When the special protection or support is removed, the adjustments that producers and workers often have to make then can be much more severe than they would have been when the government programs were first adopted. That has happened when price support programs for milk and other agricultural products were phased out, and when policies that subsidized U.S. oil production and limited imports of oil were dropped in the 1970s, during the worldwide oil shortage.
For these reasons, if public assistance is provided to a particular industry, economists are likely to favor only temporary payments to cover some of the costs of relocation and retraining of workers. That policy limits the cost of such assistance and leaves workers and firms free to move their resources into whatever opportunities they believe will work best for them.
Most producers in the United States and other market economies must face competition every day. If they are successful, they stand to earn large returns. But they also risk the possibility of failure and large losses. The lure of profits and the risk of losses are both part of what makes production in a market economy efficient and responsive to consumer demands.
CORPORATIONS AND OTHER TYPES OF BUSINESSES
Three major types of firms carry out the production of goods and services in the U.S. economy: sole proprietorships, partnerships, and corporations. In 1995 the U.S. economy included 16.4 million proprietorships, excluding farms; 1.6 million partnerships; and about 4.3 million corporations. The corporations, however, produce far more goods and services than the proprietorships and partnerships combined.
Proprietorships and Partnerships
Sole proprietorships are typically owned and operated by one person or family. The owner is personally responsible for all debts incurred by the business, but the owner gets to keep any profits the firm earns, after paying taxes. The owner’s liability or responsibility for paying debts incurred by the business is considered unlimited. That is, any individual or organization that is owed money by the business can claim all of the business owner’s assets (such as personal savings and belongings), except those protected under bankruptcy laws.
Normally when the person who owns or operates a proprietorship retires or dies, the business is either sold to someone else, or simply closes down after any creditors are paid. Many small retail businesses are operated as sole proprietorships, often by people who also work part-time or even full-time in other jobs. Some farms are operated as sole proprietorships, though today corporations own many of the nation’s farms.
Partnerships are like sole proprietorships except that there are two or more owners who have agreed to divide, in some proportion, the risks taken and the profits earned by the firm. Legally, the partners still face unlimited liability and may have their personal property and savings claimed to pay off the business’s debts. There are fewer partnerships than corporations or sole proprietorships in the United States, but historically partnerships were widely used by certain professionals, such as lawyers, architects, doctors, and dentists. During the 1980s and 1990s, however, the number of partnerships in the U.S. economy has grown far more slowly than the number of sole proprietorships and corporations. Even many of the professions that once operated predominantly as partnerships have found it important to take advantage of the special features of corporations.
Corporations
In the United States a corporation is chartered by one of the 50 states as a legal body. That means it is, in law, a separate entity from its owners, who own shares of stock in the corporation. In the United States, corporate names often end with the abbreviation Inc., which stands for incorporated and refers to the idea that the business is a separate legal body.
Limited Liability
The key feature of corporations is limited liability. Unlike proprietorships and partnerships, the owners of a corporation are not personally responsible for any debts of the business. The only thing stockholders risk by investing in a corporation is what they have paid for their ownership shares, or stocks. Those who are owed money by the corporation cannot claim stockholders’ savings and other personal assets, even if the corporation goes into bankruptcy. Instead, the corporation is a separate legal entity, with the right to enter into contracts, to sue or be sued, and to continue to operate as long as it is profitable, which could be hundreds of years.
When the stockholders who own the corporation die, their stock is part of their estate and will be inherited by new owners. The corporation can go on doing business and usually will, unless the corporation is a small, closely held firm that is operated by one or two major stockholders. The largest U.S. corporations often have millions of stockholders, with no one person owning as much as 1 percent of the business. Limited liability and the possibility of operating for hundreds of years make corporations an attractive business structure, especially for large-scale operations where millions or even billions of dollars may be at risk.
When a new corporation is formed, a legal document called a prospectus is prepared to describe what the business will do, as well as who the directors of the corporation and its major investors will be. Those who buy this initial stock offering become the first owners of the corporation, and their investments provide the funds that allow the corporation to begin doing business.
Separation of Ownership and Control
The advantages of limited liability and of an unlimited number of years to operate have made corporations the dominant form of business for large-scale enterprises in the United States. However, there is one major drawback to this form of business. With sole proprietorships, the owners of the business are usually the same people who manage and operate the business. But in large corporations, corporate officers manage the business on behalf of the stockholders. This separation of management and ownership creates a potential conflict of interest. In particular, managers may care about their salaries, fringe benefits, or the size of their offices and support staffs, or perhaps even the overall size of the business they are running, more than they care about the stockholders’ profits.
The top managers of a corporation are appointed or dismissed by a corporation’s board of directors, which represents stockholders’ interests. However, in practice, the board of directors is often made up of people who were nominated by the top managers of the company. Members of the board of directors are elected by a majority of voting stockholders, but most stockholders vote for the nominees recommended by the current board members. Stockholders can also vote by proxy—a process in which they authorize someone else, usually the current board, to decide how to vote for them.
There are, however, two strong forces that encourage the managers of a corporation to act in stockholders’ interests. One is competition. Direct competition from other firms that sell in the same markets forces a corporation’s managers to make sound business decisions if they want the business to remain competitive and profitable. The second is the threat that if the corporation does not use its resources efficiently, it will be taken over by a more efficient company that wants control of those resources. If a corporation becomes financially unsound or is taken over by a competing company, the top managers of the firm face the prospect of being replaced. As a result, corporate managers will often act in the best interests of a corporation’s stockholders in order to preserve their own jobs and incomes.
In practice, the most common way for a takeover to occur is for one company to purchase the stock of another company, or for the two companies to merge by legal agreement under some new management structure. Stock purchases are more common in what are called hostile takeovers, where the company that is being taken over is fighting to remain independent. Mergers are more common in friendly takeovers, where two companies mutually agree that it makes sense for the companies to combine. In 1996 there were over $556.3 billion worth of mergers and acquisitions in the U.S. economy. Examples of mergers include the purchase of Lotus Development Corporation, a computer software company, by computer manufacturer International Business Machines Corporation (IBM) and the acquisition of Miramax Films by entertainment and media giant Walt Disney Company.
Takeovers by other firms became commonplace in the closing decades of the 20th century, and some research indicates that these takeovers made firms operate more efficiently and profitably. Those outcomes have been good news for shareholders and for consumers. In the long run, takeovers can help protect a firm’s workers, too, because their jobs will be more secure if the firm is operating efficiently. But initially takeovers often result in job losses, which force many workers to relocate, retrain, or in some cases retire sooner than they had planned. Such workforce reductions happen because if a firm was not operating efficiently, it was probably either operating in markets where it could not compete effectively, or it was using too many workers and other inputs to produce the goods and services it was selling. Sometimes corporate mergers can result in job losses because management combines and streamlines departments within the newly merged companies. Although this streamlining leads to greater efficiency, it often results in fewer jobs. In many cases, some workers are likely to be laid off and face a period of unemployment until they can find work with another firm.
How Corporations Raise Funds for Investment
By investing in new issues of a company’s stock, shareholders provide the funds for a company to begin new or expanded operations. However, most stock sales do not involve new issues of stock. Instead, when someone who owns stock decides to sell some or all of their shares, that stock is typically traded on one of the national stock exchanges, which are specialized markets for buying and selling stocks. In those transactions, the person who sells the stock—not the corporation whose stock is traded—receives the funds from that sale.
An existing corporation that wants to secure funds to expand its operations has three options. It can issue new shares of stock, using the process described earlier. That option will reduce the share of the business that current stockholders own, so a majority of the current stockholders have to approve the issue of new shares of stock. New issues are often approved because if the expansion proves to be profitable, the current stockholders are likely to benefit from higher stock prices and increased dividends. Dividends are corporate profits that some companies periodically pay out to shareholders.
The second way for a corporation to secure funds is by borrowing money from banks, from other financial institutions, or from individuals. To do this the corporation often issues bonds, which are legal obligations to repay the amount of money borrowed, plus interest, at a designated time. If a corporation goes out of business, it is legally required to pay off any bonds it has issued before any money is returned to stockholders. That means that stocks are riskier investments than bonds. On the other hand, all a bondholder will ever receive is the amount of money specified in the bond. Stockholders can enjoy much larger returns, if the corporation is profitable.
The final way for a corporation to pay for new investments is by reinvesting some of the profits it has earned. After paying taxes, profits are either paid out to stockholders as dividends or held as retained earnings to use in running and expanding the business. Those retained earnings come from the profits that belong to the stockholders, so reinvesting some of those profits increases the value of what the stockholders own and have risked in the business, which is known as stockholders’ equity. On the other hand, if the corporation incurs losses, the value of what the stockholders own in the business goes down, so stockholders’ equity decreases.
Entrepreneurs and Profits
Entrepreneurs raise money to invest in new enterprises that produce goods and services for consumers to buy—if consumers want these products more than other things they can buy. Entrepreneurs often make decisions on which businesses to pursue based on consumer demands. Making decisions to move resources into more profitable markets, and accepting the risk of losses if they make bad decisions—or fail to produce products that stand the test of competition—is the key role of entrepreneurs in the U.S. economy.
Profits are the financial incentives that lead business owners to risk their resources making goods and services for consumers to buy. But there are no guarantees that consumers will pay prices high enough to cover a firm’s costs of production, so there is an inherent risk that a firm will lose money and not make profits. Even during good years for most businesses, about 70,000 businesses fail in the United States. In years when business conditions are poor, the number approaches 100,000 failures a year. And even among the largest 500 U.S. industrial corporations, a few of these firms lose money in any given year.
Entrepreneurs invest money in firms with the expectation of making a profit. Therefore, if the profits a company earns are not high enough, entrepreneurs will not continue to invest in that firm. Instead, they will invest in other companies that they hope will be more profitable. Or if they want to reduce their risk, they can put their money into savings accounts where banks guarantee a minimum return. They can also invest in other kinds of financial securities (such as government or corporate bonds) that are riskier than savings accounts, but less risky than investments in most businesses. Generally, the riskier the investment, the higher the return investors will require to invest their money.
Calculating Profits
The dollar value of profits earned by U.S. businesses—about $700 billion a year in the late 1990s—is a great deal of money. However, it is important to see how profits compare with the money that business owners have risked in the business. Profits are also often compared to the level of sales for individual firms, or for all firms in the U.S. economy.
Accountants calculate profits by starting with the revenue a firm received from selling goods or services. The accountants then subtract the firm’s expenses for all of the material, labor, and other inputs used to produce the product. The resulting number is the dollar level of profits. To evaluate whether that figure is high or low, it must be compared to some measure of the size of the firm. Obviously, $1 million would be an incredibly large amount of profits for a very small firm, and not much profit at all for one of the largest corporations in the country, such as telecommunications giant AT&T Corp. or automobile manufacturer General Motors (GM).
To take into consideration the size of the firm, profits are calculated as a percentage of several different aspects of the business, including the firm’s level of sales, employment, and stockholders’ equity. Various individuals will use one of these different methods to evaluate a company’s performance, depending on what they want to know about how the firm operates. For example, an efficiency expert might examine the firm’s profits as a percentage of employment to determine how much profit is generated by the average worker in that firm. On the other hand, potential investors and a company’s chief executive would be more interested in profit as a percentage of stockholder equity, which allows them to gauge what kind of return to expect on their investments. A sales executive in the same firm might be more interested in learning about the company’s profit as a percentage of sales in order to compare its performance to the performances of competing firms in the same industry.
Using these different accounting methods often results in different profit percent figures for the same company. For example, suppose a firm earned a yearly profit of $1 million, with sales of $20 million. That represents a 5-percent rate of profit as a return on sales. But if stockholders’ equity in the corporation is $10 million, profits as a percent of stockholders’ equity will be 10 percent.
Return on Sales
Year after year, U.S. manufacturing firms average profits of about 5 percent of sales. Many business owners with profits at this level or lower like to say that they earn only about what people can earn on the interest from their savings accounts. That sounds low, especially considering that the federal government insures many savings accounts, so that most people with deposits at a bank run no risk of losing their savings if the bank goes out of business. And in fact, given the risks inherent in almost all businesses, few stockholders would be satisfied with a return on their investment that was this low.