies.

The many exchanges or “handoffs” involvedin converting iron ore into finished productsgreatly increased operating costs. At eachstage of the production process, steel had to beshipped to the next company and reheated untilit became soft enough to work on. Moreover,these intermediaries were earning large profitsfor providing this service, something that alsoraised the cost of the finished products.

The second thing that Carnegie noticed wasthat the steel produced by British steel millswas of a higher quality than that made in U.S.mills. The British had made major advances insteelmaking technology, and U.S. railroads pre-ferred to buy their steel rails. On one of his fre-quent trips to Britain to sell U.S. railroad stock,

Carnegie saw a demonstration of Sir HenryBessemer’s new “hot blasting” method for mak-ing steel. Bessemer’s famous process made itpossible to produce great quantities of higher-quality steel continuously, as a process, not insmall batches. Carnegie instantly realized theenormous cost-saving potential of the newtechnology. He rushed to become the first steel-maker in the United States to adopt it.

Carnegie subsequently sold all his railroadstock and used the proceeds to create theCarnegie Steel Company, the first low-costBessemer steelmaking plant in the UnitedStates. Determined to retain the profit inter-mediaries were making in his business, he alsodecided his company would perform all thesteelmaking operations necessary to convertiron ore into finished products. For example, heconstructed rolling mills to make steel rails nextto his blast furnace so that iron ore could beconverted into finished steel products in onecontinuous process.

Carnegie’s innovations led to a dramatic fallin steelmaking costs and revolutionized the U.S.steel industry. His new production methodsreduced the price of U.S. steel from $135 a tonto $12! Despite the cheaper price, his companywas still enormously profitable. Most of his com-petitors could not compete with his low pricesand were driven out of business. He ploughedback all his profits into building his steel busi-ness and constructed many new low-cost steelplants. By 1900, his company became the lead-ing U.S. steelmaker, and he was one of the rich-est men in the world.

Although this might seem like “business asusual” there was a dark side to Carnegie’s busi-ness activities, and he is regarded as one of theearly U.S. industry’s “Robber Barons.” Criticssay he increased profitability “on the backs” ofhis workers. Despite the enormous increase inproductivity he had achieved by using the newsteelmaking technology, he was driven by theneed to find every way possible to reduce oper-ating costs.

To increase productivity Carnegie graduallyincreased the normal workday from 10 to 12hours, six days a week. He also paid his workersthe lowest wage rate possible even though theirincreasing skills were contributing to the increase





Does your city have a Carnegie Library? If so, it is probably a well-built brick building containing the original mission-style furniture of

the late 1800s, the time at which Carnegie constructed his libraries. Almost everysmall town in Texas has one. Carnegie created these libraries because in his youth, arich Pittsburgh merchant decided to open his personal 400-volume library to the pub-lic, allowing anyone to take out one volume a week to read. Carnegie read most ofthem, and all his life attributed his business success to the knowledge he had gainedfrom books. Carnegie decided that an important way he could help other people suc-ceed in business was to provide them with access to valuable knowledge. So he builthis new libraries in places such as small Texas towns where books were a rare sight.

However, as one of Carnegie’s workers commented: “A library is small use for aman who works hard twelve hours a day.”

Biographers claim it was the guilt Carnegie felt later in life that led to his greatphilanthropy—guilt because of the way he had treated his workers and the fact thathis former company monopolized the steel industry for decades. He ended up giv-ing away most of his huge fortune, establishing the Carnegie Foundation, whichremains today one of the richest nonprofit organizations in the United States.

We can tell a lot about why business is the way it is today by looking at how it hasevolved over time. The history of business is the story of people’s constant struggle toobtain scarce resources to increase their well-being—resources such as the food, shel-ter, land, money, and savings people need to survive, protect their futures, andimprove the future prospects of those they care about. The story of Carnegie’s risefrom poverty to wealth and power illustrates just this struggle.

In this chapter, we look at the evolution of business and how and why the nature ofbusiness has changed over time. We go back in history and trace the way the controlof land and labor have been used to build capital and wealth. First, we chart thedevelopment of Feudalism, a business system based on the control of property rightsto land and labor. Second, we look at the operation of money in a business system,the way it facilitates trade, and promotes the accumulation of capital. Third, weexamine mercantilism, the business system in which products are traded across mar-kets and countries until they are put to their most highly valued use.

We then describe the Industrial Revolution and the emergence of capitalism. Cap-italism is the economic or business system in which private property rights becomethe basis for the production, trade, and distribution of goods and services. Finally, wetake a look at the different forms of business organizations that have emerged overtime to make more productive use of resources, enabling people to build capital andwealth. By the end of this chapter you will appreciate how business has always cen-tered on the quest to obtain capital, wealth, and the power and influence that goeswith them.

The Evolution of Business 37

Overview

in productivity. He also paid no attention to im-proving the safety of his mills where workerstoiled in dangerous conditions. Thousands ofworkers were injured each year because of spillsof molten steel. Any attempts by workers toimprove their work conditions were uniformlyrejected, and Carnegie routinely crushed any ofthe workers’ attempts to unionize.

When Carnegie decided to get out of the steelbusiness he sold his company “lock, stock, andbarrel” to a consortium of New York investors for

$485 million. The company was renamed U.S.Steel, and it is still one of the largest U.S. steel-makers today. The investors paid a high price forCarnegie’s company because they knew theycould use its low-cost, competitive advantage tocreate a monopoly in the steel industry—whichis exactly what they did. U.S. Steel kept the priceof steel high and made huge profits for decades.Of course, Carnegie sold his company knowingthis would likely happen. This further tarnishedhis reputation.1 •





38 Chapter Two

The earliest writings about business date back to Mesopotamiain 3000 BC and were discovered by archaeologists in what isnow the Middle East. Business goes back to the Stone Age,however. Economists regard the clan, or tribe, as the earliestform of organized “business” activity. The division of laborbetween a clan’s members into skilled hunters, food gatherers,craftspeople, priests, shaman, and sages is a good example of

how these people organized their activities. (See Figure 2.1.) In fact, their very sur-vival depended on it. Only by working together could people gather sufficientamounts food and perform the other activities necessary to protect themselves andsurvive in harsh conditions—such as through wars, severe winters, and so on. Only acooperative group of hunters could bring down the biggest game or make the canoesand nets possible to fish on a large scale, for example.

The Emergence of the HierarchyTo facilitate goal-directed activity, some form of power and control is needed todecide who will perform which task and how much each person should receive forhis or her work. The need to reduce the transaction costs involved in exchanges ledto the development of a hierarchy of authority in a tribe, clan, or any other “orga-nized” setting. The hierarchy of authority is a ranking of people according to theirrelative rights and responsibilities to control and utilize resources. People at one levelin the hierarchy have the right to make certain kinds of resource decisions, and theyhave the right to expect obedience from those below them in the hierarchy. At thesame time, the people who make these decisions also bear the responsibility forwhether or not their decisions work out. A person’s ranking in a hierarchy will

Feudalism: Land,Labor, and

Property Rights

CHIEF

Hunters Food Gatherers

Priests, Shamansand Sages

Craftspeople

Family Units (Clans)

Figure 2.1Division of Labor in a Tribe

hierarchy of authorityThe ranking of peopleaccording to their relativerights and responsibilitiesto control and utilizeresources.





change if they can show their ability (or inability) to use resources profitably to theadvantage of the organization and its members. If the person succeeds, he or she willbe promoted; if the person fails, he or she will be fired or deposed.

At the top of the hierarchy emerged the ruler of the tribe who, as tribes becameallied with one another, took on the title of chief, prince, king, or emperor. Com-monly, the ruler used power and status to create a dynasty, or ruling family, that thenclaimed the perpetual right to govern. The present Emperor of Japan, for example,can trace his family’s royal bloodline back over five thousand years, while the presentQueen of England traces her right to the monarchy back for almost 2000 years.

Hierarchy and Property RightsAt the heart of any claim of a right to rule or govern and to direct the activities of oth-ers is the possession of property rights. Property rights are the claims by people toown, use, and sell the rights to valuable resources. In earliest times, the claim to prop-erty rights was a matter of brute force. Today laws provide people with a legitimateclaim to own and use a resource. Since earliest times land has always been consideredthe most secure resource, hence the term “property” right, implying control over land(property) and the things on it. Today, property rights pertain not only to land butalso to any valuable resource such as the use of one’s own labor; the tangible resultsof enterprise such as patents and copyrights; and ownership of financial capital in theform of bank accounts and stock. This is illustrated in Figure 2.2.

In the past, the ruler of a tribe or people claimed the legitimate power to assign theproperty rights to control land to whomever they chose. Commonly, monarchs, whowere always the largest landowner in a country, granted their most powerful support-ers the rights to control (not own) large landed estates. In this way they attempted toretain the loyalty of their most powerful followers and prevent them from trying toseize the crown for themselves! Thus came into being the aristocracy, the landednobility that had the right to control all the resources, including the people on theirestates. Consequently, they were given the power to direct all business and socialactivity within their particular domains.

Once aristocrats were in control of their estates, they had the incentive to be enter-prising—to find ways to use the estates’ land and labor more profitably and increase theirpersonal wealth and power. Indeed, improving the land to make it more productive


CapitalOwnership of the rights to financial assets such as stock, bonds,

money.

LaborOwnership of the rights to ones ownlabor and the right

to work freely.

LandOwnership of the rights to land andthe buildings andstructures upon it.

PropertyRights

EnterpriseOwnership of the

rights to the products of enterprise such

as patents and copyrights to

products.

Figure 2.2Property Rightsand Resources

property rights Theright of people to own, use,or sell valuable resources.

aristocracy Peoplegiven the right by a ruler to control a country’sresources, including itsland and labor.





was the principal way of building capital and wealth at this time. In most societies, ahierarchy of aristocrats came into being. An aristocrat’s position in the hierarchy waslargely determined by the income their estates generated. Such a hierarchy, the onethat developed in England, is depicted in Figure 2.3.

Aristocrats were required to be loyal to the monarch in return for being grantedthe rights to control estates. They were also obligated to perform various importantservices for the monarch. For example, in times of war, which was often the mostusual situation, aristocrats had to furnish soldiers and arms to the monarch in propor-tion to the size and wealth of their estates.

In most societies, ordinary “land-less” people had no property rights; they weresimply a resource owned by the estate as laborers and slaves in bondage. In Russia,for example, the slaves who worked the aristocrats’ estates were called serfs. LargeRussian estates might have hundreds of thousands of serfs whose rights were deter-mined at the whim of their owners. It was not until 1861, that Tsar Alexander II freedthe serfs and allowed them to buy land from their former owners.

FeudalismThe business or economic system in which one class of people (aristocrats) control theproperty rights to all valuable resources, including people, is known as feudalism.(See Figure 2.4.)

Throughout the Middle Ages (A.D. 500–1500) this business system endured. Grad-ually, however, laborers began to receive more rights and rewards. In large part thiswas because people with few or no rights had little motivation to perform at a highlevel because they did not share in the profits. So, to increase the motivation of work-ers, and increase the productivity of land, the system of tenant farming evolved.

To make their estates more profitable landowners assigned the most able workersto take control of specific farms on their estates. Landowners then charged theseworkers, or tenant farmers, rent to work the farm per year, payable either in the form

40 Chapter Two

Kingand Queen

Prince andPrincess

Duke and Duchess

Marquess and Marchioness

Earl and Countess

Viscount and Viscountess

Baron and Baroness

Baronet and Lady

Knight and Lady

Commoners

Figure 2.3The Hierarchy ofEnglish Aristocrats

feudalism The businessor economic system inwhich one class of people,aristocrats, control theproperty rights to allvaluable resources,including people.





of produce or money. Tenant farmers could either give the landowner a share of theirproduce each harvest time, or they could sell the produce in the local markets andkeep any profit or surplus over and above that necessary to pay the rent.

The amount of the rent a tenant paid depended on the value of the goods and ser-vices a particular farm produced and sold. Landlords had the incentive to charge ashigh a rent as they could get. But, to keep their tenants motivated to work well andimprove the land, they had to let the tenants profit from their efforts. Thus, bargain-ing and negotiation between landowner and tenant to determine the fair market rentwas common. From these negotiations arose the familiar terms we use today of land-lord, lease, and tenant.

The conflict between aristocratic landowners and tenants over how to share theprofits from farming is just one example of the kinds of problems that arose underfeudalism, however. Conflicts arose between the aristocrats themselves. Throughouthistory wars have been fought between opposing aristocratic families, both inside acountry and between countries, to possess the others’ land, labor, and capital. “Enter-prising” aristocrats tried to conquer their “enemies” and seize their property by force.At the time this was legitimate because different tribes and countries did not recog-nize each other’s property rights. “Might makes right” and “to the strongest goes thespoils,” were the principles of doing business.

The Hundred Years War, for example, was fought in England between the Lan-caster and York families to secure the rights to the English throne—and thus gain con-trol of England’s property rights and resources. The fighting lasted for more than acentury, from 1337-1453, during which time the need for more soldiers and arma-ments drained England’s labor and capital. At the same time, England’s land andestates were ruined by the constant warfare that also resulted in the deaths on the bat-tlefield of most of the aristocrats themselves. When Henry Tudor claimed the Englishthrone based on a distant royal bloodline (those most directly in the bloodline weredead), more vicious fighting ensued. After he finally secured the throne and foundedthe Tudor dynasty, Henry protected his family’s future claims by executing most ofthe remaining “old” aristocratic families and then granting their estates to his loyalsupporters. Another, but very different, example of the way in which the drive to pos-sess private property rights has affected business and society is discussed in Businessin Action.


FeudalismBusiness or economic

system in which one classof people, aristocrats,

possess property rights toall valuable resources,

including people.

MercantilismBusiness or economic

system in which merchantsand bankers organize the trade of products across

markets and countries untilthey are put to theirmost valued use.

CapitalismBusiness or economic

system in which capitalists or industrialists privately own

the physical capital ofindustrial production anduse it to produce, trade and distribute products.

Figure 2.4Feudalism,Mercantilism, and Capitalism

Business in Action

The Southern Kwakiutl IndiansThe Southern Kwakiutl (Kwa’kee’oot’l) Indians lived among the inland waterwaysbetween Vancouver Island and the adjacent mainland of British Columbia,Canada. When Europeans first encountered the Kwakiutls around 1800, they wereamazed at their custom of “potlatching.” Every year at the Kwakiutl potlatch cere-mony, the 28 different Kwakiutl clans, or extended families that formed the tribe,gave valuable gifts, or potlatch, to other families in the tribe. Moreover, the richestclans competed to give away the most valuable potlatch gifts, and thus a significantpart of their wealth, to other clans in the tribe.





42 Chapter Two

Europeans, used to living in a society where gift giving outside a family wasunheard of were shocked by this custom. Anthropologists became interested in dis-covering why, when most people behave in a self-interested way, potlatching existedamong the Kwakiutls. After much study they found some interesting answers.

The Kwakiutls’ prosperity and wealth was based upon their ability to catch andpreserve the salmon that swam up the many rivers to spawn each year during theirannual summer migration. Salmon fishing was the Kwakiutls’ business. Each of the28 clans had the right to fish a different river, and some of these rivers containedmany more salmon than others. As a result, some clans caught significantly morefish because their rivers were richer with salmon.

Apparently, in the past, the different clans had fought many wars against eachother to obtain the rights to the best rivers. This had resulted in much bloodshed andrivers changed hands often. This fighting also resulted in high transaction costs—theenormous amount of time and effort each Kwakiutl clan had to spend protecting itsstream from being taken away by other clans. This time and effort could have beenused more productively in catching and drying salmon, making fishing nets, and allthe other kinds of products necessary to improve their well-being.

The Kwakiutl’s solution to this business problem—fighting over salmon streamsand high transaction costs—was to permanently assign the property rights to a par-ticular river to one of the clans. This had two main advantages. First, this gave eachclan the incentive to learn about its river and find better ways to fish it because theclan members knew it would be theirs in the future. Second, private property rightsalso protected each stream from overfishing. Each clan knew that if it caught toomany salmon in any one year, this would reduce its salmon catch in future years.

To remove the incentive of the poorer tribesto wage war to obtain the best streams, pot-latching emerged as a way of redistributingwealth between clans. To create a fairer distrib-ution of wealth within the whole tribe, thericher clans gave away a significant portion oftheir wealth (potlatch in the form of driedsalmon, blankets, canoes, and so on) to thepoorer tribes, although all the clans exchangedgifts. Potlatching did not result in all clans hav-ing equal wealth. Some clans might be moreskilled than others in fishing or in crafts, ormore enterprising, and these differences inprofitability between clans were recognized inthe gift giving process. Higher-performing clanswere wealthier than lower-performing clans.

There was another important reason why therichest clans competed among themselves togive away the most valuable gifts to the otherclans, however. Those that gave the greatest giftsobtained the most respect, status, and prestige inthe tribe. They were the ones who gained themost power to influence the tribal government.In a sense, they were the tribe’s “aristocrats.”2

The Kwakiutl, a North American tribe,“potlatched” in the 1800s. The richest clansof the tribe gave some of their wealth tothe poorer clans in return for fishing rightsto the best rivers. This helped to preserveharmony among the clans and quell strifein the tribe.

The fight for the right to own and profit from land and laborunderlies the history of business. Just as the Kwakiutl’s riversvaried in their productivity, so land also differs widely in itsfertility. Thus, it was rare that any farm, or even estate, was

Money, Capital,and Commerce





self-sufficient, meaning it could supply all its own needs. For example, one estate’sland might be particularly suitable for growing wheat or raising cattle or growinggrapes. Rarely, however, can all three activities be pursued successfully on the samepiece of land. Given differences in the characteristics of land and labor across estates,regions, and countries, people have to engage in barter and trade to obtain productsthey cannot make themselves.

From Barter to MoneyWhen people meet to barter one kind of good or service for another,a problem economists call the double coincidence of wants arises. Theproblem is that each person has to want the product that the otherperson has to offer for the exchange to be successful. For example, ifI specialize in raising pigs, and you specialize in raising cows, youhave to want my bacon, if I am to be able to obtain your beef. More-over, a cow is worth far more than a pig. For exchange to take placeI would have to be able to offer you, say, six pigs in return for yourcow—but you might have no use for six pigs. You might want threepigs, a horse, and five sacks of flour.

At some point in history, people started to use money to over-come this exchange problem. When people will accept some com-modity, like coins made from gold or silver, in exchange for theirvaluable goods or services it becomes much easier to trade goodsand services. This is because money acts as an exchange standard ormeasure against which the value of different goods and services canbe compared and their relative prices determined. (See Figure 2.5.)

As we discussed in the last chapter, the forces of supply and demand determine theprice of a product. The price of a cow, pig, or share of Kroger stock, is determined byits buyers and sellers. Its price will go up when there are more buyers than sellers ofthe product (and therefore the product is in short supply). Its price will go down whenthere are more sellers than buyers (and therefore there is an excess amount of theproduct being supplied). In our example of trading cows and pigs in the local market,the price of cows and pigs is determined by how much buyers are willing to pay for acow or pig, and how willing suppliers are to sell a cow or pig at that price. The markettells us how much a product is worth in terms of money. This makes it easier to com-pare the relative value of different products in order to trade them.

One important economic consequence that arises when people agree to usemoney to buy and sell products is that it increases the profitability of trade because itis possible to structure exchanges more efficiently. To see how, let’s continue with ourexample of cows and pigs. Under a barter system, only whole animals can beexchanged. But when money is used, animals can be butchered and their meat soldon a piece-by-piece basis according to the specific needs of a particular buyer. Ineffect, money makes the product “divisible.” The effect of this change in trade is thatthere will be more buyers for the meat, which increases its value and price. We there-fore will receive more money for our products. Furthermore, we can then use themoney from the sale of our products to buy exactly what quantity and combination of

goods or service we need—a round of beef, aleg of pork, two sacks of corn, and the servicesof a blacksmith. This makes these productsmore valuable to us. By using money to trade,both buyers and sellers can better fulfill theirneeds and profit from exchanges.

There is another important way in whichmoney increases the profitability of trade.Beyond making the exchange process easier,the use of money creates many new kinds of prof-itable business opportunities. For example, rather


Ten sacksof corn

FiveSheep

OneCow$100

ShoeingTwenty Horses

= =

==

==

Figure 2.5Money as a Standard of Value

Did You Know?Two of the oldest businesses with offices in the United Statesare the Takenaka Corporation, an architecture firm estab-lished in Tokyo in 1610, and Zildjian, a musical cymbal anddrumstick manufacturer, founded in Constantinople in 1623.America’s oldest family firm is the Shirley Plantation, inoperation since 1638.3





than take on the task of trading for a cow and butchering the animal ourselves, wecould sell our cow to a butcher—a person specialized in preparing meat. The butcherwould then assume the responsibility for selling our meat, and we could take themoney we get from the butcher and buy exactly what we need. In addition, and veryimportantly, we now have more time available and we can develop better skills toimprove our land or raise better quality animals. Thus, we can use our time in ways thatallow us to create more future profit and capital. In short, the use of money as a mediumof exchange facilitates occupational specialization and this increases the wealth thatcan be generated from labor and land.

As noted in the last chapter, we have to be careful that while engaging in businessactivity we are not cheated by an unscrupulous butcher who tries to convince us ouranimals are poor quality and offers us a price far less than they are worth. On theother hand, the butcher must be careful not to buy poor quality or sick animals fromunethical farmers who might disguise the poor condition of their livestock. Suchunethical behavior does occur and must be guarded against. The problems of ensur-ing that an exchange is fair, and the need to avoid being cheated, led to the coining ofthe famous phrase “caveat emptor” or “buyer beware” by the Romans.

From Money to CapitalWhy would people accept commodities like gold or silver in exchange for theirproducts? First, gold and silver coins are scarce and in short supply, so their scarcitygives them value. Second, coins are a country’s legal currency, and in the past, their

purchasing power or value was personallyguaranteed by the ruler (hence the king’shead on the coin). Thus, at a time whenwars were commonplace and survivalitself in doubt, the ability to carry, store,and hide gold and silver to protect againstfuture unknown threats was, and still istoday, perceived as offering substantialsecurity. As such, money is considered astore of value.

When money serves as a store of value,the money itself, not just ownership of landand labor, becomes an important form ofcapital that can be used to purchase anygood or service its owner desires in thefuture. Money can also be loaned out toincrease the owner’s future wealth. Peopleare always looking for new opportunitiesto profit from enterprise, but capital is fre-quently required to buy the resourcesneeded to engage in commerce. To obtaincapital, these people offer its owners incen-tives to lend it to them.

When capital is available in the form of money and is not tied to land or labor, it ismuch easier to loan it to prospective borrowers. The owners of capital recognize theopportunity to “grow” their capital by lending it out. Bargaining then takes placebetween lenders (capital suppliers) and borrowers (capital buyers) over the price, orinterest rate, at which capital will be loaned. A capital market then emerges, like amarket for any other product.

Determining the fair market price for capital is a complicated process. This isbecause its price depends on the specific use to which it will be put, and especially therisk related to it. In general, the higher the risk (the higher the possibility of incurringlosses), the higher the returns or rewards an owner of capital expects to receive for lend-

44 Chapter Two

The owners of capital recognize the opportunityto “grow” their capital and increase their wealthby lending it out.

interest rate The priceat which capital will beloaned.

risk The possibility ofincurring future financiallosses because of one’sinvestment decisions.





ing that capital. Frequently, this return amounts to the interest rate the borrower willhave to pay. The higher a project’s risk, the higher the interest rate lenders willdemand for funding it.

But it’s not just interest lenders are interested in. In high-risk ventures, the ownersof capital run the risk of losing their money altogether. They therefore demand aneven higher fee, or “rent,” for their capital. Frequently, this rent amounts to a largeportion of the venture firm’s stock and/or profits it generates. When capital is lent anda profit is generated from it, “money starts to make money” (instead of land and labormaking money). A highly profitable investment is one that results in a high rate offuture return on capital invested.


From early times, one of the most important uses for borrowedcapital was to fund business trading. Mercantilism is the busi-ness system in which products are traded across markets andcountries until they are put to their most highly valued use, thatis, invested or consumed where they create the most utility.(SeeFigure 2.4.) Merchants are traders who notice a discrepancy(difference) between the value and price of a product in one

market and its value and price in another. They recognize an opportunity to profitfrom the price difference. The higher price can be obtained when a product has ahigher utility (is more highly valued) in one market because it is more scarce and thusin higher demand. Merchants borrow capital and use it to purchase products in themarket where they are plentiful, and then transport them to another market wherethey can be sold at a higher price.

Most commonly such price discrepancies are found in international trading arenas.This is because countries differ widely in the nature of their productive resources.Some countries have better quality land or a better climate, for example, whichallows them to produce large quantities of a particular product such as wool, wheat,or grapes. Or some countries may have made advances in a certain technology likecomputer-chip making and people skilled in certain occupations. India and France,for example, are known for their high quality of engineers. Countries also differ withregard to their natural resources. Oil is abundant in the Middle East, but scarce inmany Asian countries, where much of it must be imported. When a product is inplentiful supply its price drops sharply so suppliers are happy to have their productsbought by merchants and shipped to other markets and countries where they are inshort supply.

From the time of the Phoenician traders onwards, there was a great deal of mercan-tilism between countries in the Middle East and Europe. Even in Egyptian times this

trade was huge. Papyrus records exist that describevast quantities of grain and olive oil being stored inwarehouses that extended over many playing fieldsin Alexandria, Egypt for sale abroad.

Merchants could, and still can, make enormousprofits by taking advantage of differences in theprices of products in different markets. In the seven-teenth century, tea imported from India into Britaincost the equivalent of $100 a pound in today’smoney. Tea was so expensive it was kept locked upin sterling silver tea caddies and was carefullyspooned out as needed. The same was true of manyspices such as nutmeg and cloves. The attempt bythe British to maintain the artificially high price oftea in North America helped bring about the Amer-ican Revolution.

Mercantilism:Trade andEnterprise

mercantilism Thebusiness system in which aproduct’s price differencesare exploited by trading theproduct across marketsand countries.

merchant A trader whouses the discrepancybetween the value andprice of a product in onemarket and another totrade goods for profit.

The attempt by the British to artificially control the price of tea led tothe Boston Tea Party, which proved to be a rallying cry for theAmerican Revolution.





46 Chapter Two

Another commonly traded commodity was wine which, while cheap and readilyavailable in hot climates, is in great demand in countries where grapes cannot begrown, such as in Northern Europe. In the fifteenth century silk from China, in theseventeenth century wool from Britain, and in the nineteenth century furs and even-tually cotton from the U.S., became the products that made vast fortunes for thosewho controlled their distribution and trade.

As the wealth of a country came to increasingly depend on the success of its mer-chants, European kingdoms raced to become centers of trade. The wealth of citieslike Venice, Florence, Amsterdam, and London can be traced to successful mercantil-ism. Monarchs and their aristocratic families were the leaders of these country- orcity-based trading empires. These families frequently attempted to “corner” the mar-ket, that is, create a monopoly to control the supply and price of a product in which itwas sold. Moreover, these monarchs had the power to grant to a person or companythe exclusive right to control a product being traded within their countries. Theycould even grant to one person or company the sole right to trade with a particularcountry, such as India. In return, the monarch received a large payment for grantingthe monopoly and often a percentage of the profits of the trading venture.

The growing supply of profits and capital brought about bycombining land, labor, and trade led to a rapid increase in thefourth productive resource, enterprise. Traders and merchantsincreasingly functioned as the agents of wealthy people whosought to increase their capital and wealth in ways that were

unobtainable just by focusing on their landed estates. Great banking families, withclose ties to rich propertied families, became the intermediaries between the mer-chants and owners of capital.

Bankers are the people who estimate the risks associated with a new venture anddetermine the way profits from a venture should be shared. Bankers therefore pro-mote enterprise because they help capital to flow to its most highly valued use. Notonly do they receive payment for this service, they also receive a percentage of theprofits earned by the owners of capital. Thus, if they are skilled, bankers can quicklybuild up vast amounts of capital in their own right that they, themselves, can theninvest in business ventures. Over the centuries the names of bankers such as theMedicis, Rothschilds, and later the Morgans became famous, often because their fab-ulous wealth allowed them to live like aristocrats.

Indeed, many of the most successful merchants and bankers actually became aristo-crats, often by purchasing their titles from monarchs determined to share in the profitsbeing made. Many English dukes and earls were originally successful merchants andbankers, as well as being brewers or soap makers. Sometimes it was very dangerous fornewly rich merchants and bankers to become too successful. Some would build them-selves large palaces and act in ways that challenged the prominence of the monarch.This frequently proved dangerous, as described in Business in Action, which also high-lights the intimate relationship between profit, capital, and power.

The Growth of Enterprise

Business in Action

Power Plays and Medieval BankingBy the sixteenth century, rich merchants and bankers throughout Europe beganbuying themselves titles and estates and joining the ranks of the aristocracy. Theyused their huge trading fortunes to gain political power, often by lending largesums of money to the European kings to help finance wars. Two of these merchantbankers, the Italian Medici and Gonda families, had developed the best economicand political intelligence organizations in Europe. They were utterly ruthless inusing their wealth to squash potential competition and protect their monopolies.Their power, in fact, influenced the course of European history.

bankers The peoplewho estimate the risksassociated with a newventure and determine theway profits from a ventureshould be shared.






In France, for example, the Protestant Reformation had led tothe rise of the Huguenots, a Protestant sect. The Huguenots wereenterprising and thrifty and fast becoming a dominant force inFrance’s trading and banking system. The Medici and Gondafamilies feared the Huguenots continuing commercial successmight give them the political power necessary to turn CatholicFrance into a Protestant country like England. Worse yet, theyfeared the Huguenots would threaten their control over Euro-pean trade.

To prevent this from happening, Catherine de Medici tookadvantage of the weakness of the French king to use the Medici’smoney and power to crush the Huguenots and effectively takecontrol of France’s economic and political system. The Italianbanking families began buying up titles and estates throughoutFrance. This gave them direct access to the French king. Con-vincing the king of the danger posed by the Huguenots to histhrone, the king agreed to allow the Italian banking families tofund a campaign to destroy the Huguenots by force. At the infa-mous “Massacre of St. Bartholomew,” foreign mercenary troops,paid for by the Italian bankers, massacred many thousands ofthe leading Huguenots. This effectively destroyed them as aneconomic and political force in France and set back that coun-try’s economic development for a century.

By the seventeenth century, the kings of France had gradually reasserted theircontrol over the aristocracy. The Sun King, Louis XIV, was fast becoming themost spendthrift of Europe, dazzling the world with expensive pageantry designedto show off his power. He had a rival, however—a French banker named Fouquet,who was the richest man in France and routinely lent money to the king. Fouquetlived in grand style, and one year he invited Louis XIV to stay with him at hischateau, La Fontaine. There Fouquet entertained the Sun-King with a feast. Sixthousand aristocrats were invited to the dinner where, among other things, Fou-quet gave away fine jewels and horses to the guests as prizes. His guests admiredthe hundreds of pieces of his gold and silver collection made by the finest Italiancraftsmen; the hundreds of rooms of his palace decorated with works of art andceilings painted by great artists; and the incredible outdoor gardens and fountainsthat made La Fontaine so famous.

Louis XIV was furious at this banker who dared to live in a richer state than aking. The king was so jealous he trumped up charges against Fouquet for treason,confiscated his property and wealth, and threw him into jail. After nineteen terri-ble years in prison, he died.

Fouquet is said to have inspired the tale of the “Man in the Iron Mask.” Louishimself was now inspired to imitate La Fontaine; he decided to build himself asplendid new palace, Versailles, which was to be big enough to house the entireFrench aristocracy in great style. His motivation to do so, however, was to keep thearistocracy under his close control so they would not be able to conspire againsthim! His strategy worked. He and his successors were in total control of the coun-try until the French Revolution in 1789.4

Catherine de Medici, who was Italian butbecame the queen of France by marriage, used her family’s money and power to help take control of France’s economic and politicalsystem in the sixteenth century.

European rulers like Louis XIV had the “absolute power” they needed to crushtheir opponents and control the path of economic development in their countries.In England, however, the king could not act in such a high-handed way because inthat country, aristocrats had forced King John to sign the Magna Carta in 1215.King John was in a very weak position, bankrupt and deeply in debt. He lacked a





strong army to protect his throne. As a result, he was forced to sign the MagnaCarta, an event that changed the balance of power between English rulers and theiraristocratic families forever.

In a nutshell, the Magna Carta granted aristocratic families the right to hold prop-erty in their own names, not just in the name of the king—it granted them private prop-erty rights, in other words. Henceforth, although the aristocrats had a duty to obey theking, they nevertheless claimed the rights to do with their property as they saw fit. TheMagna Carta was a turning point in business history for the now-propertied Englishclass. Secure in their claim to land and capital, they became much more willing to useand risk that capital in business ventures to increase it.

Craft Guilds and Occupational SpecializationAround the same time the Magna Carta was signed, major changes were also takingplace in other areas of business. In every country, a skilled class of artisans or crafts-people existed. These people were valued by society because they had the skills toproduce higher-quality goods and services people wanted. In addition, as the wealthof a society increased, the demand for these products increased, and craftspeopleprospered.

Just like the aristocrats, this rising class of affluent people also recognized the needto protect their property and wealth. They did this by banding together into craftguilds. Guilds of goldsmiths, silversmiths, metal workers, clothing makers, coachmakers, barrel makers, builders, masons, and carpenters were organized to controland govern different business trades in different cities or regions. These craft guildsacted like monopolies. They were able to dictate the quality and quantity of the goodsmade and the prices charged for them. They were a form of business organization,with task and authority relationships, rules, and procedures necessary to control andregulate all aspects of their trades. Formal, seven-year apprenticeships were estab-lished for new craftspeople, for example, and the number of new apprentices admit-ted into a guild strictly limited. This, of course, also limited competition.

Nonetheless, craft guilds helped increase the occupational specialization of society,thereby increasing its wealth. Rulers allowed the guild system to operate because theybenefited from the taxes levied on the sale of the guilds’ products.

48 Chapter Two

In all aspects of business—commerce, occupations, and organi-zations—the pace of change was accelerating. More and morepeople found opportunities to share in the wealth being gener-ated by the combination of all four productive resources—land,

labor, capital, and enterprise. Eventually, technological progress led to the next majorchange in business system:the Industrial Revolution. The Industrial Revolution,which burgeoned in the late eighteenth and early nineteenth centuries, marked amajor shift in the production and trade brought about by advances in technology. Itfirst began in Britain and then spread to the continent of Europe and the UnitedStates. As we discussed in the opening case, Andrew Carnegie suffered from itseffects—the transition from handloom to steam-powered weaving—but then tookadvantage of improvements in steel production methods and made a fortune.

Although scholars dispute the exact cause of the Industrial Revolution, many agreethat the emergence of the steam engine was a crucial event. The steam engine pro-vided the power needed to work the new spinning and weaving machines that pro-duced the wool and cotton cloth that had become a major part of world trade. It alsoallowed production to be centralized in huge new factories where thousands of peo-ple labored together to make low-cost products. The steam engine also led to thedevelopment of steam trains and railways that sped communication and travel andspurred trade both inside of and between countries.

The IndustrialRevolution

craftspeople Workersor artisans with the skills toproduce higher-qualitygoods and services.

craft guild A group ofskilled artisans organizedto control and governdifferent aspects of itstrade.

Industrial RevolutionAn era in the eighteenthand nineteenth centuriesthat marked improvedproduction and tradebrought about byadvances in technology.





Because the steam engine required huge amounts of coal to power it, this ignitedthe development of coal mining, an industry that soon employed millions of people.High-quality steel was also needed to make the engines, and this led to the search forimproved methods of making steel, such as Bessemer’s process. In turn, improvedtechnology resulted in the rapid growth of the steel industry. The ability to producelow-cost steel led to growing demand for steel products such as rail track, an opportu-nity Carnegie was quick to notice and act upon. Finally, as steam engines becamemore powerful, steamships quickly replaced wooden ships because they werecheaper to operate. This lowered the cost of global trade as well as sped it up.

A Revolution in Farming and ManufacturingThe Industrial Revolution affected both farming and manufacturing and led to a dra-matic increase in the wealth and prosperity of the countries in which it occurred.Three factors transformed farming and increased the productivity of land. First, newand improved methods of planting and harvesting crops, breeding and rearing ani-mals, and fertilizing the land increased productivity. Second, mechanization and thearrival of steam-powered farm machinery meant that far fewer farm laborers wereneeded to work the land. Third, during the Middle Ages, a significant amount of landhad been set aside as “common land” for peasants, serfs, and farm laborers to use ontheir own time, once their obligations to their owner or landlord were fulfilled. Now,throughout Europe this common land was being fenced in and enclosed by peoplewho claimed property rights over it. The result was that a multitude of people werebeing displaced from the land.

Without jobs or income, millions of people throughout Europe starved to death. Tosurvive, millions of other people began to emigrate to countries such as the UnitedStates, which needed immigrants to propel their own economic development. Otherpeople were saved from starvation by going to work in new industrial enterprises—manufacturing companies brought about by the Industrial Revolution.

Why Did the Industrial Revolution Occur So Late?Why did it take so many centuries for people todiscover and utilize the physical and engineeringprinciples that made the invention of machinery,such as the steam engine, possible? The answercited by most scholars is that the constant warsthat had raged throughout the world for centuriesisolated people, making it difficult for them tolearn about new innovations from one another.Innovation is the development of new andimproved products and the discovery of new andimproved methods to create or produce them.Because people were relatively isolated, therewas little dissemination of new ideas and innova-tions. Cooperation was needed to advance sci-ence and speed up the process of innovation.

The Greeks, for example had acquired greatknowledge of mathematics and science. TheRomans capitalized on this knowledge to advancetheir road building and engineering skills. But thewars that led to the fall of the Roman Empireresulted in the loss of much of this knowledge. Formany centuries, scientific advances in differentcountries were unknown to scientists elsewhere,


Until the Industrial Revolution, inventionssuch as the steam engine were notpossible, in part, because of wars thatraged for years. These wars isolatedpeople and hampered the disseminationof knowledge among them.

innovation Thedevelopment of new andimproved products andnew and improvedmethods to create them.





50 Chapter Two

as lone thinkers tried their best to piece together available information and advance it.With growing commercial trade, however, knowledge and new ideas also spread aspeople came into more contact with one another.

Recognizing that technological advances were economically and politically impor-tant, rulers in many countries established colleges and universities where talentedpeople could pursue knowledge for its own sake. Many propertied people, Sir IsaacNewton and Louis Pasteur among them, also began to pursue scientific research.Churches and chapels, especially Protestant ones, established schools and advancedthe education of ordinary people. Eventually, this made it possible for the IndustrialRevolution to occur and societies to prosper like they never had before.

Even though the Industrial Revolution rendered obsolete many old-style monopo-lies (those operated by aristocrats and craftspeople), people like John D. Rockefellerfound ways to create new monopolies. History repeats itself, as Business in Actiondescribes.

Business in Action

Rockefeller Plays MonopolyBy the 1880s, people understood that monopolies raised prices artificially and hurtconsumers. Nonetheless, laws in the United States preventing monopolies werequite weak at the time. There was little to prevent clever, unethical people fromfinding ways to control the supply and prices of products. One such person wasJohn D. Rockefeller.

Rockefeller started life as bookkeeper in Columbus, Ohio. Always an enterpris-ing man, he had a knack for finding profitable business opportunities and was agenius at raising capital to fund his ventures. In 1884 an engineer named Walker,who was an expert in the design of oil refineries, approached Rockefeller. Manydifferent uses for oil had been discovered, and refineries were springing up ingrowing numbers in the United States. Walker had designed a new kind of oilrefinery that could extract many times the amount of saleable oil from a gallon ofcrude oil than was possible using the old technology. The huge potential profitsfrom this new process attracted Rockefeller. He began to invest heavily in Walker’srefinery and eventually bought it from him.

Rockefeller realized, however, that oil would soon be in plentiful supply. New oilfields were being discovered quickly in response to the growing demand for oil. Heknew the price of oil would tumble as its supply grew to match demand. Rockefellerneeded a plan to control the supply of oil and its price. The problem was how couldhe create a monopoly and keep it hidden from public view? If the public realizedwhat he was doing the ensuing outcry would lead to laws that made such unethicalanticompetitive tactics illegal.

Rockefeller’s solution was to use the profits from his efficient oil refineries, andcapital he raised from friends, to secretly buy up every small refining company hecould get his hands on. These companies became, for all intents and purposes, apart of the main company he created, The Standard Oil Company. But from theoutside, these companies still appeared to be separate and independent companies.Each had its own stock and management teams. Yet Rockefeller had created atrust, a combination of companies, linked by legal titles and property rights, whichallowed them to function as a single corporation. From a legal point of view, how-ever, they were still separate entities.

The trust was effective. Although it appeared Rockefeller was only producingabout 30% of U.S. oil, he actually controlled about 90% of the oil coming fromthe wells and going into U.S. refineries. This allowed him to set the price of oil,and he set it high. Standard Oil was making profits of between 35-50%, and by1900, Rockefeller had become the richest man in the world, with a fortune of over$900 million.

trust A combinationof companies linked bylegal titles and propertyrights that allow themto function like onelarge company.






Capitalism, Unionization, and the ModernClass SystemCapitalism is the economic, business, and political system that allows people to ownresources and use them to engage in production, trade, and the distribution of goodsand services. (See Figure 2.4.) Capitalists are people, like Carnegie and Rockefeller,who personally own and/or control the physical capital of industrial production—machinery, factories, distribution networks, raw materials and inputs, research anddevelopment and technology. Today, the word “capitalist” has many negative over-tones because of the actions of industrialists like Rockefeller and Carnegie who ruth-lessly pursued their own self-interest at the expense of others. It was not only for theirability to control product prices that capitalists came to be so feared and disliked,however. It was also because of the way they treated one particular resource: labor.

As we discussed, capitalists like Carnegie and Rockefeller built the factoriesneeded to manufacture large quantities of low-cost products—products that couldbe sold profitably at prices much lower than competing products made by skilledworkers. In many manufacturing settings, little skill was required of most workers;

In the early 1900s the public finallywoke up to fact that something “illegal”must be going on if huge profits could bemade from a cheap commodity like oil.The nature of Rockefeller’s trust systemwas gradually exposed, as were the manyother unethical business practices Rocke-feller had used to control the oil supply.He became the target of intense publiccriticism and the most hated and despisedman in America.

One reason for the intense public dis-like was that Rockefeller’s actions inspiredother bankers and industrialists to do thesame, including the investors who hadbought out Carnegie. By 1900 there wereover 198 trusts in the United States. Even-tually comprehensive antitrust laws werepassed that made Rockefeller’s unethicaltactics illegal. His trust and the otherswere broken up, and many new compa-nies that were truly independent were cre-ated. However, by this time the car and its

internal combustion engine had been invented. Demand for oil was so great thatthe oil industry remained highly profitable.

Shocked by the hostility he had inspired, Rockefeller spent the last part of hislife competing with Andrew Carnegie to give away the greatest portion of their for-tunes. He established the Rockefeller Foundation with over $100 million of hismoney and is estimated to have given away over half his fortune by the time of hisdeath. Nevertheless, the U.S. public never responded positively to his benevo-lence, and he died a hated man. The next generation of Rockefellers who, ofcourse, were still fabulously wealthy, continued to give away a large part of theirfamily fortune. Eventually, the Rockefellers did reestablish their good familyname, and today their philanthropy is widely recognized.5

By 1900, John D. Rockefeller had become theworld’s richest man. He did so by finding ways tocovertly control the supply and price of oil in theUnited States.

capitalism Theeconomic or businesssystem in which the privateownership of resourcesbecomes the basis for theproduction and distributionof goods and services.

capitalists People whopersonally own or controlthe physical capital ofindustrial production suchas machinery, factories,distribution networks, rawmaterials, and technology.





complex tasks could be done by machines. As a result,skilled workers were now competing for unskilled jobsjust to survive—as in Carnegie’s father’s case.

Capitalists and factory owners began to take ad-vantage of their economic power by putting greaterdemands on labor. The average worker’s wage fellrapidly, and workers were forced to work longer hours.(Twelve-hour days and six-day workweeks were com-mon.) Conditions were often difficult and downrightdangerous. Women, and children as young as six, wereincreasingly being employed in factories and minesbecause they could be paid much less than men. Thisnew working class came to be called the proletariat,the vast, faceless mass of laborers who worked for sub-sistence wages. The rise of the new capitalist class, andthe conversion of both skilled and farm labor into theproletariat, changed the world forever.

Take conditions at Henry Ford’s Dearborn, Michigan, car plant, which manufac-tured the “Model T.” Ford’s workers were actually paid 25% more than a typical fac-tory worker could expect in 1914. Yet to keep Ford’s assembly lines up and running,500 workers had to be hired each day to replace those who had quit. Why? Because ofthe horrendous work conditions. Workers toiled continuously for 12 hours a day, withhardly a break. To keep up with the speed of the assembly lines, they were forced toperform thousands of repetitive actions as quickly as they could. Moreover, they werebarred from joking around or even talking. If they broke any rules, they were instantlyfired, Now do you understand why 500 new workers were needed on a daily basis?

In most newly industrialized countries, the response of workers to these conditionsis to band together into trade unions. A trade union is a business organization thatlobbies on behalf of its members to increase their wages and working conditions. Infact, the craft guilds were the original breeding grounds of the trade unions. Through-out the twentieth century hundreds of millions of workers in countries around theworld became unionized, often after bloody battles with companies like CarnegieSteel, Standard Oil, and Ford, which refused to negotiate with them and tried to“break” them.

Eventually most countries enacted labor laws upholding the rights of workers tounionize and bargain with their employers. Laws were also passed to regulate the nego-tiation, or collective bargaining, process to ensure fair play. The goal was to create amore level playing field with industrial companies to prevent violence, strikes, and gen-eral economic problems. We discuss the issue of labor relations in detail in Chapter 13.

In most industrialized countries, the Industrial Revolution also led to the develop-ment of the modern class system. A class system is a ranking of people in a socialhierarchy based upon the amount of their capital, wealth and other factors such astheir heredity, kinship, fame, occupations, and connections. At the top are the upperclass, the owners of capital—industrialists, merchants, bankers, and lawyers—who con-trol a significant amount of a nation’s private financial wealth.

At the bottom is the working class, people who own their own labor and often very lit-tle else. In the center developed the “great middle class,” people who through educa-tion, training, enterprise, luck, marriage, thrift, and so on, are able to accumulate

enough capital to purchase their own homesand/or make the investments necessary toprovide a secure future for themselves andtheir families. The relationship between theclasses is shown in Figure 2.6.

Today, sociologists divide the middleclass into at least two different layers. The“lower middle class,” for example, is com-

52 Chapter Two

Did You Know?In medieval Italian city-states, maritime firms began to callthemselves compagnie because their members took breadtogether (cum-panis).6

Capitalists like Carnegie and Rockefeller employed children asyoung as six because they could be paid much less than adults.

proletariat The class of unskilled workers whohave no capital and onlypossess the rights to selltheir own labor.

trade union Anorganization that lobbieson behalf of its members(workers) to increase theirbargaining power in work-related negotiations.

class system A socialranking of people basedupon the amount of theircapital and wealth, andbecause of factors such asheredity, kinship, fame,and occupation.





posed of people who still must possess a regular job to maintain their standard of liv-ing. They are people, for example, who might own modest homes and have three- tosix-months’ savings to carry them through the times they are unemployed. Once theircapital is exhausted, they face the prospect of joining the working class. On the otherhand, if their fortunes improve they might be able to join the “upper middle class.”

The upper middle class is composed of people like successful small-business own-ers and entrepreneurs, medical doctors, senior corporate executives, and so on.These people have high incomes and are able to invest a significant proportion oftheir income to increase their capital, which is held in the form of property, stock,bonds, and so on. Eventually, their rising wealth makes them impervious to a loss ofjob or some other economic misfortune. Since these people might possess millions ortens of million of dollars, the gap between the upper middle class and upper classoften becomes a matter of social factors. These factors include their family ties andconnections through marriage, and the social status they have achieved by virtue oftheir fame, philanthropy, and expertise.

The Industrial Revolution ContinuesFinally, we should note that this chapter only describes some of the main events thattook place in Western countries. Most developed countries around the world haveexperienced at least some of the aspects of the Industrial Revolution, and this has hada lasting effect on their business and social systems. We should also note that theIndustrial Revolution is still going on. Many third-world nations are just now begin-ning to mechanize, and companies are increasingly locating their facilities in thesecountries such as in China, India, Malaysia, Mexico, and Brazil. In developed coun-tries, vastly improved communications, digital information technology, the Internet,and the globalization of business are continuing the transformation. In fact, somewould say that the pace of change is quickening because of the Internet. It hasspawned the emergence of millions of small new businesses around the world andchanged the way people do business.


UpperClass

UpperMiddle Class

LowerMiddle Class

Working Classand Proletariat

Figure 2.6The Class Systemin Capitalism





54 Chapter Two

Side by side with these major changes taking place in businesscommerce and occupations, the form of business organizationwas also changing. At each stage in the history of business dis-cussed above, new forms of organization came into being toput the four productive resources to their most profitable use.Recall from Chapter 1 that a business organization is a tool cre-ated to give owners and managers the power they need toshape and control the behavior of workers or employees toproduce goods and services. Choosing the right form of organi-

zation is important because this determines how productively and profitablyresources will be used to create the most wealth for their owners.

Early Forms of Business OrganizationPerhaps the first type of business organization was the tribe or clan discussed earlier(Figure 2.7). Composed of family groups united by ties of blood and kinship, it wasusually organized into some kind of hierarchy, as with the Kwakiutl. Tribal leadersowed their positions to their membership of a particular family, or to particular quali-ties such as prowess in hunting or the ability to settle disputes and negotiateexchanges between families and maintain the tribal organization as an effective unit.

The tribal organization can function effectively when the property rights and obli-gations of all its individual members—and the rights of different tribes—are recognizedand protected. Problems start to arise when tribes compete for resources, such as theland of their neighbors, herds of wild animals, fishing streams, or good harbors. Com-petition over property rights has been the cause of most wars.

Throughout history slavery and serfdom was the norm in most societies. Slavery isa form of business organization because it is based on ownership of a resource (peo-ple) that builds capital and wealth. For example the conquests of the Pharaohsbrought hundreds of thousands of slaves to Egypt. There the slaves tilled the fields togrow corn and build the cities and monuments for which the country is famous. Thegrowth and prosperity of the Greek and Roman Empires was based on the use ofslaves for agricultural and building purposes.

Although obviously unethical (and illegal) by today’s standards, the problem withslavery as a form of business organization is that the costs related to managing slavesare enormous. Lacking any right to accumulate capital of their own, and being a prin-cipal source of wealth of their owners, slaves have little or no motivation beyond fearto work hard. Slavery does not provide any incentive for people to be enterprisingand develop the skills and abilities that spur economic growth. Another major prob-lem with slavery is that it reduces the enterprise of slave owners. What motivation dothey have to learn new skills and engage in new ventures when they can simply livecomfortably and prosper off the labor of others? Thus, slavery not only brutalizesthose who are owned, it also corrupts their owners. As a result, forms of businessorganization like slavery tend to wither and die because they do not provide a plat-form on which a people and society can advance economically, socially, and morally.

The Joint-Stock CompanyLabor and land are normally used in conjunction with capital and enterprise to pro-mote trade and commerce. The trick is to create a form of business organizationthat provides a way to employ all four productive factors to create profit andwealth. A major obstacle to being able to do this effectively is aligning the interestsof people who want to borrow capital with the interests of people who own it. Oneof the problems with mercantilism, for example, was being able to attract investors.We mentioned earlier how trading ventures were risky. Ships might sink or berobbed of their valuable cargoes, for example.

The ChangingForms ofBusiness

Organization

Clans, Tribesand Slavery

Joint-StockCompanies

Limited-LiabilityCompanies

MultinationalCompanies

Figure 2.7Changing Forms of BusinessOrganization





To overcome this problem, people invented a form of business organizationknown as the joint-stock company. In a joint-stock company an entrepreneur raisescapital by issuing stock certificates of its ownership. This involves selling shares ofthe stock to investors that guarantee them the right to a certain percentage of thecompany’s profits. For example, a group of merchants might retain a 30% share of aventure’s stock as their reward for organizing and managing the venture; its in-vestors would then share the other 70%. To minimize their risk, wealthy investorswould spread their money around. They would invest in many ventures, just astoday people are advised to buy an assortment of stocks and bonds to reduce theirinvestment risks. That way, they didn’t have “all of their eggs in one basket” shouldany single venture fail.

The joint-stock form of business organization allowed many people to share, andhence reduce, the risks of investing in individual trading ventures. As such, thisform of business organization facilitated the funding of many business ventures,and this, in turn, expanded global trade. However, one significant risk still existedwhen a person decided to invest in a joint-stock company. If it failed—and many didbecause of poor management, economic downturns, and fraud—the people towhom the business owed money such as its suppliers or creditors could sue all ofthe company’s stockholders to recover their money. Stockholders in these compa-nies had unlimited liability meaning that all of a stockholder’s capital and wealth,right down to his or her house, furniture, and clothes could be seized to pay thecompany’s debts. Stockholders could also be thrown into debtors’ prison. This wasstill too much for most investors to bear.


VideoSmall

Business in Action

Joe To GoSummary: Seven short years ago, Jerry Andrews was a soccer dad who promisedto bring coffee to the field for a large group of parents as shown in this originalvideo on your Student DVD. Jerry was faced with several vexing issues—how totransport that much coffee, keep it hot, and contain it from spilling all over thecar. The soccer dad’s dilemma was the catalyst that launched the now nationallydistributed “Joe-To-Go” coffee “box.” The evolution of this business was fraughtwith challenges. Without much capital, and virtually no distribution expertise,Andrews had difficulty bringing his product to a large market. Today, however,the “Joe To Go” coffee box has been adopted by all major chains including DunkinDonuts and Starbucks.

The story demonstrates the struggles involved in taking a new business ideafrom the development and patent stages through successful marketing, licensingand distribution. The evolution of this new business demonstrates several impor-tant characteristics leading to Andrews’s success. Personal characteristics such asself-direction, self-nurturing, action orientation and a high energy level are theessential elements in a successful business evolution.

The “Joe To Go” success story is even more impressive when one considers thatstatistics suggest that more than 50% of all small business start-ups fail within thefirst four years.

Discussion Questions1. Identify the impediments that interfere with the successful evolution of the

“Joe To Go” concept.2. What type of business organization would characterize Jerry Andrews’s “Joe

To Go?”3. The video notes that more than 56% of all college students indicate an interest

in becoming entrepreneurs. What are the potential barriers and risks associ-ated with entrepreneurship?

unlimited liabilityA legal system in whichthe personal capital and wealth of all of acompany’s stockholderscan be seized to pay itsdebts.





The Limited Liability CompanyThe burden associated with unlimited liability was choking off the supply of capitalnecessary to fund businesses growing rapidly as a result of the Industrial Revolution.This threatened to derail economic progress. Consequently, capitalists and industrial-ists lobbied for laws to create a new form of business organization, called the limitedliability company. With limited liability, if a company goes bankrupt, its creditorscannot seek the personal wealth of its stockholders for reimbursement. Only themoney stockholders have initially invested in the business is at risk.

This was a major change in the form of business organization. One reason theunlimited liability law had been implemented in the first place was to discourage cor-ruption and fraud. It was thought that investors would think very carefully aboutwhere to invest their money if they were personally liable for the actions of the ven-ture they funded. However, the world is a very uncertain place, there are enormousrisks involved in starting any new business venture, and many new businesses do fail.The new limited liability law was passed because people believed that more wealthwould be created—if people were encouraged to risk their capital to promote enter-prise—than would be lost because of fraud.

In the event, the new form of organization did achieve its goal. It led to the found-ing of thousands of new businesses that further spurred specialization and the divisionof labor and led to unprecedented economic growth. The new limited liability modelbecame the standard way of organizing a company. Today, even a single entrepre-neur can set up a business as a limited liability company to protect his or her personalassets should the business fail. Once again, the upper class were the big investors inthese new, limited liability enterprises. Via an emerging international banking sys-tem, they were able to invest worldwide. So, for example, propertied British, Ger-man, and French families invested heavily in U.S. commerce and business. Some likethe DuPont family also owned and managed companies. The outcome of all this earlyinvestment has been the emergence of the giant multinational companies that domi-nate the global business system today. Multinationals are the most recent develop-ment in the history of business organization and are discussed in Chapter 4.

The Partnership and the Sole ProprietorshipThroughout history, another way to pool risks and returns on a smaller scale has beento use a business organization known as a partnership. In a partnership, skilled pro-fessionals such as bankers, merchants, doctors, lawyers, and accountants agree to pooltheir talent and resources by establishing a company in which they are the only stock-holders and owners. Each founding partner receives an agreed-upon percentage of thestock of the business based upon the money the partner initially puts into it, the value

of his or her skills, experience, and so on. The profitsof the business are then divided according to the per-centage of stock each partner owns. If the businessgrows and prospers, new professional employees arecommonly added. If these employees perform well,they are sometimes selected to become new partners.In this case they are given the right to purchase stockin the company and also become an owner.

Many prestigious and profitable companies, includ-ing a number of New York law firms and investmentbanks, began as limited liability partnerships. In the1990s when the stock market was going gangbusters, anumber of them decided to “go public,” that is, to selltheir stock to outside investors. Salomon Smith Bar-ney, an investment banking company, and Accenture,a consulting company, are two notable examples.

56 Chapter Two

It’s common for a law firm to be created by a partnership and then eventually expand by hiring new employees who often thenbecome partners.

limited liability A legalsystem that preventscreditors from seizing the personal wealth of acompany’s stockholders topay a company’s debts.

partnership Two ormore skilled professionalswho agree to pool theirtalents and capital toestablish a company inwhich they are thestockholders and owners.





The advantage of going public for partners is that this establishes a free market fortheir company’s stock. This allows the stock’s value (price) to be competitively deter-mined in the marketplace. If the public thinks the business is valued more highly thanthe price the stock is being offered at, the partners will receive a premium for theshares they sell. This money could not be realized if the business remained private.

The owners of a limited liability business can take it public at any time. In this way,its owners can realize the value they created by launching the company. The moneyraised from the sale of the stock can be used to fund the company’s future growth. Orthe owners can use the proceeds from the sale and invest it in other companies, land,and so on to diversify their investments and lower their risk. (This is not a bad ideawhen you consider the fact that few companies perform successfully forever.)

Bill Gates is a case in point. Gates, who took Microsoft public in the 1980s, hasseen the value of his personal Microsoft stock exceed $50 billion. At the same time,however, he has sold hundreds of thousands of Microsoft shares and used the billionsof dollars generated from the sale to buy stock in many other companies. He has alsoused some of this money to establish a charitable foundation to which he and his wifehave given over $25 billion, making it the largest charitable foundation in the world.

Finally, a sole proprietorship is a nonincorporated business entirely owned byone person. A sole proprietorship is the simplest form of business organization tostart and maintain. The business has no existence apart from its owner, and its liabili-ties are the owner’s personal liabilities. The owner undertakes all of the financial risksassociated with the business, and the rewards, or income, are included on the owner’spersonal tax return. Frequently, highly skilled people such as dentists, lawyers, orplumbers choose this route to avoid the disputes that often arise in partnerships. Also,they are often the form of organizing chosen by entrepreneurs, who are discussed inthe next chapter.


sole proprietorshipA nonincorporatedbusiness entirely owned by one person.

This chapter de-scribed the waybusiness systemshave evolved fromearliest times to

feudalism, mercantilism, and then to capitalism. Italso described how people organized themselves intobusiness systems to take control of productiveresources and use them to create capital and wealth.How business organization forms have changed overtime was also discussed. This short account of theevolution of business has enriched our discussion ofbusiness in Chapter 1. It charts the way business ascommerce, occupation, and organization evolved toallow land, labor, capital, and enterprise to be usedmost productively and profitably.

The chapter made the following main points:

1. The hierarchy of authority is a ranking of peopleaccording to their relative rights and responsibilitiesto control and utilize resources.

2. Property rights are the claims by people to own, use,or sell the rights to valuable resources. In earliesttimes, the claim to property rights was a matter ofbrute force. Today laws provide people with thelegitimate claim to own and use resources.

3. Feudalism is the system in which one class ofpeople, aristocrats, control the property rights to allvaluable resources, including people.

4. Much of the bargaining and negotiating that goes onin society, like that between landowners and tenantsunder feudalism, for example, results in land, labor,and capital being put to its best use.

5. The need to overcome problems associated with thedouble coincidence of wants led to the developmentof money. Money acts as a standard of value, a storeof value, and is a source of capital in its own right.The use of money creates many new kinds ofprofitable business opportunities. When it is loanedout and a profit is generated from it, “money starts tomake money.” Money then becomes a desirableproductive resource in and of itself.

Summary ofthe Chapter





58 Chapter Two

6. Mercantilism is the business system in whichproducts are traded across markets and countriesuntil they are put to their most highly valued use.Merchants and bankers are traders who notice adifference between the value and price ofcommodities—resources and products—in onemarket and its value and price in another. Theyrecognize an opportunity to profit from the differencein prices by trading commodities between onemarket and the next.

7. Increased trade led to the development of financeand banking institutions. It also led to a generalincrease in specialization and the division of labor,thereby increasing the capital and wealth of society.

8. The Industrial Revolution provided new opportunitiesfor capital to be put to work. It represented a majorshift in production and trade brought about byadvances in technology. This technology transformedthe production process and increased the profitabilityof all kinds of business activities.

9. Capitalism is the economic or business system inwhich the private ownership of productive resourcesbecomes the basis for the production, trade, anddistribution of goods and services. Capitalistspersonally own and/or control the physical capital of industrial production—the

machinery, factories, distribution networks, rawmaterials and inputs, research and developmentand technology.

10. Capitalism gave rise to increasing conflicts betweencapitalists and workers. This led to the formation oftrade unions that lobby on behalf of their membersto increase their wages and working conditions.Capitalism also gave rise to a more complicatedclass system: a social hierarchy based uponpeople’s capital and wealth, heredity, kinship, fame,occupations, and connections.

11. As business commerce evolved so did the forms ofbusiness organizations used to increase theproductivity and profitability of productiveresources. The hierarchy of authority evolved earlyto reduce the transaction costs surroundingbusiness activity. The joint-stock corporationevolved to make it easier for enterprising people toborrow capital to pursue new ventures, and forwealthy people to find new ways in which theycould build their capital and increase their wealth.

12. Joint-stock companies evolved into limited liabilitycompanies to encourage people to risk theircapital to promote enterprise. Today, the limitedliability model is the standard way to organize abusiness.

Developing Business Skills

1. What are property rights andhow do they affect the use of pro-ductive resources?2. In what ways can the use of

money lead (1) to a more produc-tive use of resources, and (2) to a more

profitable use of resources? 3. What is the difference between feudalism andmercantilism? How are the two connected?

4. What is the relationship between capital andenterprise? How did capitalism affect the use of pro-ductive resources?5. What caused the Industrial Revolution, and whydid it take so long?6. How did the emergence of business organiza-tion forms based on (1) the hierarchy of authority (2)the joint-stock arrangement and (3) limited liabilityhelp to further business commerce and occupations?

QUESTIONS FOR DISCUSSION AND ACTION






Ethics and History

Each of the three main kinds ofbusiness systems—feudalism, mer-cantilism, and capitalism—is associ-

ated with a particular kind of ethicalor moral position: for example, different

views about the rights workers should have relativeto the owners of land or capital.

• Identify differences in the ethical or moralpositions that explain how labor is treated ineach of these three business systems.

• Do you see any themes going through them?Would you say the treatment of workersimproved over time from an ethical point ofview or did it get worse? Why?

• What basic kinds of rights do you think work-ers should have in business organizationstoday? For example, do you think rights, suchas the rights to unionize, or to receive fair andequitable treatment are appropriate? Whatabout workers’ rights to privacy? Do employ-ers have a right to monitor workers’ e-mailand telephone conversations, for example?

• What ethical principles do you think multina-tional companies should abide by when decid-ing where to locate their operations or how totreat their workforces in the countries inwhich they operate?

ETHICS IN ACTION

The Landscape ArchitectureBusiness

After reading the following scenariobreak up into groups of three or four

people and discuss the issues involved.Be prepared to share your thinking with the

rest of the class.

Imagine you and some of your college friends havedecided to start your own business doing landscapearchitecture, the subject each of you majored in. Oneof you has the capital to start the new venture. The

SMALL GROUP EXERCISE

rest of you are bringing your skills and experience tothe business. You know that many new businessesfail because their owners frequently have a fallingout as their businesses grow. Owners frequently dis-agree on the right way to operate the business. Theyalso disagree on how to share the profits, and conflictbetween owners is a very common occurrence.

What form of business organization will youchoose? Should the person supplying the capitalhave more rights or a greater say in the way the busi-ness operates? Who will be in charge of the business?What criteria should you use to allocate future profitsamong yourselves?

The Lessons of History

Using the material in the chap-ter, what does the history of busi-ness teach you about the general

issues that underlie the way moderncompanies operate? To answer this ques-

tion, think about the following.

1. What kind of skills and qualities does an enter-prising person need to succeed in business?2. As you consider what your personal role in thebusiness world will be, what do the lessons about theway businesses are organized teach you?3. What general business principles do you thinkmodern multinational companies follow today?

DEVELOPING GOOD BUSINESS SENSE





60 Chapter Two

The Evolution of Union Pacific

Go the Web site of Union PacificRailroad (www.up.com), click onthe “General Public” tab, and then

the “History of the Company” tab(http://www.uprr.com/aboutup/history/

index.shtml).Read the material in this section, including the

historical overview, the chronological history, andpast and present railroad job descriptions. Thenanswer the following questions. For more Web activ-ities, log on to www.mhhe.com/jonesintro

1. Why did the growth of national railroads likeUnion Pacific transform the nature of business activ-ity in the United States?2. In what ways have the occupations of railroademployees changed over time?3. Why did gas-driven vehicles and then the jet air-craft come to replace the railroad as the principalmethod of passenger transportation?

EXPLORING THE WEB

CASE FOR DISCUSSION

The New Nike: No Longer the Brat of Sports Marketing, It Has a Higher Level of Discipline and Performance

In many ways, the sleek, four-story building thathouses Nike Inc.’s Innovation Kitchen is a throw-back to the company’s earliest days. Located on theground floor of the Mia Hamm building on Nike’s175-acre headquarters campus in Beaverton, Oregon,the Kitchen is where Nike cooked up the shoes thatmade it the star of the $35 billion athletic footwearindustry. In this think tank for sneakers, designersfind inspiration in everything from Irish architectureto the curving lines of a Stradivarius violin. One walldisplays models of every Air Jordan ever made,while low-rise cubicles are littered with sketches ofnew shoes. The Kitchen is off limits to most visitorsand even to most Nike employees. The sign on thedoor says, only half in jest: “Nobody gets in to seethe cooks. Not nobody. Not no how.”

This is where, nearly 20 years ago, Nike stardesigner Tinker Hatfield came up with the Air Jor-dan—the best-selling sports shoe of all time. Rightnow, Hatfield and his team are tallying the results ofthe Athens 2004 Olympic Games. Hatfield and hisdesign geeks produced an array of superfast sneakersfor the Games, including the sleek track spike calledMonsterfly for sprinters and the Air Zoom Miler fordistance runners. As befits a global company, Nike’ssponsored athletes hailed from all over the world.They took home a lot of hardware from Athens,including 50 gold medals and dozens more silverand bronze. And Nike apparel had its day in the sun,too. The top four finishers in the men’s 100-meterrace all wore the sign of the Swoosh.

GOING ESTABLISHMENT. The most tellingevents for Nike didn’t take place on the track, how-ever. The brash guerrilla marketer, famous forthumbing its nose at big-time sporting events, wasshowing a new restraint. Eight years ago in Atlanta,Nike ambushed basketball sponsor Champion (abrand of Sara Lee Corporation) by sneaking giantSwoosh signs into the arena. When the cameraspanned the stands, TV audiences saw the Nike logoloud and clear, while Champion had nothing. Nikehas even signed up to become an official U.S.Olympic sponsor in four years in Beijing, and it hastoned down its anti-Establishment attitude. For goodreason:These days, Nike is the Establishment when itcomes to global sports marketing. With revenuesexceeding $12 billion in fiscal 2004, the companythat Philip H. Knight started three decades ago byselling sneakers out of the back of a car at trackmeets has finally grown up.

The kind of creativity that led Bill Bowerman, theUniversity of Oregon track coach who co-foundedthe company with Knight, to dream up a new kind ofsneaker tread after studying the pattern on his wife’swaffle iron, is still revered at Nike. When it comes tothe rest of the business, however, it’s a whole newball game. Gone are the days when Nike execs,working on little more than hunches, would do justabout anything and spend just about any amount inthe quest for publicity and market share.

But in the past few years, the company hasdevoted as much energy to the mundane details ofrunning a business—such as developing top-flightinformation systems, logistics, and (yawn) supply-chain management—as it does to marketing coupsand cutting-edge sneaker design. More and more,






Nike is searching for the right balance between itscreative and its business sides, relying on a newfoundfinancial and managerial discipline to drive growth.“Senior management now has a clear understandingof managing the creative process and bringing it tothe bottom line. That’s the big difference comparedto the past,” says Robert Toomey, an equity analystat RBC Dain Rauscher Inc. in Seattle.

BUSINESSLIKE—AND UNCOOL? In the olddays, Nike operated pretty much on instinct. It tooka guess as to how many pairs of shoes to churn outand hoped it could cram them all onto retailers’shelves. Not anymore. Nike has overhauled its com-puter systems to get the right number of sneakers tomore places in the world more quickly. By methodi-cally studying new markets, it has become a power-house overseas—and in new market segments that itonce scorned, such as soccer and fashion. It has alsobeefed up its management team. And after stumblingwith its acquisitions, Nike has learned to managethose brands—Cole Haan dress shoes, Converseretro-style sneakers, Hurley International skateboardgear, and Bauer in-line and hockey skates—more effi-ciently. Indeed, part of Nike’s growth strategy is toadd to its portfolio of brands.

To many of the Nike faithful, those sorts of changessmacked of heresy. Lebron James is cool. Matrixorganization and corporate acquisitions aren’t. Butcool or not, the new approach is working. In fiscal2004, ended May 31, Nike showed just how far it hadelevated its financial game. It turned in a record year,earning almost $1 billion, 27% more than the yearbefore, on sales that climbed 15%, to $12.3 billion.What’s more, orders worldwide were up a healthy10.7%. In North America orders rose 10% followingeight stagnant quarters.

Nike believes its newfound discipline will enableit to meet its targets of 15% average annual profitgrowth and revenue growth in the high single digits.Wall Street shares that optimism. Says John J. Shan-ley, an analyst at Susquehanna Financial Group, aninstitutional broker in Bala Cynwyd, Pennsylvania:“Nike is probably in the best financial position it hasbeen in a decade.” In fact, some analysts believeNike is poised to become a $20 billion company bythe end of the decade.

That would have seemed laughable just a fewyears ago—sales started falling after hitting the $9.6billion mark in 1998. Even before Nike’s superstarendorser and basketball great Michael Jordan retiredfrom the game in 2003, Nike’s creative juices seemedto have run dry. Air Jordans at $200 were collectingdust on store shelves as buyers seeking a differentlook began switching to Skechers, K-Swiss, and NewBalance shoes. Nike wrestled with accusations thatit exploited Asian factory workers. Ho-hum new

sneakers and troubled acquisitions didn’t help.Nike, eager to regain its old momentum, bumpedup production—only to end up pushing more sneak-ers into the market than the customers wanted tobuy. As for financial discipline? Well, just considerthis: From 1997 to 1999, Nike didn’t even have achief financial officer.

It was during those tough times that Phil Knight,who had disengaged from Nike in order to traveland pursue other interests, came back to the com-pany. The year was 1999. Co-founder Bowermanhad died, and Nike was floundering. Knight, now 66,needed to set things straight. Standing before thou-sands of employees at a company meeting, he admit-ted that the managers who were running the placehad failed. And he went on to blame himself. “Hesaid he wasn’t as engaged as he should be, and hesaid there were things he could do better,” recallsSteve Miller, Nike’s former global sports marketingdirector, who was there. “I was personally stunnedhe would be so open about his failings.”

Still, when his iconoclastic company faltered,Knight looked beyond the technology and marketingantics that had served it well in the past. Upon hisreturn to the company five years ago, his first orderof business was to put together a new executiveteam. Knight drew on some Nike veterans, execu-tives who carry the heritage and culture of Nike’searly years. But he also recruited some key playersfrom far outside Nike and its industry. CFO DonaldW. Blair, who came aboard in 1999, was lured fromPepsi, while Mindy F. Grossman was plucked fromPolo Ralph Lauren Corporation the next year withthe mission of redefining Nike’s $3.5 billion globalapparel business. The-day-to-day boss, Chief Oper-ating Officer Thomas E. Clarke, now runs Nike’snew business ventures division.

Knight made his boldest management move in2001, when he named two longtime Nike insiders,creative brand and design wonk Mark G. Parkerand operations maven Charles D. Denson, as co-presidents. With Grossman and Blair providing anoutsider’s perspective and with Parker and Densonsteeped in the company’s culture, Knight hoped toachieve a balance between the old and the new, thecreative and the financially responsible. The unusualco-president structure was hardly Business 101, andmany observers figured the new team wouldn’t last.Few believed co-presidents could survive the in-evitable political maneuvering and clash of egos.

Possibly because there was little time for politick-ing or backstabbing, given Nike’s plight, Parker,Denson, and the rest have mostly steered clear ofthose pitfalls and focused on shoring up Nike’s weak-nesses. In the old days at Nike, the culture encour-aged local managers to spend big and to go flat-out





62 Chapter Two

for market share instead of profitability. In Paris, forinstance, the company spent lavishly for a soccerpark at the 1998 World Cup to promote itself. Ana-lysts estimate, conservatively, that it was more than$10 million over budget. The cost, which Nike neverdisclosed, caused Wall Street to start asking whetheranyone was in charge.

So Parker and Denson engineered a matrix struc-ture that breaks down managerial responsibility bothby region and product. Because the company pumpsout 120,000 products every year in four differentlaunch cycles, local managers always had plenty ofchoice—but also plenty of ways to screw up. Underthe matrix, Nike headquarters establishes whichproducts to push and how to do it, but regional man-agers are allowed some leeway to modify thoseedicts. The matrix won’t guarantee that anotherfiasco like the Paris soccer park cannot occur, but itmakes it a lot less likely.

FILLING THE ORDERS. Nike also overhauledits supply-chain system, which often left retailerseither desperately awaiting delivery of hot shoes orstruggling to get rid of the duds. The old jerry-builtcompilation strung together 27 different computersystems worldwide, most of which couldn’t talk withthe others. Under Denson’s direction, Nike has spent$500 million to build a new system.

Nike has also had to grapple with the touchy topicof sweatshop labor at the 900-odd independent over-seas factories that make its clothes and sneakers.When Nike was getting pummeled on the subject inthe 1990s, it typically had only two responses:angerand panic. Executives would issue denials, lash out atcritics, and then rush someone to the offending sup-plier to put out the fire. But since 2002, Nike hasbuilt an elaborate program to deal with charges oflabor exploitation. It allows random factory inspec-tions by the Fair Labor Assn., a monitoring outfit itfounded with human rights groups and other bigcompanies, such as Reebok International Ltd. andLiz Claiborne Inc., that use overseas contractors.Nike also has an in-house staff of 97 which hasinspected 600 factories in the past two years, gradingthem on labor standards.

It’s overseas, in fact, where most of Nike’s salesnow come from. Last year, for the first time, interna-tional sales exceeded U.S. sales—still the company’s

single largest market. Under Grossman, Nike is mak-ing sports fashion a core business, something unthink-able until recently inside Nike’s male-dominated cul-ture. Thanks to stylish athletic wear—think tennis starSerena Williams at the U.S. Open—Nike’s worldwideapparel sales climbed 30% in three years, to $3.5 bil-lion in fiscal 2004.

SWIFTEST KICK. Just before this summer’sEuropean soccer championships, Nike launched itsTotal 90 III, a sleek shoe that draws inspiration fromcars used in the Le Mans 24-hour road race. Nikerealized that millions of kids around the globe playcasual pickup soccer games in the street and devel-oped the shoe especially for them. That insight doesnot impress soccer purists. “Nike is selling a lot of theTotal 90 street shoes and is including them in the soc-cer category,” huffs Adidas CEO Herbert Hainer.“They are trying to turn the business model into alifestyle.” He’s right, of course. Just as Nike madebasketball shoes into an off-the-court fashion state-ment, its Total 90s have become fashion accessoriesfor folks who may never get closer to a soccer pitchthan the stands.

What’s the lesson? Let other companies worryabout the traditional boundaries between sport andfashion. Nike has built its empire by transforming thetechnology and design of its high performance sportsgear into high fashion, vastly expanding its pool ofpotential customers. If competitors want to get hungup on what exactly Nike’s selling, that’s O.K. with thefolks in Beaverton. It’s all Nike to them.

Source: Stanley Holmes and Aaron Bernstein, “The New Nike:No Longerthe Brat of Sports Marketing, It Has a Higher Level of Discipline andPerformance,” BusinessWeek Online, September 20, 2004.

QUESTIONS

1. What was Nike’s original approach to businesscommerce? What kinds of business occupations andorganization did Nike adopt to pursue its businessmodel?2. What kinds of business problems did Nikeencounter as it evolved over time?3. In what ways has Nike been changing its busi-ness operations and processes, especially its func-tions, to improve its performance as it has grown andmatured over time?






Computers and cell phones are con-sidered “old” after a year or two.Change is occurring at an increas-ingly rapid pace in our technology,

business, social, and political sys-tems. Conditions in the world are con-

stantly in flux and affect the way we do

BUILDING YOUR MANAGEMENT SKILLSKnow Thyself

business and with whom. U.S. government surveystell us that employers value flexibility, the ability toadapt to change, very highly. The self-assessmentexercise on your Student DVD called “AssessingYour Flexibility” will help you determine how easilyyou adapt to change and give you some tips tobecoming more flexible.

Levi Strauss is a name that mostAmericans recognize. They usuallyrelate the brand to “jeans” or levis.Changes in trends and consumer

preferences forced Levi Strauss todiversify its product lines over many

years. In fact, at one time the company hadover 65,000 different products on the market. Overthe past six years, Levi’s has seen it sales volumedecrease by 40%. With the first three months after9/11/2001, Levi’s was down a whopping 12% insales. Further, Levi’s management perceives its mar-keting plan as consistent with the research data. Out-side industry experts disagree, however. There was atime not long ago when Levi’s would introduce massproduced trendy jean wear (at around $30) andsimultaneously attempt to market high-end productsto an entirely different market segment. In a sense,Levi’s was trying to be all things to all consumers atthe same time. Based on this and other examples,

industry experts suggest that Levi’s must segment themarket and target their segments more directly andcarefully if they are to return to profitability.

High labor and production costs and the need torespond rapidly to changes in the marketplace haveforced Levis’ to locate all of its manufacturing facili-ties outside of the U.S. The company has reduced thenumber of products it sells from 65,000 to 20,000.While Levi Strauss is a 4.2 billion dollar firm, it needsto find a way to define its customer more clearly, tar-get that market, and continue reducing costs as it hasrecently. While Levis may no longer be manufac-tured in the United States, it may remain an Ameri-can icon nevertheless.

1. The chapter discusses the hierarchy of authority.How does this concept relate to Levi Strauss?2. What qualities does Levi Strauss have that mayensure continued success in business?3. How does the video segment relate to the evolu-tion of capitalism as discussed in the text?

CHAPTER VIDEODenim Blues

jones: introduction to i. the environment of 2. the

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