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Our Economy: Capitalism at Work

The Law of Supply and Demand: the Free Market Economy

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Our Economy: Capitalism at Work
The economy of the United States is based on a political and economic system that is known as capitalism. This means that the means of production of goods and services in our country, and of their distribution and sale is privately owned (there is no setting of government quotas or price regulation, for instance).

The marketplace works on the premise of the law of supply and demand (which is the basis for our "free enterprise" system). This means that when an item is in limited supply, and the demand is great, then prices can be higher; but if an item is overproduced, and /or demand is low, then the price is driven down until supplies are sold.

Our banking system is based on the idea of capital (money) invested: a person "lends" money, or invests it, in a bank or lending institution, and the bank in return pays "interest" for the privilege of using this money. The government also has a hand in regulating interest rates, since the prime interest rate is set by the Federal Reserve.

Private companies may also decide to sell stocks and bonds in their company; the national stock market is a place where trading of stocks is done. If a company is doing well and making a profit, its stock will be in higher demand, and the price will go up (but the reverse can also occur). Often companies which produce a product that people want, that is effectively marketed and distributed, will do well in our economic system which encourages private ownership of goods and services.

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Capitalism Defined

Capitalism has been defined as an economic system in which private or corporate ownership of goods and services occurs. This includes factories to produce the goods, and the marketing and distribution of these goods and services, which is in contrast to socialism, in which the government runs the planning, production and distribution of goods. In capitalism, a person can make a personal profit by investing capital (money or goods) and labor into a company.

Most economies, including that of the United States, are actually a mixture of the two philosophies, but in our country the concept of capitalism is based on the concept of a free market. In a capitalistic economy, there is competition between rival producers or suppliers of goods and services. This is in contrast with socialism, which encourages cooperation instead of competition. In a capitalistic economy, the corporation that can provide good services at a highly competitive price that buyers like will often do well and be able to generate a large number of sales, which is balanced by the seller's need to make a profit. The limits to the economic development of a company under capitalism are limited to the profits gained in a free market.

Capitalism has also been defined as a social/political system based on the principle of individual rights, including property rights, that allow the economic system to flourish. It is based on the principles of free competition, which is the freedom to produce and to trade what a person has produced, for one's self -interest (versus the good of the government or people, as socialism proposes).

The Law of Supply and Demand: the Free Market Economy

Jean Baptist Say has been credited with conceiving this term with his famous phrase "Supply creates demand" (in a free market economy). Supply refers to how much of an item (or service) is available to be purchased, while demand refers to the number of people willing to buy that good or service. If a product is overproduced, then the demand cannot meet the supply and the price is cut until supplies can be sold; while if a product is in short supply but there is a high demand, then prices can be raised. When prices are low, and the demand is low, it is considered a "buyer's market" or favorable for the buyer; and when prices are high and the demand for a product is high, it is considered a "sellers market".

The free market system is also known as free enterprise, and is an economy in which businesses are governed by the law of supply and demand, and are not restrained by government interference, regulation, or subsidy. Proponents of pure capitalism argue that the government should not intervene in the economy, and that the free market should determine prices and demand for goods. The reality is that at times government regulation and safeguards are necessary in the area of commerce to prevent abuses, and our own economic system is a compromise. Also, although our economy is considered capitalistic, at times the federal government has played a significant role in the economy, such as during the Great Depression when policies were formulated at the national level in the form of government subsidies, tax credits and incentives.

The government has also become involved in the economy with antitrust laws which were created to prevent the formation of huge monopolies (which take away competition, the basis of capitalism).

Under the free enterprise system, before producing goods, a company will often have to create a market analysis (look at competitors, see what the demand is, and whether there is a niche that can be filled). This becomes the basis of a business plan, which includes capital outlays (how much money the company needs to start production), the expected debits (expenses), and how much capital the company is starting with.

The goal of any business is to maximize profits, which is the amount of money left over after the cost of producing the item and marketing and distributing it, while having a price low enough to be competitive. The price of the final product may also be determined by factors such as the technology needed to produce it (if the technology changes and more can be produced at a cheaper rate, then the price can be lowered). But if another company comes up with a technology that outdates the item that your company produced, then the demand for an item will go down and the price will drop. Prices may also be determined by whether there are taxes or subsidies for production of the item.

Other determinates of price include the number of items to be produced (the more items that are produced, the higher the production costs, and the greater the number of items which must be sold to cover this cost, or else the price must rise to cover costs). One challenge for producers of goods is to determine how much of an item to produce without creating too many (overproduction).

Investments and Interest

There are several types of investments that people can make to earn a return (interest payment) on their investment.

One type is investing in the government (certificates of debt or bonds). Basically this means lending money to the government for a specified period of time, and then earning interest (money paid for the privilege of borrowing the money) on the loan.

Another form of investment is buying stocks. When a company decides to open up a share in itself, it must first form a corporation. This corporation then can begin to sell shares in the company (stock) to individuals who are willing to invest in the company by buying shares of its stocks (shareholders), This means that the shareholder owns a small piece of the company equal to the value of the stock that he or she has bought (if a company issued 1000 shares of stock as its total, and one investor buys 100 of these shares, then the investor would own 10% interest in that company, for example). The corporation that sells the stock is required by law to have a board of directors, who are usually the major stockholders in the company or people elected by them to represent them in directing the company. The company stock is also known as a security, which gives the owner legal rights to money or other property. Other types of securities include bonds, notes, and mortgages.

These shares of stock are bought, sold, and traded at one of several stock exchanges in our country. The New York Stock Exchange is the largest and best known one. Normally stock brokers place orders and sell shares of stock to individuals, or help them sell their shares of stock. The stockholder will also share in any profits that the company he or she has invested in makes (this is called a dividend). But if the company does poorly, and the stock price drops, the investor can suffer a loss. Stock prices can drop if the company is not doing well and a lot of its investors try to sell their stock at one time. Bad publicity can also drive stock prices down. But if a company is making a profit, usually people are eager to invest in it, and the stock prices go up.

Sometimes, instead of investing in individual companies, a group of people invest together through the brokerage of an investment company in several different companies. This is known as a mutual fund : the investors put their money (capital) into the mutual fund, and the company invests the money for them.

Another method of investing money is a bond, which is a certificate of debt issued by the government or a corporation that states that it guarantees payment of the loan plus interest at a specified future date. This is one way the national government raises money, in addition to the federal income tax, to fund its programs and enterprises.

Our Banking System

Banks are institutions that are normally chartered organizations through a state or federal government that deal with money and credit. Money is defined as currency (paper issued by the federal government) and coins that are used as a medium to exchange for goods and services instead of direct trading or bartering of items). Historically, in its earlier years the currency of our nation was backed by either gold or silver and then at the beginning of the century, by gold (the "gold standard" for currency). But in more recent years, the currency is no longer backed by gold, and the value of our money stands alone on its own merit. Inflation occurs when the federal money begins producing more currency while at the same time not raising the value of goods and services.

Basically, commercial banks make most of their money by taking the money that people deposit and invest it in investments which return a high rate of interest. These deposits can be in the form of a checking account, savings account, certificate of deposit, or a money market account. The bank then pays the original depositor a lower rate of interest, and reinvests the profit that is left over. This is how most commercial banks generate their income. Commercial banks also make loans to people, and charges interest (extra money paid for the privilege of borrowing this money). And commercial banks often make even more money by charging customers service charges on their accounts and ATM transactions.

A commercial bank can only make a loan if it has sufficient money in its reserves. It has to keep some money held back in case a lot of customers choose to clear out their accounts at one time. Some banks are covered by a special federal program under the Federal Reserve system, to cover any losses that occur.

Another type of bank is a mutual savings bank which can make loans based on the capital (money) deposited by investors. There are also institutions that perform banking functions, including savings and loans organizations, credit unions, and mortgage companies. Mortgage companies offer loans to people who borrow money to pay for their home or real estate. The home or real estate becomes collateral (capital or goods offered as a guarantee that the loan will be paid) and if the borrower defaults on the loan (or doesn't pay), then the mortgage company will assume ownership of the home or property. Many banks and savings and loans institutions also offer mortgage loans.

The interest rates that banks charge for making loans or mortgages are often tied to the prime lending rate which is set by the Federal Reserve and can fluctuate up and down. Most banks add a certain percentage above the prime rate when calculating the interest rate it charges, or pays out to customers. Lower interest rates tend to encourage economic growth (since it is less expensive to borrow money for new growth), while high interest rates have the reverse effect. The Federal reserve's job is to monitor the economy, and to ensure that inflation is not excessive (2.8% annually is considered the highest safe inflation figure for economic growth). If inflation increases more than this, the Federal Reserve will step in and attempt to tighten the money supply by asking banks to raise their interest rates and drive inflation back down.

Banks also often offer money market accounts, which will offer a higher rate of return (interest rate) for the investor than savings accounts. But there are often minimum balances required and early withdrawal penalties in these accounts. Certificates of deposit offer even higher interest rates to the investor, but there are high penalties if a person tries to withdraw them early (these are often a longer-term investment).

An in-depth look at the American banking system is found in our Coming to the USA: Banking in the USA section.

Making it Practical: an Example of the Free Market in Action

Did Microsoft Create a Monopoly?

For the past few years, when a consumer bought a new computer and installed Microsoft® Windows® into their computer, the new operating system already came prepared with an integrated web browser: Internet Explorer. Browsers allow a person to view web pages, and many of the consumers, new to computers, simply clicked on the large blue "e" on their desktop to access the Internet. What most of them did not realize is that Internet Explorer was only one of several browsers available to them. Or that until Windows integrated this browser software (known as "middleware") into its system, that the number-one selling browser on the market was Netscape.

Microsoft developers created Internet Explorer specifically to integrate well with Windows, and as Windows grew in popularity, Netscape saw its market share drop dramatically from nearly 100% in 1995 (it created the first popular browser software and had no competition then) to less than 10% of the market by 1999.

Netscape filed suit with others in court, claiming that Microsoft had set out to create a monopoly in the marketplace for the browser Internet Explorer (along with other middleware, including its email client, its media player, and its instant messaging software). They claimed that anyone who wanted to install Windows on their PC virtually was forced to use the products that Microsoft chose to integrate with Windows, excluding others and eliminating competition in the marketplace.

They contended that this violated antitrust laws, designed to prevent the creation of a monopoly.

The question in court was also raised whether Microsoft itself was a monopoly, discouraging competitors in the PC software marketplace, since over 90% of PCs today use Windows as its operating system. Microsoft argued that no one is forcing people to buy Microsoft or to use the browsers or software included, and so buyers are actually buying what they want to use. They claim that there was no intent to create a monopoly with their browser or other products.

A lawsuit was filed in May, 1998 in the U.S. District Court in the District of Columbia to resolve this very issue of whether Microsoft was breaking antitrust laws (laws created to prevent the formation of a monopoly which would corner the lion's share of a market and eliminate competition). Manufacturers of competing software claimed that Microsoft created its browser and other middleware specifically to integrate with Windows products, allowing only its products to integrate smoothly with Windows. And that Microsoft refused to share the interface technology with competitors.

Microsoft in turn argued that it did not prevent Netscape or other software developers from competing in an open marketplace when it integrated Internet Explorer with its Windows operating system. It also argued that Internet Explorer was not a "separate product" but was actually part of the Windows operating system, because the two products were created specifically to integrate with each other (versus "stand alone" middleware products).

This lawsuit was ruled on by the Court of Appeals in June 2001, when the courts judged that Microsoft had maintained a virtual monopoly on its highly popular operating systems. It decided that Microsoft had prohibited computer manufacturers from supporting competing software products, and had violated US antitrust laws and deliberately intended to dominate the Internet browser market with Internet Explorer.
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