Warren buffett rejected by harvard

Enter the World of Business

Warren Buffet: The Oracle of Omaha

Warren Buffett did not change his life plans when he was rejected by Harvard. An avid reader with a photographic memory, he persevered. He researched other universities and discovered that Benjamin Graham, the author of the The Intelligent Investor, was a professor at Columbia University. He immediately enrolled there, was accepted, and became the star pupil and eventual partner of the famous Graham. After graduating, Buffett started a lucrative career, taking ownership in companies that he believed would do well in business.

Buffett’s company, Berkshire Hathaway, has become a conglomerate with ownership in well-performing companies, including Geico, Heinz, Benjamin Moore, and See’s Candies. Because Berkshire Hathaway owns companies in so many different industries, it reduces the risk that the failure of any one industry will significantly affect the company. Most importantly, Buffett believes in these firms and their value, a strategy that has made him one of the 10 richest people in the world.

Leading such a variety of companies comes with challenges as well. Companies require leaders who know the business and have specialized expertise—something nearly impossible for one person to do with so many different business areas. For this reason, Buffett depends on his managers to lead the various companies. He believes giving his managers autonomy allows them to achieve their highest performance. He wants his managers to “own” their job. By hiring knowledgeable managers and empowering them to run the companies as they believe best, Buffett is able to lead his vast business conglomerate successfully.

Buffett’s organizational leadership philosophy includes focusing on the business. At his headquarters, 25 people run the organization. He encourages entrepreneurs “to focus on the business and not growing a large staff.” Buffett has earned the moniker “Oracle of Omaha” because he has lived there most of his life and many investors follow his advice and decisions.1

LO 1-1

Define basic concepts such as business, product, profit, and economics.

Introduction

We begin our study of business in this chapter by examining the fundamentals of business and economics. First, we introduce the nature of business, including its goals, activities, and participants. Next, we describe the basics of economics and apply them to the U.S. economy. Finally, we establish a framework for studying business in this text.

The Nature of Business

A business tries to earn a profit by providing products that satisfy people’s needs. The outcomes of its efforts are products that have both tangible and intangible characteristics that provide satisfaction and benefits. When you purchase a product, you are buying the benefits and satisfaction you think the product will provide. A Subway sandwich, for example, may be purchased to satisfy hunger, while a Honda Accord may be purchased to satisfy the need for transportation and the desire to present a certain image.

business

individuals or organizations who try to earn a profit by providing products that satisfy people’s needs.

product

a good or service with tangible and intangible characteristics that provide satisfaction and benefits.

Most people associate the word product with tangible goods—an automobile, smartphone, jeans, or some other tangible item. However, a product can also be a service, which occurs when people or machines provide or process something of value to customers. Dry cleaning, a checkup by a doctor, a movie or sports event—these are examples of services. An Uber ride satisfies the need for transportation and is therefore a service. A product can also be an idea. Accountants and attorneys, for example, provide ideas for solving problems.

The Goal of Business

The primary goal of all businesses is to earn a profit , the difference between what it costs to make and sell a product and what a customer pays for it. In addition, a business has to pay for all expenses necessary to operate. If a company spends $8 to produce, finance, promote, and distribute a product that it sells for $10, the business earns a profit of $2 on each product sold. Businesses have the right to keep and use their profits as they choose—within legal limits—because profit is the reward for their efforts and for the risks they take in providing products. Earning profits contributes to society by creating resources that support our social institutions and government. Businesses that create profits, pay taxes, and create jobs are the foundation of our economy. In addition, profits must be earned in a responsible manner. Not all organizations are businesses, however. Nonprofit organizations —such as National Public Radio (NPR), Habitat for Humanity, and other charities and social causes—do not have the fundamental purpose of earning profits, although they may provide goods or services and engage in fund-raising. They also utilize skills related to management, marketing, and finance. Profits earned by businesses support nonprofit organizations through donations from employees.

profit

the difference between what it costs to make and sell a product and what a customer pays for it.

nonprofit organizations

organizations that may provide goods or services but do not have the fundamental purpose of earning profits.

To earn a profit, a person or organization needs management skills to plan, organize, and control the activities of the business and to find and develop employees so that it can make products consumers will buy. A business also needs marketing expertise to learn what products consumers need and want and to develop, manufacture, price, promote, and distribute those products. Additionally, a business needs financial resources and skills to fund, maintain, and expand its operations. A business must cover the cost of labor, operate facilities, pay taxes, and provide management. Other challenges for businesspeople include abiding by laws and government regulations, and adapting to economic, technological, political, and social changes. Even nonprofit organizations engage in management, marketing, and finance activities to help reach their goals.

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Sustainability is a growing concern among both consumers and businesses. Microsoft recently completed the single largest corporate purchase of solar energy ever in the United States.

©franco lucato/Shutterstock

To achieve and maintain profitability, businesses have found that they must produce quality products, operate efficiently, and be socially responsible and ethical in dealing with customers, employees, investors, government regulators, and the community. Because these groups have a stake in the success and outcomes of a business, they are sometimes called stakeholders. Many businesses, for example, are concerned about how the production and distribution of their products affect the environment. New fuel requirements are forcing automakers to invest in smaller, lightweight cars. Electric vehicles may be a solution, but only about 1 percent of new car sales are plug-in-electric.2 Other businesses are concerned with promoting science, engineering, and mathematics careers among women. Traditionally, these careers have been male dominated. A global survey found that when the number of men and women were evenly matched, the team was 23 percent more likely to have an increase in profit over teams dominated by one gender.3 Nonprofit organizations, such as the American Red Cross, use business activities to support natural-disaster victims, relief efforts, and a national blood supply.

stakeholders

groups that have a stake in the success and outcomes of a business.

LO 1-2

Identify the main participants and activities of business.

The People and Activities of Business

Figure 1.1 shows the people and activities involved in business. At the center of the figure are owners, employees, and customers; the outer circle includes the primary business activities—management, marketing, and finance. Owners have to put up resources—money or credit—to start a business. Employees are responsible for the work that goes on within a business. Owners can manage the business themselves or hire employees to accomplish this task. The president and chief executive officer (CEO) of Procter & Gamble, David S. Taylor, does not own P&G but is an employee who is responsible for managing all the other employees in a way that earns a profit for investors, who are the real owners. Finally, and most importantly, a business’s major role is to satisfy the customers who buy its goods or services. Note also that forces beyond an organization’s control—such as legal and regulatory forces, the economy, competition, technology, the political environment, and ethical and social concerns—all have an impact on the daily operations of businesses. You will learn more about these participants in business activities throughout this book. Next, we will examine the major activities of business.

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FIGURE 1.1

Overview of the Business World

Management.  Notice that in Figure 1.1, management and employees are in the same segment of the circle. This is because management involves developing plans, coordinating employees’ actions to achieve the firm’s goals, organizing people to work efficiently, and motivating them to achieve the business’s goals. Management involves the functions of planning, organizing, leading, and controlling. Effective managers who are skilled in these functions display effective leadership, decision making, and delegation of work tasks. Management is also concerned with acquiring, developing, and using resources (including people) effectively and efficiently.

Operations is another element of management. Managers must oversee the firm’s operations to ensure that resources are successfully transformed into goods and services. Although most people associate operations with the development of goods, operations management applies just as strongly to services. Managers at the Ritz-Carlton, for instance, are concerned with transforming resources such as employee actions and hotel amenities into a quality customer service experience. In essence, managers plan, organize, staff, and control the tasks required to carry out the work of the company or nonprofit organization. We take a closer look at management activities in Parts 3 and 4 of this text.

Marketing.  Marketing and customers are in the same segment of Figure 1.1 because the focus of all marketing activities is satisfying customers. Marketing includes all the activities designed to provide goods and services that satisfy consumers’ needs and wants. Marketers gather information and conduct research to determine what customers want. Using information gathered from marketing research, marketers plan and develop products and make decisions about how much to charge for their products and when and where to make them available. They also page 7 analyze the marketing environment to understand changes in competition and consumers. The retail environment is changing based on competition from online retailing such as Amazon. This has caused some retail stores and malls to close.4 Marketing focuses on the four P’s—product, price, place (or distribution), and promotion—also known as the marketing mix. Product management involves such key management decisions as product adoption, development, branding, and product positioning. Selecting the right price for the product is essential to the organization as it relates directly to profitability. Distribution is an important management concern because it involves making sure products are available to consumers in the right place at the right time. Supply chain management involves purchasing and logistics as well as operations to coordinate suppliers, producers, and distributors to create value for customers. Marketers use promotion—advertising, personal selling, sales promotion (coupons, games, sweepstakes, movie tie-ins), and publicity—to communicate the benefits and advantages of their products to consumers and to increase sales. We will examine marketing activities in Part 5 of this text.

M&Ms uses humor in its advertising to promote the chocolate candies.

©Kisler Creations/Alamy Stock Photo

Finance.  Owners and finance are in the same part of Figure 1.1 because, although management and marketing have to deal with financial considerations, it is the primary responsibility of the owners to provide financial resources for the operation of the business. Moreover, the owners have the most to lose if the business fails to make a profit. Finance refers to all activities concerned with obtaining money and using it effectively. People who work as accountants, stockbrokers, investment advisors, or bankers are all part of the financial world. Owners sometimes have to borrow money from banks to get started or attract additional investors who become partners or stockholders. Owners of small businesses in particular often rely on bank loans for funding. Part 6 of this text discusses financial management.

LO 1-3

Explain why studying business is important.

Why Study Business?

Studying business can help you develop skills and acquire knowledge to prepare for your future career, regardless of whether you plan to work for a multinational Fortune 500 firm, start your own business, work for a government agency, or manage or volunteer at a nonprofit organization. The field of business offers a variety of interesting and challenging career opportunities throughout the world, such as marketing, human resources management, information technology, finance, production, accounting, data analytics, and many more.

Studying business can also help you better understand the many business activities that are necessary to provide satisfying goods and services. Most businesses charge a reasonable price for their products to ensure that they cover their production costs, pay their employees, provide their owners with a return on their investment, and perhaps give something back to their local communities and societies. Habitat for Humanity is an international nonprofit organization building housing for those who cannot afford simple, decent housing. Habitat operates like a business relying on volunteer labor and page 8 offers no-interest mortgages for repayment. Habitat ReStore is a retail unit that sells new and used building materials that are donated. The Home Depot Foundation has provided grants to remodel and renovate homes of U.S. military veterans.5 Thus, learning about business can help you become a well-informed consumer and member of society.

Many companies engage in socially responsible behavior to give back to their communities. Bank of America partners with Habitat for Humanity to build homes for disadvantaged families.

©asiseeit/Getty Images

Business activities help generate the profits that are essential not only to individual businesses and local economies, but also to the health of the global economy. Without profits, businesses find it difficult, if not impossible, to buy more raw materials, hire more employees, attract more capital, and create additional products that, in turn, make more profits and fuel the world economy. Understanding how our free-enterprise economic system allocates resources and provides incentives for industry and the workplace is important to everyone.

LO 1-4

Compare the four types of economic systems.

The Economic Foundations of Business

It is useful to explore the economic environment in which business is conducted. In this section, we examine economic systems, the free-enterprise system, the concepts of supply and demand, and the role of competition. These concepts play important roles in determining how businesses operate in a particular society.

Economics is the study of how resources are distributed for the production of goods and services within a social system. You are already familiar with the types of resources available. Land, forests, minerals, water, and other things that are not made by people are natural resources. Human resources , or labor , refer to the physical and mental abilities that people use to produce goods and services. Financial resources , or capital , are the funds used to acquire the natural and human resources needed to provide products. These resources are related to the factors of production, consisting of land, labor, capital, and enterprise used to produce goods and services. The firm can also have intangible resources such as a good reputation for quality products or being socially responsible. The goal is to turn the factors of production and intangible resources into a competitive advantage.

economics

the study of how resources are distributed for the production of goods and services within a social system.

natural resources

land, forests, minerals, water, and other things that are not made by people.

human resources (labor)

the physical and mental abilities that people use to produce goods and services.

financial resources (capital)

the funds used to acquire the natural and human resources needed to provide products.

Economic Systems

An economic system describes how a particular society distributes its resources to produce goods and services. A central issue of economics is how to fulfill an unlimited demand for goods and services in a world with a limited supply of resources. Different economic systems attempt to resolve this central issue in numerous ways, as we shall see.

economic system

a description of how a particular society distributes its resources to produce goods and services.

Although economic systems handle the distribution of resources in different ways, all economic systems must address three important issues:

1. What goods and services, and how much of each, will satisfy consumers’ needs?

2. How will goods and services be produced, who will produce them, and with what resources will they be produced?

3. How are the goods and services to be distributed to consumers?

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Communism, socialism, and capitalism, the basic economic systems found in the world today (Table 1.1), have fundamental differences in the way they address these issues. The factors of production in command economies are controlled by government planning. In many cases, the government owns or controls the production of goods and services. Communism and socialism are, therefore, considered command economies.

TABLE 1.1

Comparison of Communism, Socialism, and Capitalism

Communism

Socialism

Capitalism

Business ownership

Most businesses are owned and operated by the government.

The government owns and operates some basic industries; individuals own small businesses.

Individuals own and operate all businesses.

Competition

Government controls competition and the economy.

Restricted in basic industries; encouraged in small business.

Encouraged by market forces and government regulations.

Profits

Excess income goes to the government. The government supports social and economic institutions.

Profits earned by small businesses may be reinvested in the business; profits from government-owned industries go to the government.

Individuals and businesses are free to keep profits after paying taxes.

Product availability and price

Consumers have a limited choice of goods and services; prices are usually high.

Consumers have some choice of goods and services; prices are determined by supply and demand.

Consumers have a wide choice of goods and services; prices are determined by supply and demand.

Employment options

Little choice in choosing a career; most people work for government-owned industries or farms.

More choice of careers; many people work in government jobs.

Unlimited choice of careers.

Communism.  Karl Marx (1818–1883) first described communism as a society in which the people, without regard to class, own all the nation’s resources. In his ideal political-economic system, everyone contributes according to ability and receives benefits according to need. In a communist economy, the people (through the government) own and operate all businesses and factors of production. Central government planning determines what goods and services satisfy citizens’ needs, how the goods and services are produced, and how they are distributed. However, no true communist economy exists today that satisfies Marx’s ideal.

communism

first described by Karl Marx as a society in which the people, without regard to class, own all the nation’s resources.

Karl Marx, the founder of communism, described a society in which the people own all of the nation’s resources and contribute according to their ability.

©Everett Historical/Shutterstock

On paper, communism appears to be efficient and equitable, producing less of a gap between rich and poor. In practice, however, communist economies have been marked by low standards of living, critical shortages of consumer goods, high prices, corruption, and little freedom. Russia, Poland, Hungary, and other eastern European nations have page 10 turned away from communism and toward economic systems governed by supply and demand rather than by central planning. However, their experiments with alternative economic systems have been fraught with difficulty and hardship. Countries such as Venezuela have tried to incorporate communist economic principles without success. Even Cuba is experiencing changes to its predominately communist system. Massive government layoffs required many Cubans to turn toward the private sector, opening up more opportunities for entrepreneurship. The U.S. government has reestablished diplomatic relations with Cuba. Americans have more opportunities to visit Cuba than they have had for the past 50 years. Similarly, China has become the first communist country to make strong economic gains by adopting capitalist approaches to business. Economic prosperity has advanced in China with the government claiming to ensure market openness, equality, and fairness through state capitalism.6 As a result of economic challenges, communism is declining and its future as an economic system is uncertain.

Need help understanding basic economic systems? Visit your Connect ebook video tab for a brief animated explanation.

Socialism.  Socialism is an economic system in which the government owns and operates basic industries—postal service, telephone, utilities, transportation, health care, banking, and some manufacturing—but individuals own most businesses. For example, in France the postal service industry La Poste is fully owned by the French government and makes a profit. Central planning determines what basic goods and services are produced, how they are produced, and how they are distributed. Individuals and small businesses provide other goods and services based on consumer demand and the availability of resources. Citizens are dependent on the government for many goods and services.

socialism

an economic system in which the government owns and operates basic industries but individuals own most businesses.

Most socialist nations, such as Norway, India, and Israel, are democratic and recognize basic individual freedoms. Citizens can vote for political offices, but central government planners usually make many decisions about what is best for the nation. People are free to go into the occupation of their choice, but they often work in government-operated organizations. Socialists believe their system permits a higher standard of living than other economic systems, but the difference often applies to the nation as a whole rather than to its individual citizens. Socialist economies profess egalitarianism—equal distribution of income and social services. They believe their economies are more stable than those of other nations. Although this may be true, taxes and unemployment are generally higher in socialist countries. However, countries like Denmark have a high standard of living and they rate high in being happy.

Cuba and the United States restored diplomatic relations, and as a result, there are more opportunities to visit and do business with Cuba.

©Maurizio De Mattei/Shutterstock

Capitalism.  Capitalism , or free enterprise, is an economic system in which individuals own and operate the majority of businesses that provide goods and services. Competition, supply, and demand determine which goods and services are produced, how they are produced, and how they are distributed. The United States, Canada, Japan, and Australia are examples of economic systems based on capitalism.

capitalism (free enterprise)

an economic system in which individuals own and operate the majority of businesses that provide goods and services.

There are two forms of capitalism: pure capitalism and modified capitalism. In pure capitalism, also called a free-market system , all economic decisions are made without government intervention. page 11 This economic system was first described by Adam Smith in The Wealth of Nations (1776). Smith, often called the father of capitalism, believed that the “invisible hand of competition” best regulates the economy. He argued that competition should determine what goods and services people need. Smith’s system is also called laissez-faire (“let it be”) capitalism because the government does not interfere in business.

free-market system

pure capitalism, in which all economic decisions are made without government intervention.

Modified capitalism differs from pure capitalism in that the government intervenes and regulates business to some extent. One of the ways in which the United States and Canadian governments regulate business is through laws. Laws such as the Federal Trade Commission Act, which created the Federal Trade Commission to enforce antitrust laws, illustrate the importance of the government’s role in the economy. In the United States, states have leeway to regulate business. For example, the state of Washington requires employers to provide paid sick leave, and a number of states have legalized cannabis.7

Mixed Economies.  No country practices a pure form of communism, socialism, or capitalism, although most tend to favor one system over the others. Most nations operate as mixed economies , which have elements from more than one economic system. In socialist Sweden, most businesses are owned and operated by private individuals. In capitalist United States, an independent federal agency operates the postal service and another independent agency operates the Tennessee Valley Authority, an electric utility. In Great Britain and Mexico, the governments are attempting to sell many state-run businesses to private individuals and companies. In Germany, the Deutsche Post is privatized and trades on the stock market. In once-communist Russia, Hungary, Poland, and other eastern European nations, capitalist ideas have been implemented, including private ownership of businesses.

mixed economies

economies made up of elements from more than one economic system.

Countries such as China and Russia have used state capitalism to advance the economy. State capitalism tries to integrate the powers of the state with the advantages of capitalism. It is led by the government but uses capitalistic tools such as listing state-owned companies on the stock market and embracing globalization.8 State capitalism includes some of the world’s largest companies such as Russia’s Gazprom, which has the largest reserves of natural gas. China’s ability to make huge investments to the point of creating entirely new industries puts many private industries at a disadvantage.9

The Free-Enterprise System

Many economies—including those of the United States, Canada, and Japan—are based on free enterprise, and many communist and socialist countries, such as China and Russia, are applying more principles of free enterprise to their own economic systems. Free enterprise provides an opportunity for a business to succeed or fail on the basis of market demand. In a free-enterprise system, companies that can efficiently manufacture and sell products that consumers desire will probably succeed. Inefficient businesses and those that sell products that do not offer needed benefits will likely fail as consumers take their business to firms that have more competitive products.

A number of basic individual and business rights must exist for free enterprise to work. These rights are the goals of many countries that have recently embraced free enterprise.

1. Individuals must have the right to own property and to pass this property on to their heirs. This right motivates people to work hard and save to buy property.

2. Individuals and businesses must have the right to earn profits and to use the profits as they wish, within the constraints of their society’s laws, principles, and values.

3. Individuals and businesses must have the right to make decisions that determine the way the business operates. Although there is government regulation, the philosophy in countries like the United States and Australia is to permit maximum freedom within a set of rules of fairness.

4. Individuals must have the right to choose what career to pursue, where to live, what goods and services to purchase, and more. Businesses must have the right to choose where to locate, what goods and services to produce, what resources to use in the production process, and so on.

Two entrepreneurs present an idea for a new product. Entrepreneurs are more productive in free-enterprise systems.

©Cultura Creative (RF)/Alamy Stock Photo

Without these rights, businesses cannot function effectively because they are not motivated to succeed. Thus, these rights make possible the open exchange of goods and services. In the countries that favor free enterprise, such as the United States, citizens have the freedom to make many decisions about the employment they choose and create their own productivity systems. Many entrepreneurs are more productive in free-enterprise societies because personal and financial incentives are available that can aid in entrepreneurial success. For many entrepreneurs, their work becomes a part of their system of goals, values, and lifestyle. Consider the panelists (“sharks”) on the ABC program Shark Tank who give entrepreneurs a chance to receive funding to realize their dreams by deciding whether to invest in their projects. They include Barbara Corcoran, who built one of New York’s largest real estate companies; Mark Cuban, founder of Broadcast.com and MicroSolutions; and Daymond John, founder of clothing company FUBU, as well as others.10

LO 1-5

Describe the role of supply, demand, and competition in a free-enterprise system.

The Forces of Supply and Demand

In the United States and in other free-enterprise systems, the distribution of resources and products is determined by supply and demand. Demand is the number of goods and services that consumers are willing to buy at different prices at a specific time. From your own experience, you probably recognize that consumers are usually willing to buy more of an item as its price falls because they want to save money. Consider handmade rugs, for example. Consumers may be willing to buy six rugs at $350 each, four at $500 each, but only two at $650 each. The relationship between the price and the number of rugs consumers are willing to buy can be shown graphically with a demand curve (see Figure 1.2).

demand

the number of goods and services that consumers are willing to buy at different prices at a specific time.

FIGURE 1.2

Equilibrium Price of Handmade Rugs

Supply is the number of products that businesses are willing to sell at different prices at a specific time. In general, because the potential for profits is higher, businesses are willing to supply more of a good or service at higher prices. For example, a company that sells rugs may be willing to sell six at $650 each, four at $500 each, but just two at $350 each. The relationship between the price of rugs and the quantity the company is willing to supply can be shown graphically with a supply curve (see Figure 1.2).

supply

the number of products—goods and services—that businesses are willing to sell at different prices at a specific time.

Need help understanding supply and demand? Visit your Connect ebook video tab for a brief animated explanation.

In Figure 1.2, the supply and demand curves intersect at the point where supply and demand are equal. The price at which the number of products that businesses are willing to supply equals the amount of products that consumers are willing to buy at page 13 a specific point in time is the equilibrium price. In our rug example, the company is willing to supply four rugs at $500 each, and consumers are willing to buy four rugs at $500 each. Therefore, $500 is the equilibrium price for a rug at that point in time, and most rug companies will price their rugs at $500. As you might imagine, a business that charges more than $500 (or whatever the current equilibrium price is) for its rugs will not sell as many and might not earn a profit. On the other hand, a business that charges less than $500 accepts a lower profit per rug than could be made at the equilibrium price.

equilibrium price

the price at which the number of products that businesses are willing to supply equals the amount of products that consumers are willing to buy at a specific point in time.

If the cost of making rugs goes up, businesses will not offer as many at the old price. Changing the price alters the supply curve, and a new equilibrium price results. This is an ongoing process, with supply and demand constantly changing in response to changes in economic conditions, availability of resources, and degree of competition. For example, the price of oil can change rapidly and has been between $30 and $113 a barrel over the last eight years. Prices for goods and services vary according to these changes in supply and demand. Supply and demand is the force that drives the distribution of resources (goods and services, labor, and money) in a free-enterprise economy.

Critics of supply and demand say the system does not distribute resources equally. The forces of supply and demand prevent sellers who have to sell at higher prices (because their costs are high) and buyers who cannot afford to buy goods at the equilibrium price from participating in the market. According to critics, the wealthy can afford to buy more than they need, but the poor may be unable to buy enough of what they need to survive.

The Nature of Competition

Competition , the rivalry among businesses for consumers’ dollars, is another vital element in free enterprise. According to Adam Smith, competition fosters efficiency and low prices by forcing producers to offer the best products at the most reasonable price; those who fail to do so are not able to stay in business. Thus, competition should improve the quality of the goods and services available and reduce prices. Competition allows for open markets and provides opportunities for both individuals and businesses to successfully compete. Entrepreneurs can discover new technology, page 14 ways to lower prices, as well as methods for providing better distribution or services. Founder Jeff Bezos of Amazon is a prime example. Amazon was able to offer products online at competitive prices. Today, Amazon competes against such retail giants as Walmart in a number of industries, including cloud computing, entertainment, food, and most consumer products found in retail stores. Bezos is now the richest person in the world.

competition

the rivalry among businesses for consumers’ dollars.

Within a free-enterprise system, there are four types of competitive environments: pure competition, monopolistic competition, oligopoly, and monopoly.

Pure competition exists when there are many small businesses selling one standardized product, such as agricultural commodities like wheat, corn, and cotton. No one business sells enough of the product to influence the product’s price. And, because there is no difference in the products, prices are determined solely by the forces of supply and demand.

pure competition

the market structure that exists when there are many small businesses selling one standardized product.

Monopolistic competition exists when there are fewer businesses than in a pure-competition environment and the differences among the goods they sell are small. Aspirin, soft drinks, and jeans are examples of such goods. These products differ slightly in packaging, warranty, name, and other characteristics, but all satisfy the same consumer need. Businesses have some power over the price they charge in monopolistic competition because they can make consumers aware of product differences through advertising. Consumers value some features more than others and are often willing to pay higher prices for a product with the features they want. For example, many consumers are willing to pay a higher price for organic fruits and vegetables rather than receive a bargain on nonorganic foods. The same holds true for non-genetically modified foods.

monopolistic competition

the market structure that exists when there are fewer businesses than in a pure-competition environment and the differences among the goods they sell are small.

An oligopoly exists when there are very few businesses selling a product. In an oligopoly, individual businesses have control over their products’ price because each business supplies a large portion of the products sold in the marketplace. Nonetheless, the prices charged by different firms stay fairly close because a price cut or increase by one company will trigger a similar response from another company. In the airline industry, for example, when one airline cuts fares to boost sales, other airlines quickly follow with rate decreases to remain competitive. On the other hand, airlines often raise prices at the same time. Oligopolies exist when it is expensive for new firms to enter the marketplace. Not just anyone can acquire enough financial capital to build an automobile production facility or purchase enough airplanes and related resources to build an airline.

oligopoly

the market structure that exists when there are very few businesses selling a product.

When there is one business providing a product in a given market, a monopoly exists. Utility companies that supply electricity, natural gas, and water are monopolies. The government permits such monopolies because the cost of creating the good or supplying the service is so great that new producers cannot compete for sales. Government-granted monopolies are subject to government-regulated prices. Some monopolies exist because of technological developments that are protected by patent laws. Patent laws grant the developer of new technology a period of time (17 or 20 years) during which no other producer can use the same technology without the agreement of the original developer. The United States granted its first patent in 1790. Now its patent office receives hundreds of thousands of patent applications a year, although China has surpassed the United States in patent applications.11 This monopoly allows the developer to recover research, development, and production expenses and to earn a reasonable profit. A drug can receive a 17-year patent from the time it is discovered or the chemical is identified. For example, Tamiflu lost its patent, and now the generic version can be made by other firms.

monopoly

the market structure that exists when there is only one business providing a product in a given market.

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Economic Cycles and Productivity

Expansion and Contraction.  Economies are not stagnant; they expand and contract. Economic expansion occurs when an economy is growing and people are spending more money. Their purchases stimulate the production of goods and services, which in turn stimulates employment. The standard of living rises because more people are employed and have money to spend. Rapid expansions of the economy, however, may result in inflation , a continuing rise in prices. Inflation can be harmful if individuals’ incomes do not increase at the same pace as rising prices, reducing their buying power. The worst case of hyperinflation occurred in Hungary in 1946. At one point, prices were doubling every 15.6 hours. One of the most recent cases of hyperinflation occurred in Zimbabwe.12 Zimbabwe suffered from hyperinflation so severe that its inflation percentage rate rose into the hundreds of millions. With the elimination of the Zimbabwean dollar and certain price controls, the inflation rate began to decrease, but not before the country’s economy was virtually decimated.13

economic expansion

the situation that occurs when an economy is growing and people are spending more money; their purchases stimulate the production of goods and services, which in turn stimulates employment.

inflation

a condition characterized by a continuing rise in prices

Economic contraction occurs when spending declines. Businesses cut back on production and lay off workers, and the economy as a whole slows down. Contractions of the economy lead to recession —a decline in production, employment, and income. Recessions are often characterized by rising levels of unemployment , which is measured as the percentage of the population that wants to work but is unable to find jobs. Figure 1.3 shows the overall unemployment rate in the civilian labor force over the past 75 years. Rising unemployment levels tend to stifle demand for goods and services, which can have the effect of forcing prices downward, a condition known as deflation. Deflation poses a serious economic problem because price decreases could result in consumers delaying purchases. If consumers wait for lower prices, the economy could fall into a recession.

economic contraction

a slowdown of the economy characterized by a decline in spending and during which businesses cut back on production and lay off workers.

recession

a decline in production, employment, and income.

unemployment

the condition in which a percentage of the population wants to work but is unable to find jobs.

FIGURE 1.3

Annual Average Unemployment Rate, Civilian Labor Force, 16 Years and Over

Sources: Bureau of Labor Statistics, “Labor Force Statistics from the Current Population Survey,” http://data.bls.gov/timeseries/LNS14000000 (accessed March 25, 2018).

The United States has experienced numerous recessions, the most recent ones occurring in 1990–1991, 2002–2003, and 2008–2011. The most recent recession (or economic slowdown) was caused by the collapse in housing prices and consumers’ page 16 inability to stay current on their mortgage and credit card payments. This caused a crisis in the banking industry, with the government bailing out banks to keep them from failing. This in turn caused a slowdown in spending on consumer goods and a decrease in employment. Unemployment reached 10 percent of the labor force. Don’t forget that personal consumption makes up almost 70 percent of gross domestic product, so consumer engagement is extremely important for economic activity. A severe recession may turn into a depression , in which unemployment is very high, consumer spending is low, and business output is sharply reduced, such as what occurred in the United States in the early 1930s. The most recent recession is often called the Great Recession because it was the longest and most severe economic decline since the Great Depression.

depression

a condition of the economy in which unemployment is very high, consumer spending is low, and business output is sharply reduced.

Economies expand and contract in response to changes in consumer, business, and government spending. War also can affect an economy, sometimes stimulating it (as in the United States during World Wars I and II) and sometimes stifling it (as during the Vietnam, Persian Gulf, and Iraq wars). Although fluctuations in the economy are inevitable and to a certain extent predictable, their effects—inflation and unemployment—disrupt lives and thus governments try to minimize them.

LO 1-6

Specify why and how the health of the economy is measured.

Measuring the Economy.  Countries measure the state of their economies to determine whether they are expanding or contracting and whether corrective action is necessary to minimize the fluctuations. One commonly used measure is gross domestic product (GDP) —the sum of all goods and services produced in a country during a year. GDP measures only those goods and services made within a country and therefore does not include profits from companies’ overseas operations; it does include profits earned by foreign companies within the country being measured. However, it does not take into account the concept of GDP in relation to population (GDP per capita). Figure 1.4 shows the increase in U.S. GDP over several years, while Table 1.2 compares a number of economic statistics for a sampling of countries.

gross domestic product (GDP)

the sum of all goods and services produced in a country during a year.

FIGURE 1.4

Growth in U.S. Gross Domestic Product

Source: U.S. Department of Commerce Bureau of Economic Analysis, “National Economic Accounts,” www.bea.gov/national/index.htm#gdp (accessed March 25, 2018).

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TABLE 1.2

Economic Indicators of Different Countries

Source: CIA, The World Fact Book, https://www.cia.gov/library/publications/the-world-factbook/rankorder/rankorderguide.html (accessed March 25, 2018).

Another important indicator of a nation’s economic health is the relationship between its spending and income (from taxes). When a nation spends more than it takes in from taxes, it has a budget deficit. In the 1990s, the U.S. government eliminated its long-standing budget deficit by balancing the money spent for social, defense, and other programs with the amount of money taken in from taxes.

budget deficit

the condition in which a nation spends more than it takes in from taxes.

In recent years, however, the budget deficit has reemerged and grown to record levels, partly due to defense spending in the aftermath of the terrorist attacks of September 11, 2001. Massive government stimulus spending during the most recent recession also increased the national debt. Because many Americans do not want their taxes increased and Congress has difficulty agreeing on appropriate tax rates, it is difficult to increase taxes and reduce the deficit. Like consumers and businesses, when the government needs money, it borrows from the public, banks, and even foreign investors. The national debt is more than $24 trillion.14 This figure is especially worrisome because to reduce the debt to a manageable level, the government either has to increase its revenues (raise taxes) or reduce spending on social, defense, and legal programs, neither of which is politically popular. The United States recently enacted tax cuts that are projected to increase the national debt every year over the next 10 years.15 The national debt figure changes daily and can be seen at the Department of the Treasury, Bureau of the Public Debt, website. Table 1.3 describes some of the other ways we evaluate our nation’s economy.

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TABLE 1.3

How Do We Evaluate Our Nation’s Economy?

Unit of Measure

Description

Trade balance

The difference between our exports and our imports. If the balance is negative, as it has been since the mid-1980s, it is called a trade deficit and is generally viewed as unhealthy for our economy.

Consumer Price Index

Measures changes in prices of goods and services purchased for consumption by typical urban households.

Per capita income

Indicates the income level of “average” Americans. Useful in determining how much “average” consumers spend and how much money Americans are earning.

Unemployment rate

Indicates how many working-age Americans are not working who otherwise want to work.

Inflation

Monitors price increases in consumer goods and services over specified periods of time. Used to determine if costs of goods and services are exceeding worker compensation over time.

Worker productivity

The amount of goods and services produced for each hour worked.

LO 1-7

Outline the evolution of the American economy.

The American Economy

As we said previously, the United States is a mixed economy with a foundation based on capitalism. The answers to the three basic economic issues are determined primarily by competition and the forces of supply and demand, although the federal government does intervene in economic decisions to a certain extent. For instance, the federal government exerts oversight over the airline industry to make sure airlines remain economically viable as well as for safety and security purposes.

Standard of living refers to the level of wealth and material comfort that people have available to them. The United States, Germany, Australia, and Norway all have a high standard of living, meaning that most of their citizens are able to afford basic necessities and some degree of comfort. These nations are often characterized by a high GDP per capita. However, a higher GDP per capita does not automatically translate into a higher standard of living. Costs of goods and services are also factors. The European Union and Japan, for instance, tend to have higher costs of living than in the United States. Higher prices mean that it costs more to obtain a certain level of comfort than it does in other countries. Countries with low standards of living are usually characterized by poverty, higher unemployment, and lower education rates. To understand the current state of the American economy and its effect on business practices, it is helpful to examine its history and the roles of the entrepreneur and the government.

standard of living

refers to the level of wealth and material comfort that people have available to them.

The Importance of the American Economy

The American economy is an open economy , or an economy in which economic activities occur between the country and the international community. As an open economy, the United States is a major player in international trade. Open economies tend to grow faster than economies that do not engage in international trade. This is because international trade is positively related to efficiency and productivity. Companies in the United States have greater access to a wider range of resources and knowledge, including technology. In today’s global environment, the ability to harness technology is critical toward increased innovation.16 In contrast, research page 19 indicates a negative relationship between regulatory actions and innovation in firms, suggesting that too much regulation hinders business activities and their contribution to the American economy.17

open economy

an economy in which economic activities occur between the country and the international community.

When looking at the American economy, growth in GDP and jobs are the two primary factors economists consider. A positive relationship exists between a country’s employment rate and economic growth. A nation’s output depends on the amount of labor used in the production process, so there is also a positive correlation between output and employment. In general, as the labor force and productivity increase, so does GDP. Profitable companies tend to hire more workers than those that are unprofitable. Therefore, companies that hire employees not only improve their profitability but also drive the economic well-being of the American economy.18

Government public policy also drives the economy through job creation. In order for any nation to ensure the social and economic health of the country, there must be a tax base to provide for the public interest. The vast majority of taxes come from individuals. It is estimated that the U.S. government obtains $2.3 trillion in individual income taxes annually.19 Figure 1.5 shows the distribution of returns and income taxes paid by individuals based on their gross income. Unmarried individuals who earn more than $500,000 pay 37 percent of individual income taxes.20