REGULATING THE BUSINESS CYCLE

Because of the severity of the Great Depression, action was taken during the 1930s to both promote recovery and to reduce the likelihood and severity of future business downturns. Legislation known as New Deal programs created federal unemployment insurance, the Social Security system, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC).

Unemployment insurance provides workers with income when they are laid off. Social Security furnishes some income to retired or disabled persons. These two programs thus provide greater income stability because people retain some purchasing power even when they are no longer working. The FDIC gives consumers confidence in their financial institutions and helps prevent a repeat of the massive withdrawals of funds or bank panic that led to the collapse of several thousand banks during the Great Depression. The SEC helps prevent financial fraud by requiring corporations that publicly trade their stock to report accurate financial information.

Other aspects of New Deal legislation also helped promote economic stability. The New Deal’s National Industrial Recovery Act of 1933 enabled workers to bargain collectively in trade unions. Although not as powerful as they once were, labor unions help prevent spiraling wage declines that have worsened previous downturns. Similarly, government support of crop prices shields farmers from disastrous loss of income. Whether or not these changes represent all or part of the explanation, the fact remains that since the Great Depression all economic contractions have been significantly less severe.

Beyond these structural changes, the government can also engage in direct intervention to counter a recession. Two main counter-cyclical policy options are available: monetary policy and fiscal policy. Economists disagree on the effectiveness of these options.

Monetary policy involves control of the money supply and interest rates by a central bank. In the United States the central bank is known as the Federal Reserve System, or simply the Fed. These controls determine the amount of credit available to businesses and consumers and the cost of that credit. By reducing the rate of money supply growth and allowing interest rates to rise, the Fed reduces the amount of available credit and increases the cost of borrowing in order to slow an economic expansion. This practice is known as contractionary monetary policy. Alternatively, expansionary monetary policy involves increasing the rate of growth in the money supply and lowering interest rates. In this fashion the Fed increases the availability of credit and lowers the cost of borrowing in an effort to stimulate the economy.

Fiscal policy consists of changes in government spending or taxation or both. If the government seeks to constrain an economic expansion by engaging in contractionary fiscal policy, it can lower its purchases of goods and services, reduce the amount of money it spends on social services and subsidies, or increase taxes. Expansionary fiscal policy involves the opposite actions—namely, increases in purchases of goods and services, increases in social service spending and subsidies, or reductions in taxes—in an effort to stimulate production and employment.

In discussing the relative merits of monetary and fiscal policies as counter-cyclical tools, economists often argue over which policy to pursue. Some economists note that changes in monetary policy can be implemented quickly whereas changes in fiscal policy take much longer. The Fed’s Open Market Committee, for example, makes decisions regarding the money supply and interest rates. All that is needed to change monetary policy is a vote by this committee. Fiscal policy, on the other hand, typically requires the approval of both the legislative and executive branches of the federal government. For example, a lowering of taxes needs approval from both the U.S. House of Representatives and Senate as well as the approval of the U.S. president, approvals that sometimes may take longer than a year to secure.

However, many economists also note that it takes fiscal policy less time than monetary policy to have an impact on the economy once a specific action has been implemented. For example, a fiscal-policy reduction in the personal income tax will show up immediately in higher take-home pay for workers. By contrast, consumers and business firms may take awhile before they modify their spending in response to a monetary-policy change, such as a reduction in interest rates. For example, not everyone goes out to buy a new car just because the interest rate on car loans has decreased.

CAUSES OF BUSINESS CYCLES

A variety of explanations have been offered for business cycles. The Austrian American economist Joseph Schumpeter published his innovation theory in the late 1930s. He related upswings in the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions develop unevenly, business conditions alternate between expansion and contraction, according to Schumpeter’s theory.

In the early 1960s American economist Milton Friedman offered another explanation of the business cycle, known as a monetarist theory. In a careful review of American economic history Friedman and his collaborator Anna Schwartz found that turning points in the growth rate of the money supply (the total amount of money circulating in the economy) preceded business cycle turning points. They also found that the sources of the changes in the money supply’s growth rate—for example, the spread of commercial banking and the output of gold during the 19th century—were independent of the changes in economic activity. This finding indicated that the money supply was the primary cause of changes in business conditions.

Some business cycle analysts, including statistician Edward Tufte, have argued that politics plays a major role in the business cycle. These analysts believe that elected officials manipulate monetary and fiscal policies in an effort to win reelection. According to this viewpoint, as a presidential election approaches, officeholders seek to stimulate the economy with reductions in taxes, increases in government spending, and decreases in interest rates. The elected officials do this because they believe voters, enjoying the favorable economic conditions, will reward them by reelecting them to office. But in the process they may be stimulating an expansion that cannot be sustained and so may lead soon to a contraction.

Still another explanation for business cycles, advanced by American economist Robert E. Lucas, Jr., and others, examines misperceptions about the movements of wages and prices. In this view producers mistakenly perceive an overall increase in the level of prices in the economy as increased demand for their products. They respond by expanding production and employment within their firms. If enough firms make the same mistake, overall business activity will accelerate, followed by a contraction when the firms realize that they were mistaken in perceiving a growing demand.

A fifth explanation for business cycles is known as real business cycle theory and was developed in the 1980s by American economist Edward C. Prescott and others. It looks beyond political, monetary, and perception considerations to “real” factors, such as significant changes in technology and productivity.

Some business cycle analysts believe that there is no single consistent cause of business cycles. Instead they study what might be called shocks to the economy—a positive shock promoting a business expansion and a negative shock pushing the economy into recession. World War II (1939-1945) might be considered a positive economic shock that ended the Great Depression, whereas the events leading up to the 1991 Persian Gulf War represented a negative shock that explained the recession of 1990-1991. Other negative shocks might include agricultural failures associated with droughts. Discoveries of precious resources such as oil or gold would represent positive shocks. So these economists view the history of business cycles as a history of alternating positive and negative shocks.

MEASURING THE BUSINESS CYCLE

Economists use contractions as a way to document the beginning and end of a business cycle. They can determine when a contraction, or recession, has begun by using a variety of measurements. The common definition of a recession is two consecutive quarterly declines in the gross domestic product (GDP, the total of all goods and services produced within a country). Many economists, however, regard this definition as simplistic because it measures national economic performance according to a single, although important, economic statistic. In short, by looking at only one aspect of national economic activity—the GDP—an evaluation is made of the whole economy.

A more detailed definition of a recession is the one used by the National Bureau of Economic Research (NBER), a nonprofit organization regarded as the official agency for the measurement of business cycles. According to the NBER, a recession is “a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy.”

Using this definition, the NBER has identified nine complete business cycles during the period from 1945 to 1991. The average duration of these business cycles, measured from trough to previous trough—that is, from the end of one recession to the end of the previous recession—is 53 months. During these cycles the average contraction lasted 18 months, and the average expansion lasted 35 months. For the current business cycle an expansion began in March 1991 and ended in March 2001. This expansion covering 120 months was the longest in United States economic history. As of November 2002, the NBER had not declared an official end to the recession that began in March 2001.

Besides differing in length, business cycles differ considerably in degree, especially in the severity of contractions. The most significant contraction in American economic history occurred during the 1930s. This contraction was so severe that it became known as the Great Depression. The NBER marks August 1929 as the start of the Great Depression with an initial contraction that lasted for 43 months. During this downturn the unemployment rate rose from about 3 percent to 25 percent while the production of goods and services fell by 30 percent. A very modest recovery began in March 1933, but the economy experienced another contraction that began in 1937 and lasted for another 13 months. A true economic recovery did not begin until 1941.

Business Cycle

Business Cycle term used by economists to designate a periodic increase and decrease in an economy’s production and employment.


Ever since the Industrial Revolution of the 1800s, the overall level of production in industrialized capitalist countries has varied from high output and employment to low output and employment. Economists study business cycles because they have a significant impact on all aspects of an economy.

BUSINESS CYCLE CHARACTERISTICS

 

 

A business cycle has a period of expansion and a period of contraction. Although each business cycle has its own unique characteristics, all business cycles share certain similarities. For example, in the expansion phase, production increases while employment, wages, and business profits also rise. During the contraction phase of the business cycle, production, employment, wages, and business profits all fall. These phases sometimes go by different names. Expansions are referred to as recoveries, booms, upturns, periods of prosperity, and upswings. Contractions are variously called recessions, downturns, downswings, and liquidations. The word “depression” also applies to business cycle contractions but is normally reserved for the worst or most severe contractions.

All business cycles also have peaks and troughs, words that economists use for the turning points in a business cycle. A peak marks the end of an expansion and the beginning of a contraction, while a trough marks the end of a contraction and the beginning of an expansion.

In the typical business cycle expansion, business firms will exhibit optimism about the economic outlook. They will express this optimism by investing in facilities, thereby expanding their ability to produce goods and services. The firms will also hire more people to work in their stores, factories, and offices. Consumers will also be optimistic during an expansion. Their optimism leads them to increase their purchases, typically resorting to additional borrowing to finance the acquisition of more goods and services.

As the upswing continues, however, obstacles begin to develop that hinder further expansion. For example, production costs may increase, shortages of raw materials may develop, interest rates will start to rise, and prices will begin to increase, or, if already increasing, will start to rise more rapidly. Consumers react to higher prices and higher interest rates by buying less. As purchases begin to lag behind production, business firms begin to accumulate inventories (the merchandise or goods that a company or store has on hand). Producers begin to cut back on investment in facilities and reduce employment. Despite these adjustments, profits fall and further cutbacks are made. The economy now enters the contraction phase of the business cycle.

Several different factors can trigger a recovery from a contraction, including an increase in consumer demand, the depletion of inventories, or government action to stimulate the economy. Although generally slow and uneven at the start, the recovery soon gathers momentum. Production and employment begin to increase again, putting additional purchasing power into the hands of consumers. Investment expands in industries that make goods or machinery for sale to other businesses, rather than directly to consumers—industries that are known as capital goods industries. Optimism returns, old businesses expand, and new businesses are created. A new cycle has started.

Business cycles are important not just for their economic consequences but also for their broader social consequences. Several studies have shown that declines in economic activity coincide with declines in birth rates and increases in death and divorce rates. The higher unemployment rates caused by recessions are also associated with higher suicide rates and higher crime rates. See also Suicide; Crime.

CURRENT TRENDS

Business activities are becoming increasingly global as numerous firms expand their operations into overseas markets. Many U.S. firms, for example, attempt to tap emerging markets by pursuing business in China, India, Brazil, and Russia and other Eastern European countries. Multinational corporations (MNCs), which operate in more than one country at once, typically move operations to wherever they can find the least expensive labor pool able to do the work well. Production jobs requiring only basic or repetitive skills—such as sewing or etching computer chips—are usually the first to be moved abroad. MNCs can pay these workers a fraction of what they would have to pay in a domestic division, and often work them longer and harder. Most U.S. multinational businesses keep the majority of their upper-level management, marketing, finance, and human resources divisions within the United States. They employ some lower-level managers and a vast number of their production workers in offices, factories, and warehouses in developing countries. MNCs based in the United States have moved many of their production operations to countries in Central and South America, China, India, and nations of Southeast Asia.

In the United States, for example, America Online, Inc. (AOL) and Time Warner merged in 2000 to form AOL Time Warner, Inc., (present-day Time Warner Inc.) a massive corporation that brought together AOL’s Internet franchises, technology and infrastructure, and e-commerce capabilities with Time Warner’s vast array of media, entertainment, and news products.

With large mergers and the development of new free markets around the world, major corporations now wield more economic and political power than the governments under which they operate. In response, public pressure has increased for businesses to take on more social responsibility and operate according to higher levels of ethics. Firms in developed nations now promote—and are often required by law to observe—nondiscriminatory policies for the hiring, treatment, and pay of all employees. Some companies are also now more aware of the economic and social benefits of being active in local communities by sponsoring events and encouraging employees to serve on civic committees. Businesses will continue to adjust their operations according to the competing goals of earning profits and responding to public pressures for them to behave in ways that benefit society.

BUSINESS IN A FREE MARKET ECONOMY

The economy of the United States, as well as that of most developed nations, operates according to the principles of the free market. This differs from the economies of Socialist or Communist countries, where governments play a strong role in deciding what goods and services will be produced, how they will be distributed, and how much they will cost (see Socialism; Communism). Businesses in free-market economies benefit from certain fundamental rights or freedoms. All people in free-market societies have the right to own, use, buy, sell, or give away property, thus permitting them to own and operate their own businesses as private, profit-seeking enterprises. Business owners in free markets may choose to run their businesses however they like, within the limits of other, mostly non-business-oriented laws. This right gives businesses the authority to hire and fire employees, invest money, purchase machinery and equipment, and choose the markets where they want to operate. In doing so, however, they may not violate or infringe on the rights of other businesses and people. Free-market businesses also have the right to keep or reinvest their profits.

All free-market economies, however, keep the rights of businesses in check to some degree through laws and regulations that monitor business activities. Such laws vary from country to country, but they generally encourage competition by protecting small businesses and consumers from being hurt by more powerful, large enterprises. For example, in the United States the Sherman Antitrust Act, enacted in 1890, and the Clayton Antitrust Act of 1914 forbid business agreements that impede interstate and most international commerce. The Clayton Antitrust Act also protects against unfair business practices aimed at creating monopolies and guarantees the rights of labor to challenge management practices perceived as unfair. The U.S. Federal Trade Commission Act of 1914 prohibits businesses from attempting to control the prices of its products or services, among other provisions. Other laws prohibit mergers that decrease competition within an industry and require large merging companies to notify the Federal Trade Commission (FTC) for approval.

BUSINESS OPERATIONS

A variety of operations keep businesses, especially large corporations, running efficiently and effectively. Common business operation divisions include (1) production, (2) marketing, (3) finance, and (4) human resource management.

Production

Production includes those activities involved in conceptualizing, designing, and creating products and services. In recent years there have been dramatic changes in the way goods are produced. Today, computers help monitor, control, and even perform work.

Flexible, high-tech machines can do in minutes what it used to take people hours to accomplish. Another important development has been the trend toward just-in-time inventory. The word inventory refers to the amount of goods a business keeps available for wholesale or retail. In just-in-time inventory, the firm stocks only what it needs for the next day or two. Many businesses rely on fast, global computer communications to allow them to respond quickly to changes in consumer demand. Inventories are thus minimized and businesses can invest more in product research, development, and marketing.

Marketing

 

Marketing is the process of identifying the goods and services that consumers need and want and providing those goods and services at the right price, place, and time. Businesses develop marketing strategies by conducting research to determine what products and services potential customers think they would like to be able to purchase. Firms also promote their products and services through such techniques as advertising and personalized sales, which serve to inform potential customers and motivate them to purchase. Firms that market products for which there is always some demand, such as foods and household goods, often advertise if they face competition from other firms marketing similar products. Such products rarely need to be sold face-to-face. On the other hand, firms that market products and services that buyers will want to see, use, or better understand before buying, often rely on personalized sales. Expensive and durable goods—such as automobiles, electronics, or furniture—benefit from personalized sales, as do legal, financial, and accounting services.

Finance

 

Finance involves the management of money. All businesses must have enough capital on hand to pay their bills, and for-profit businesses seek extra capital to expand their operations. In some cases, they raise long-term capital by selling ownership in the company. Other common financial activities include granting, monitoring, and collecting on credit or loans and ensuring that customers pay bills on time. The financial division of any business must also establish a good working relationship with a bank. This is particularly important when a business wants to obtain a loan.

Human Resource Management 

 

Businesses rely on effective human resource management (HRM) to ensure that they hire and keep good employees, and that they are able to respond to conflicts between workers and management. HRM specialists initially determine the number and type of employees that a business will need over its first few years of operation. They are then responsible for recruiting new employees to replace those who leave and for filling newly created positions. A business’s HRM division also trains or arranges for the training of its staff to encourage worker productivity, efficiency, and satisfaction, and to promote the overall success of the business. Finally, human resource managers create workers’ compensation plans and benefit packages for employees.

FORMS OF BUSINESS OWNERSHIP

There are a number of different forms of business ownership. These include (1) sole proprietorships, (2) partnerships, (3) corporations, (4) joint ventures, and (5) syndicates.

Sole Proprietorship

The most common form of ownership is a sole 

proprietorship—that is, a business owned by one individual. At the beginning of the 21st century, there were more than 17 million sole proprietorships in the United States. These businesses have the advantage of being easy to set up and to dissolve because few laws exist to regulate them. Proprietors, as owners, also maintain direct control of their businesses and own all their profits. On the other hand, owners of proprietorships are personally responsible for all business debts and, because they are constrained by the limits of their personal financial resources, they may find it difficult to expand or increase their profits. For those reasons, sole proprietorships tend to be small, primarily service and retail businesses.

Partnership 

A partnership is an association of two or more people who operate a business as co-owners. There are different types of partners. A general partner is active in the operation of a business and is liable for all of its debts. In small businesses with only two or three owners, all typically will be general partners. A limited partner, by contrast, invests in a business but is not involved in its daily operations. Partnerships, like sole proprietorships, are relatively easy to establish. Furthermore, partners can pool financial resources to fund expansion and can divide their duties and responsibilities according to personal expertise and abilities. For example, one partner may be very good at selling, while another has a knack for maintaining good financial records. As with sole proprietorships, however, partnerships may entail substantial financial risks, as all of the general partners are liable for the debts of the business. And unlike proprietorships, disagreements among partners can harm partnership businesses.

Corporation

 

 A corporation is a legal entity that exists as distinct from the individuals who control and invest in it. As a result, a corporation can continue indefinitely through complete changes of ownership, leadership, and staffing. Current owners can sell their holdings to other individuals or, if they die, have their assets transferred to heirs. This is possible because a corporation creates shares of stock that are sold to investors. One strength of the corporate business structure is that stockholders have limited liability, as opposed to the unlimited liability of general partners, so they cannot lose more than their initial investment. Investors may also easily buy and sell stocks of public corporations through stock exchanges. By offering stock publicly, a corporation enables anyone with some money to buy the stock and become a part-owner of the company. As a result, corporations can more easily raise capital for business expansion than can sole proprietorships and most partnerships.

Investors control a corporation through the election of a managing body, known as a board of directors. In a large corporation, investors collectively decide who will oversee the operation of the enterprise. In turn, the board chooses a president, who decides on the key company personnel and helps formulate company strategy.

Many corporations are highly successful business organizations, with profits far exceeding those of many sole proprietorships and partnerships. However, they traditionally have higher tax burdens than other kinds of businesses. Also, the fees involved in creating and organizing a corporation can be expensive.

Joint Ventures and Syndicates

 

In joint ventures and syndicates, individuals or businesses cooperate to create a single product or service package. A joint venture is a partnership agreement in which two or more individual- or group-run businesses join together to carry out a single business project. For example, U.S.-based General Motors Corporation and Toyota Motor Corporation, based in Japan, have a joint venture called New United Motor Manufacturing, Inc., created for the purpose of producing cars in California.

A syndicate is an association of individuals or corporations formed to conduct a specific financial transaction such as buying a business. Quite often syndicates are created for the purpose of buying sports franchises. For example, the Miami Heat basketball team and the New York Yankees baseball team are each owned by syndicates of individuals. Each member of these syndicates is also involved in the operation of other businesses.

TYPES OF BUSINESSES

There are many types of businesses in a free-market economy. The three most common are (1) manufacturing firms, (2) merchandisers, and (3) service enterprises.

Manufacturing Firms

Manufacturing firms produce a wide range of products. Large manufacturers include producers of airplanes, cars, computers, and furniture. Many manufacturing firms construct only parts rather than complete, finished products. These suppliers are usually smaller manufacturing firms, which supply parts and components to larger firms. The larger firms then assemble final products for market to consumers.

For example, suppliers provide many of the components in personal computers, automobiles, and home appliances to large firms that create the finished or end products. These larger end-product manufacturers are often also responsible for marketing and distributing the products. The advantage that large businesses have in being able to efficiently and inexpensively control any parts of a production process is known as economies of scale. But small manufacturing firms may work best for producing certain types of finished products. Smaller end-product firms are common in the food industry and among artisan trades such as custom cabinetry.

Merchandisers

Merchandisers are businesses that help move goods through a channel of distribution—that is, the route goods take in reaching the consumer. Merchandisers may be involved in wholesaling or retailing, or sometimes both.

A wholesaler is a merchandiser who purchases goods and then sells them to buyers, typically retailers, for the purpose of resale. A retailer is a merchandiser who sells goods to consumers. A wholesaler often purchases products in large quantities and then sells smaller quantities of each product to retailers who are unable to either buy or stock large amounts of the product. Wholesalers operate somewhat like large, end-product manufacturing firms, benefiting from economies of scale. For example, a wholesaler might purchase 5,000 pairs of work gloves and then sell 100 pairs to 50 different retailers. Some large American discount chains, such as Kmart Corporation and Wal-Mart Stores, Inc., serve as their own wholesalers. These companies go directly to factories and other manufacturing outlets, buy in large amounts, and then warehouse and ship the goods to their stores.

The division between retailing and wholesaling is now being blurred by new technologies that allow retailing to become an economy of scale. Telephone and computer communications allow retailers to serve far greater numbers of customers in a given span of time than is possible in face-to-face interactions between a consumer and a retail salesperson. Computer networks such as the Internet, because they do not require any physical communication between salespeople and customers, allow a nearly unlimited capacity for sales interactions known as 24/7—that is, the Internet site can be open for a transaction 24 hours a day, seven days a week and for as many transactions as the network can handle. For example, a typical transaction to purchase a pair of shoes at a shoe store may take a half-hour from browsing, to fitting, to the transaction with a cashier. But a customer can purchase a pair of shoes through a computer interface with a retailer in a matter of seconds.

Computer technology also provides retailers with another economy of scale through the ability to sell goods without opening any physical stores, often referred to as electronic commerce or e-commerce. Retailers that provide goods entirely through Internet transactions do not incur the expense of building so-called brick-and-mortar stores or the expense of maintaining them.

 Service Enterprises

 Service enterprises include many kinds of businesses. Examples include dry cleaners, shoe repair stores, barbershops, restaurants, ski resorts, hospitals, and hotels. In many cases service enterprises are moderately small because they do not have mechanized services and limit service to only as many individuals as they can accommodate at one time. For example, a waiter may be able to provide good service to four tables at once, but with five or more tables, customer service will suffer.

In recent years the number of service enterprises in wealthier free-market economies has grown rapidly, and spending on services now accounts for a significant percentage of all spending. By the late 1990s, private services accounted for more than 21 percent of U.S. spending. Wealthier nations have developed postindustrial economies, where entertainment and recreation businesses have become more important than most raw material extraction such as the mining of mineral ores and some manufacturing industries in terms of creating jobs and stimulating economic growth. Many of these industries have moved to developing nations, especially with the rise of large multinational corporations. As postindustrial economies have accumulated wealth, they have come to support systems of leisure, in which people are willing to pay others to do things for them. In the United States, vast numbers of people work rigid schedules for long hours in indoor offices, stores, and factories. Many employers pay high enough wages so that employees can afford to balance their work schedules with purchased recreation. People in the United States, for example, support thriving travel, theme park, resort, and recreational sport businesses.

Business

Business organized approach to providing customers with the goods and services they want. The word business also refers to an organization that provides these goods and services. Most businesses seek to make a profit—that is, they aim to achieve revenues that exceed the costs of operating the business. Prominent examples of for-profit businesses include Mitsubishi Group, General Motors Corporation, and Royal Dutch/Shell Group. However, some businesses only seek to earn enough to cover their operating costs. Commonly called nonprofits, these organizations are primarily nongovernmental service providers. Examples of nonprofit businesses include such organizations as social service agencies, foundations, advocacy groups, and many hospitals.

Business plays a vital role in the life and culture of countries with industrial and postindustrial (service- and information-based) free-market economies such as the United States. In free-market systems, prices and wages are primarily determined by competition, not by governments. In the United States, for example, many people buy and sell goods and services as their primary occupations. In 2001 American companies sold in excess of $10 trillion worth of goods and services. Businesses provide just about anything consumers want or need, including basic necessities such as food and housing, luxuries such as whirlpool baths and wide-screen televisions, and even personal services such as caring for children and finding companionship.