How Does Our Economic System Work? How do we set Values for Services and Products?

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In every economic system, entrepreneurs and managers bring together natural resources, labor, and technology to produce and distribute goods and services. But the way these different elements are organized and used also reflects a nation’s political ideals and its culture.
     The United States is often described as a “capitalist” economy, a term coined by 19th-century German economist and social theorist Karl Marx to describe a system in which a small group of people who control large amounts of money, or capital, make the most important economic decisions. Marx contrasted capitalist economies to “socialist” ones, which vest more power in the political system. Marx and his followers believed that capitalist economies concentrate power in the hands of wealthy business people, who aim mainly to maximize profits; socialist economies, on the other hand, would be more likely to feature greater control by government, which tends to put political aims — a more equal distribution of society’s resources, for instance — ahead of profits.
     While those categories, though oversimplified, have elements of truth to them, they are far less relevant today. If the pure capitalism described by Marx ever existed, it has long since disappeared, as governments in the United States and many other countries have intervened in their economies to limit concentrations of power and address many of the social problems associated with unchecked private commercial interests. As a result, the American economy is perhaps better described as a “mixed” economy, with government playing an important role along with private enterprise.
     Although Americans often disagree about exactly where to draw the line between their beliefs in both free enterprise and government management, the mixed economy they have developed has been remarkably successful.

Basic Ingredients of the U.S. Economy
The first ingredient of a nation’s economic system is its natural resources. The United States is rich in mineral resources and fertile farm soil, and it is blessed with a moderate climate. It also has extensive coastlines on both the Atlantic and Pacific Oceans, as well as on the Gulf of Mexico. Rivers flow from far within the continent, and the Great Lakes — five large, inland lakes along the U.S. border with Canada — provide additional shipping access. These extensive waterways have helped shape the country’s economic growth over the years and helped bind America’s 50 individual states together in a single economic unit.
     The second ingredient is labor, which converts natural resources into goods. The number of available workers and, more importantly, their productivity help determine the health of an economy. Throughout its history, the United States has experienced steady growth in the labor force, and that, in turn, has helped fuel almost constant economic expansion. Until shortly after World War I, most workers were immigrants from Europe, their immediate descendants, or African-Americans whose ancestors were brought to the Americas as slaves. In the early years of the 20th century, large numbers of Asians immigrated to the United States, while many Latin American immigrants came in later years.
     Although the United States has experienced some periods of high unemployment and other times when labor was in short supply, immigrants tended to come when jobs were plentiful. Often willing to work for somewhat lower wages than acculturated workers, they generally prospered, earning far more than they would have in their native lands. The nation prospered as well, so that the economy grew fast enough to absorb even more newcomers.
     The quality of available labor — how hard people are willing to work and how skilled they are — is at least as important to a country’s economic success as the number of workers. In the early days of the United States, frontier life required hard work, and what is known as the Protestant work ethic reinforced that trait. A strong emphasis on education, including technical and vocational training, also contributed to America’s economic success, as did a willingness to experiment and to change.
     Labor mobility has likewise been important to the capacity of the American economy to adapt to changing conditions. When immigrants flooded labor markets on the East Coast, many workers moved inland, often to farmland waiting to be tilled. Similarly, economic opportunities in industrial, northern cities attracted black Americans from southern farms in the first half of the 20th century.
     Labor-force quality continues to be an important issue. Today, Americans consider “human capital” a key to success in numerous modern, high-technology industries. As a result, government leaders and business officials increasingly stress the importance of education and training to develop workers with the kind of nimble minds and adaptable skills needed in new industries such as computers and telecommunications.
     But natural resources and labor account for only part of an economic system. These resources must be organized and directed as efficiently as possible. In the American economy, managers, responding to signals from markets, perform this function. The traditional managerial structure in America is based on a top-down chain of command; authority flows from the chief executive in the boardroom, who makes sure that the entire business runs smoothly and efficiently, through various lower levels of management responsible for coordinating different parts of the enterprise, down to the foreman on the shop floor. Numerous tasks are divided among different divisions and workers. In early 20th-century America, this specialization, or division of labor, was said to reflect “scientific management” based on systematic analysis.
     Many enterprises continue to operate with this traditional structure, but others have taken changing views on management. Facing heightened global competition, American businesses are seeking more flexible organization structures, especially in high-technology industries that employ skilled workers and must develop, modify, and even customize products rapidly. Excessive hierarchy and division of labor increasingly are thought to inhibit creativity. As a result, many companies have “flattened” their organizational structures, reduced the number of managers, and delegated more authority to interdisciplinary teams of workers.
     Before managers or teams of workers can produce anything, of course, they must be organized into business ventures. In the United States, the corporation has proved to be an effective device for accumulating the funds needed to launch a new business or to expand an existing one. The corporation is a voluntary association of owners, known as stockholders, who form a business enterprise governed by a complex set of rules and customs.
     Corporations must have financial resources to acquire the resources they need to produce goods or services. They raise the necessary capital largely by selling stock (ownership shares in their assets) or bonds (long-term loans of money) to insurance companies, banks, pension funds, individuals, and other investors. Some institutions, especially banks, also lend money directly to corporations or other business enterprises. Federal and state governments have developed detailed rules and regulations to ensure the safety and soundness of this financial system and to foster the free flow of information so investors can make well-informed decisions.
     The gross domestic product measures the total output of goods and services in a given year. In the United States it has been growing steadily, rising from more than $3.4 trillion in 1983 to around $8.5 trillion by 1998. But while these figures help measure the economy’s health, they do not gauge every aspect of national well-being. GDP shows the market value of the goods and services an economy produces, but it does not weigh a nation’s quality of life. And some important variables — personal happiness and security, for instance, or a clean environment and good health — are entirely beyond its scope.

A Mixed Economy: The Role of the Market
The United States is said to have a mixed economy because privately owned businesses and government both play important roles. Indeed, some of the most enduring debates of American economic history focus on the relative roles of the public and private sectors.
     The American free enterprise system emphasizes private ownership. Private businesses produce most goods and services, and almost two-thirds of the nation’s total economic output goes to individuals for personal use (the remaining one-third is bought by government and business). The consumer role is so great, in fact, that the nation is sometimes characterized as having a “consumer economy.”
     This emphasis on private ownership arises, in part, from American beliefs about personal freedom. From the time the nation was created, Americans have feared excessive government power, and they have sought to limit government’s authority over individuals — including its role in the economic realm. In addition, Americans generally believe that an economy characterized by private ownership is likely to operate more efficiently than one with substantial government ownership.
     Why? When economic forces are unfettered, Americans believe, supply and demand determine the prices of goods and services. Prices, in turn, tell businesses what to produce; if people want more of a particular good than the economy is producing, the price of the good rises. That catches the attention of new or other companies that, sensing an opportunity to earn profits, start producing more of that good. On the other hand, if people want less of the good, prices fall and less competitive producers either go out of business or start producing different goods. Such a system is called a market economy. A socialist economy, in contrast, is characterized by more government ownership and central planning. Most Americans are convinced that socialist economies are inherently less efficient because government, which relies on tax revenues, is far less likely than private businesses to heed price signals or to feel the discipline imposed by market forces.
     There are limits to free enterprise, however. Americans have always believed that some services are better performed by public rather than private enterprise. For instance, in the United States, government is primarily responsible for the administration of justice, education (although there are many private schools and training centers), the road system, social statistical reporting, and national defense. In addition, government often is asked to intervene in the economy to correct situations in which the price system does not work. It regulates “natural monopolies,” for example, and it uses antitrust laws to control or break up other business combinations that become so powerful that they can surmount market forces. Government also addresses issues beyond the reach of market forces. It provides welfare and unemployment benefits to people who cannot support themselves, either because they encounter problems in their personal lives or lose their jobs as a result of economic upheaval; it pays much of the cost of medical care for the aged and those who live in poverty; it regulates private industry to limit air and water pollution; it provides low-cost loans to people who suffer losses as a result of natural disasters; and it has played the leading role in the exploration of space, which is too expensive for any private enterprise to handle.
     In this mixed economy, individuals can help guide the economy not only through the choices they make as consumers but through the votes they cast for officials who shape economic policy. In recent years, consumers have voiced concerns about product safety, environmental threats posed by certain industrial practices, and potential health risks citizens may face; government has responded by creating agencies to protect consumer interests and promote the general public welfare.
     The U.S. economy has changed in other ways as well. The population and the labor force have shifted dramatically away from farms to cities, from fields to factories, and, above all, to service industries. In today’s economy, the providers of personal and public services far outnumber producers of agricultural and manufactured goods. As the economy has grown more complex, statistics also reveal over the last century a sharp long-term trend away from self-employment toward working for others.

Government’s Role in the Economy
While consumers and producers make most decisions that mold the economy, government activities have a powerful effect on the U.S. economy in at least four areas.
     Stabilization and Growth. Perhaps most importantly, the federal government guides the overall pace of economic activity, attempting to maintain steady growth, high levels of employment, and price stability. By adjusting spending and tax rates (fiscal policy) or managing the money supply and controlling the use of credit (monetary policy), it can slow down or speed up the economy’s rate of growth — in the process, affecting the level of prices and employment.
     For many years following the Great Depression of the 1930s, recessions — periods of slow economic growth and high unemployment — were viewed as the greatest of economic threats. When the danger of recession appeared most serious, government sought to strengthen the economy by spending heavily itself or cutting taxes so that consumers would spend more, and by fostering rapid growth in the money supply, which also encouraged more spending. In the 1970s, major price increases, particularly for energy, created a strong fear of inflation — increases in the overall level of prices. As a result, government leaders came to concentrate more on controlling inflation than on combating recession by limiting spending, resisting tax cuts, and reining in growth in the money supply.
     Ideas about the best tools for stabilizing the economy changed substantially between the 1960s and the 1990s. In the 1960s, government had great faith in fiscal policy — manipulation of government revenues to influence the economy. Since spending and taxes are controlled by the president and the Congress, these elected officials played a leading role in directing the economy. A period of high inflation, high unemployment, and huge government deficits weakened confidence in fiscal policy as a tool for regulating the overall pace of economic activity. Instead, monetary policy — controlling the nation’s money supply through such devices as interest rates — assumed growing prominence. Monetary policy is directed by the nation’s central bank, known as the Federal Reserve Board, with considerable independence from the president and the Congress..
     Regulation and Control. The U.S. federal government regulates private enterprise in numerous ways. Regulation falls into two general categories. Economic regulation seeks, either directly or indirectly, to control prices. Traditionally, the government has sought to prevent monopolies such as electric utilities from raising prices beyond the level that would ensure them reasonable profits. At times, the government has extended economic control to other kinds of industries as well. In the years following the Great Depression, it devised a complex system to stabilize prices for agricultural goods, which tend to fluctuate wildly in response to rapidly changing supply and demand. A number of other industries — trucking and, later, airlines — successfully sought regulation themselves to limit what they considered harmful price-cutting.
     Another form of economic regulation, antitrust law, seeks to strengthen market forces so that direct regulation is unnecessary. The government — and, sometimes, private parties — have used antitrust law to prohibit practices or mergers that would unduly limit competition.
     Government also exercises control over private companies to achieve social goals, such as protecting the public’s health and safety or maintaining a clean and healthy environment. The U.S. Food and Drug Administration bans harmful drugs, for example; the Occupational Safety and Health Administration protects workers from hazards they may encounter in their jobs; and the Environmental Protection Agency seeks to control water and air pollution.
     American attitudes about regulation changed substantially during the final three decades of the 20th century. Beginning in the 1970s, policy-makers grew increasingly concerned that economic regulation protected inefficient companies at the expense of consumers in industries such as airlines and trucking. At the same time, technological changes spawned new competitors in some industries, such as telecommunications, that once were considered natural monopolies. Both developments led to a succession of laws easing regulation.
     While leaders of both political parties generally favored economic deregulation during the 1970s, 1980s, and 1990s, there was less agreement concerning regulations designed to achieve social goals. Social regulation had assumed growing importance in the years following the Depression and World War II, and again in the 1960s and 1970s. But during the presidency of Ronald Reagan in the 1980s, the government relaxed rules to protect workers, consumers, and the environment, arguing that regulation interfered with free enterprise, increased the costs of doing business, and thus contributed to inflation. Still, many Americans continued to voice concerns about specific events or trends, prompting the government to issue new regulations in some areas, including environmental protection.
     Some citizens, meanwhile, have turned to the courts when they feel their elected officials are not addressing certain issues quickly or strongly enough. For instance, in the 1990s, individuals, and eventually government itself, sued tobacco companies over the health risks of cigarette smoking. A large financial settlement provided states with long-term payments to cover medical costs to treat smoking-related illnesses.
     Direct Services. Each level of government provides many direct services. The federal government, for example, is responsible for national defense, backs research that often leads to the development of new products, conducts space exploration, and runs numerous programs designed to help workers develop workplace skills and find jobs. Government spending has a significant effect on local and regional economies — and even on the overall pace of economic activity.
     State governments, meanwhile, are responsible for the construction and maintenance of most highways. State, county, or city governments play the leading role in financing and operating public schools. Local governments are primarily responsible for police and fire protection. Government spending in each of these areas can also affect local and regional economies, although federal decisions generally have the greatest economic impact.
     Overall, federal, state, and local spending accounted for almost 18 percent of gross domestic product in 1997.
     Direct Assistance. Government also provides many kinds of help to businesses and individuals. It offers low-interest loans and technical assistance to small businesses, and it provides loans to help students attend college. Government-sponsored enterprises buy home mortgages from lenders and turn them into securities that can be bought and sold by investors, thereby encouraging home lending. Government also actively promotes exports and seeks to prevent foreign countries from maintaining trade barriers that restrict imports.
     Government supports individuals who cannot adequately care for themselves. Social Security, which is financed by a tax on employers and employees, accounts for the largest portion of Americans’ retirement income. The Medicare program pays for many of the medical costs of the elderly. The Medicaid program finances medical care for low-income families. In many states, government maintains institutions for the mentally ill or people with severe disabilities. The federal government provides Food Stamps to help poor families obtain food, and the federal and state governments jointly provide welfare grants to support low-income parents with children.
     Many of these programs, including Social Security, trace their roots to the “New Deal” programs of Franklin D. Roosevelt, who served as the U.S. president from 1933 to 1945. Key to Roosevelt’s reforms was a belief that poverty usually resulted from social and economic causes rather than from failed personal morals. This view repudiated a common notion whose roots lay in New England Puritanism that success was a sign of God’s favor and failure a sign of God’s displeasure. This was an important transformation in American social and economic thought. Even today, however, echoes of the older notions are still heard in debates around certain issues, especially welfare.
     Many other assistance programs for individuals and families, including Medicare and Medicaid, were begun in the 1960s during President Lyndon Johnson’s (1963-1969) “War on Poverty.” Although some of these programs encountered financial difficulties in the 1990s and various reforms were proposed, they continued to have strong support from both of the United States’ major political parties. Critics argued, however, that providing welfare to unemployed but healthy individuals actually created dependency rather than solving problems. Welfare reform legislation enacted in 1996 under President Bill Clinton (1993-2001) requires people to work as a condition of receiving benefits and imposes limits on how long individuals may receive payments.

Poverty and Inequality
Americans are proud of their economic system, believing it provides opportunities for all citizens to have good lives. Their faith is clouded, however, by the fact that poverty persists in many parts of the country. Government anti-poverty efforts have made some progress but have not eradicated the problem. Similarly, periods of strong economic growth, which bring more jobs and higher wages, have helped reduce poverty but have not eliminated it entirely.
     The federal government defines a minimum amount of income necessary for basic maintenance of a family of four. This amount may fluctuate depending on the cost of living and the location of the family. In 1998, a family of four with an annual income below $16,530 was classified as living in poverty.
     The percentage of people living below the poverty level dropped from 22.4 percent in 1959 to 11.4 percent in 1978. But since then, it has fluctuated in a fairly narrow range. In 1998, it stood at 12.7 percent.
     What is more, the overall figures mask much more severe pockets of poverty. In 1998, more than one-quarter of all African-Americans (26.1 percent) lived in poverty; though distressingly high, that figure did represent an improvement from 1979, when 31 percent of blacks were officially classified as poor, and it was the lowest poverty rate for this group since 1959. Families headed by single mothers are particularly susceptible to poverty. Partly as a result of this phenomenon, almost one in five children (18.9 percent) was poor in 1997. The poverty rate was 36.7 percent among African-American children and 34.4 percent among Hispanic children.
     Some analysts have suggested that the official poverty figures overstate the real extent of poverty because they measure only cash income and exclude certain government assistance programs such as Food Stamps, health care, and public housing. Others point out, however, that these programs rarely cover all of a family’s food or health care needs and that there is a shortage of public housing. Some argue that even families whose incomes are above the official poverty level sometimes go hungry, skimping on food to pay for such things as housing, medical care, and clothing. Still others point out that people at the poverty level sometimes receive cash income from casual work and in the “underground” sector of the economy, which is never recorded in official statistics.
     In any event, it is clear that the American economic system does not apportion its rewards equally. In 1997, the wealthiest one-fifth of American families accounted for 47.2 percent of the nation’s income, according to the Economic Policy Institute, a Washington-based research organization. In contrast, the poorest one-fifth earned just 4.2 percent of the nation’s income, and the poorest 40 percent accounted for only 14 percent of income.
     Despite the generally prosperous American economy as a whole, concerns about inequality continued during the 1980s and 1990s. Increasing global competition threatened workers in many traditional manufacturing industries, and their wages stagnated. At the same time, the federal government edged away from tax policies that sought to favor lower-income families at the expense of wealthier ones, and it also cut spending on a number of domestic social programs intended to help the disadvantaged. Meanwhile, wealthier families reaped most of the gains from the booming stock market.
     In the late 1990s, there were some signs these patterns were reversing, as wage gains accelerated — especially among poorer workers. But at the end of the decade, it was still too early to determine whether this trend would continue.

The Growth of Government
The U.S. government grew substantially beginning with President Franklin Roosevelt’s administration. In an attempt to end the unemployment and misery of the Great Depression, Roosevelt’s New Deal created many new federal programs and expanded many existing ones. The rise of the United States as the world’s major military power during and after World War II also fueled government growth. The growth of urban and suburban areas in the postwar period made expanded public services more feasible. Greater educational expectations led to significant government investment in schools and colleges. An enormous national push for scientific and technological advances spawned new agencies and substantial public investment in fields ranging from space exploration to health care in the 1960s. And the growing dependence of many Americans on medical and retirement programs that had not existed at the dawn of the 20th century swelled federal spending further.
     While many Americans think that the federal government in Washington has ballooned out of hand, employment figures indicate that this has not been the case. There has been significant growth in government employment, but most of this has been at the state and local levels. From 1960 to 1990, the number of state and local government employees increased from 6.4 million to 15.2 million, while the number of civilian federal employees rose only slightly, from 2.4 million to 3 million. Cutbacks at the federal level saw the federal labor force drop to 2.7 million by 1998, but employment by state and local governments more than offset that decline, reaching almost 16 million in 1998. (The number of Americans in the military declined from almost 3.6 million in 1968, when the United States was embroiled in the war in Vietnam, to 1.4 million in 1998.)
     The rising costs of taxes to pay for expanded government services, as well as the general American distaste for “big government” and increasingly powerful public employee unions, led many policy-makers in the 1970s, 1980s, and 1990s to question whether government is the most efficient provider of needed services. A new word — “privatization” — was coined and quickly gained acceptance worldwide to describe the practice of turning certain government functions over to the private sector.
     In the United States, privatization has occurred primarily at the municipal and regional levels. Major U.S. cities such as New York, Los Angeles, Philadelphia, Dallas, and Phoenix began to employ private companies or nonprofit organizations to perform a wide variety of activities previously performed by the municipalities themselves, ranging from streetlight repair to solid-waste disposal and from data processing to management of prisons. Some federal agencies, meanwhile, sought to operate more like private enterprises; the United States Postal Service, for instance, largely supports itself from its own revenues rather than relying on general tax dollars.
     Privatization of public services remains controversial, however. While advocates insist that it reduces costs and increases productivity, others argue the opposite, noting that private contractors need to make a profit and asserting that they are not necessarily being more productive. Public sector unions, not surprisingly, adamantly oppose most privatization proposals. They contend that private contractors in some cases have submitted very low bids in order to win contracts, but later raised prices substantially. Advocates counter that privatization can be effective if it introduces competition. Sometimes the spur of threatened privatization may even encourage local government workers to become more efficient.
     As debates over regulation, government spending, and welfare reform all demonstrate, the proper role of government in the nation’s economy remains a hot topic for debate more than 200 years after the United States became an independent nation.

The United States is the world’s third-largest economy, behind China and the European Union. The United States has a mixed economy. That means it operates as a free market economy in consumer goods and business services and as a command economy in defense, retirement programs, some aspects of medical care, and other areas. The U.S. Constitution created and now protects America’s mixed economy.

Measuring the U.S. Economy

The best way to estimate the size of the U.S. economy is with gross domestic product, or GDP. GDP measures everything produced in the United States, regardless of whether it was made by U.S. citizens and companies or by foreigners.

Note

Gross domestic product is different from gross national income, which is everything produced by U.S. citizens and companies, no matter where they are located in the world.

Components of GDP

There are four components of GDP.

Components of Real GDP (2019)
COMPONENT	PERCENTAGE OF U.S. GDP
Consumer spending	70%
Government spending	17%
Business investment	16%
Net exports	-5%
TOTAL GDP	100%

Consumer spending comprises approximately 70% of the total GDP. It includes the subcomponents of goods and services. Goods can be either durable goods, like automobiles, or nondurable goods, which are immediately consumed and used up, like gasoline. Services consist of things like banking, child care, and health care. In 2019, services made up 45% of the economy, while goods made up 25%.

Government spending is the second-largest component, driving approximately 18% of GDP. This includes national defense spending, Social Security benefits, and health care. It also includes state and municipal budgets.

Business investment makes up approximately 16% of GDP. It includes such elements as manufacturing, real estate construction, and intellectual property.

Net exports make up the fourth component. It is the sum of exports, which add to the nation’s economy, and imports, which subtract from it. The United States has a trade deficit, which means it imports more than it exports. This is why the U.S. net exports figure has a negative value.³⁴

Note

Exports are goods leaving the country, which the United States sells to or in other countries. Imports are goods coming in, which the United States buys from other countries.

Measuring GDP

There are three critical measurements of GDP.

Nominal gross domestic product: Nominal GDP is the primary measure. It describes how much would be produced for the year if the economy kept going at a constant rate.
Real gross domestic product: Real GDP does the same but removes the effects of inflation. Economists use it to compare GDP over time.
Gross domestic product growth rate: GDP growth rate uses real GDP to calculate growth as compared to the previous quarter or the previous year. This number is often described as a positive or negative percentage.

Note

Some productive activities are not included in GDP, such as the care parents provide for their children and work done by volunteers.

Forces That Affect the U.S. Economy

Three forces affect the economy: supply and demand, the business cycle, and inflation. These are measures of how consumers interact with their money and the economy. You can learn how to predict the next recession by understanding how these forces interact with each other and affect consumer behavior.

Supply and Demand

Demand is how much consumers want a good or service. Supply is how much of that good or service is available. The interaction between supply and demand affects prices, wages, and the amount of product available.

The law of supply and demand says that supply will rise or fall to meet levels of demand over time. If consumers want more of something, businesses will make more of it until supply meets demand and demand decreases. This process is cyclical.

The Supply and Demand Cycle

Demand for a product increases higher than the supply of that product.
Prices rise.
Higher prices drive up the wages of workers who can make that product.
High demand makes that product more profitable for businesses to produce.
More businesses begin producing it.
As more workers are available to make the same type of product, wages stabilize.
Supply increases to meet demand.
As supply rises, consumers buy all they need.
Demand decreases below the level of supply.
Consumers are willing to pay less, and the product becomes less profitable.
Wages for workers making that product fall.
Businesses begin to make less and focus on the next high-demand product.
Supply decreases to meet demand.

Supply is limited by the four factors of production: labor, entrepreneurship, capital, and natural resources. Demand is limited by the consumer’s willingness to pay the price of a product or service.

The Business Cycle

The economy is constantly changing, and its rise and fall depend on the business cycle. The cycle has four phases.

Expansion: This is when the economy grows. If it grows at a healthy rate of 2% to 3%, the economy can remain in the expansion phase for years.
Peak: The economy is in a phase of irrational growth. This creates an asset bubble and is unsustainable in the long term.
Contraction: The GDP growth rate turns negative. This causes a recession, along with increases in unemployment. When the economy contracts for years, it’s called a depression.
Trough: This is a recession at its lowest point. The economy then enters a new expansion phase and the cycle begins again.

Inflation and Deflation

Inflation can happen either in the short term, due to consumer behavior, or in the long term.

Short-term inflation happens when demand is greater than supply and prices go up. It generally occurs in the peak phase of the business cycle.

Once inflation occurs, people begin to expect ever-higher prices. Consumers buy now before prices go up more in the future. This increases demand and causes higher prices.

Long-term inflation generally happens because of an increase in the money supply over time.

Note

Deflation is the opposite of inflation. It occurs when prices fall, creating crashes in the stock or housing markets, as well as other financial crises. It takes place during the contraction phase of the business cycle.

Government Influences on the Economy

In a mixed economy like the United States, the government has a few tools it can use to influence the economy.

Fiscal Policy

Fiscal policy is how the government adjusts its own spending and tax rates to influence or manage economic forces.

Congress, with the influence of the president, sets the federal budget. The highest portion of federal spending goes toward Social Security benefits, military spending, and Medicare. Fiscal policy can also influence entire industries through its priorities, such as whether it focuses on renewable energy or fossil fuels.

Revenue for the federal budget comes from taxes and money that the federal government borrows. But spending is limited. When it outpaces revenue, it creates a budget deficit.

Note

Each year’s deficit gets added to the debt. The deficit is funded by the sale of Treasury securities, which the government is then required to pay back with interest. The U.S. debt is more than its entire economic output.

Trade Policy

Another government tool is trade policy. By regulating trade with other countries, the government affects the cost of imports and exports. The cost of imports affects the prices of goods and services that are imported and sold in the United States, while the cost of exports affects the revenue and wages of U.S. businesses.

Note

Trade agreements, like NAFTA, seek to reduce trade costs and increase the GDP of the United States. Between 1993 and 2015, the United States tripled exports to Mexico and Canada thanks to NAFTA.

Monetary Policy

The Federal Reserve System, the nation’s central bank, was created by Congress. Also called the Fed, the Federal Reserve System uses monetary policy to control inflation and stimulate the economy. It is also charged with the smooth functioning of the banking system. There are two types of monetary policy.

Expansionary monetary policy speeds up growth and lowers unemployment. It does that when it lowers interest rates or adds credit to banks to lend, which increases the U.S. money supply.
Contractionary monetary policy fights inflation and slows growth. To do this, the Fed raises interest rates or removes credit from banks’ balance sheets. This decreases the money supply.

Note

The Fed has three other functions:

It supervises and regulates many of the nation’s banks.
It maintains financial market stability and works to prevent financial crises.
It provides banking services to other banks, the U.S. government, and foreign banks.

The Federal Reserve has several monetary policy tools that it uses to affect the economy:

Interest rates: The most well-known tool is the Fed funds rate, which the Federal Open Market Committee adjusts to change interest rates.
Open market operations: The Fed also adjusts the money banks have available to lend by buying or selling securities to its member banks. Selling securities causes interest rates to rise, while buying them causes interest rates to fall.
Money supply: Adjusting the money supply allows the Fed to manage inflation and influence the unemployment rate.

Business Influences on the Economy

There is another major influencer that is not part of the government: financial markets on Wall Street. The behavior of traders, investors, and managers in financial markets affect the broader economy.

Trades through foreign exchange markets change the value of the U.S. dollar and foreign currencies, which affects the price of imports and exports. Hedge funds and hedge fund managers seek higher returns by trading in risky commodities and futures contracts, many of which are minimally regulated. The commodities market is where food, metals, and oil are traded.

Commodities traders change the price of these things you buy every day.

Bubbles and collapses in the financial, stock, and housing markets can affect the overall economy, causing recessions and depressions.

Understanding the Current Economy

Once you understand how the U.S. economy works, you can use certain indicators to understand both how the economy is currently doing and what might happen in the near future.

How the Economy Is Doing

These five benchmarks indicate how the economy is doing. They are closely watched by economic analysts, Wall Street, and the government.

U.S. GDP measures the state of the economy every quarter. The Bureau of Economic Analysis updates it monthly.
GDP per capita tells you how much each member of the U.S. population benefits from economic output. It is released once a year.
The current jobs report tells you how many jobs were added (or lost) each month. It will also reveal which industries are hiring. It’s updated monthly by the Bureau of Labor Statistics.
The unemployment rate is a lagging indicator. This means it follows the trends. That’s because employers wait until the economy is strong before hiring. They also wait until a recession is underway before laying off workers. The federal government and the Federal Reserve aim to keep the unemployment rate close to 4%. The Bureau of Labor Statistics reports unemployment numbers.
Both the U.S. government and the Federal Reserve measure inflation, or how much consumers have to pay for goods and services. They often have slightly different numbers for this benchmark, because the federal government uses the consumer price index, while the Federal Reserve uses the core Personal Consumption Expenditures (PCE) reading.

Note

The consumer price index sometimes gives misleading information. Because the commodities market determines oil, gas, and food prices, these numbers can sometimes plummet and skyrocket within months. The core inflation rate excludes energy and food costs to avoid these spikes.

Predicting What the Economy Will Do

Understanding these leading economic indicators can help you predict likely changes in the U.S. economy.

The durable goods orders report tells you how many orders were received by manufacturers. When orders are high, GDP will increase in the future.

Note

A critical measurement within durable goods is capital goods, or the machinery and equipment businesses need every day. Business owners only order these expensive items when they are sure the economy is getting better.

Building permits indicate whether there will be new home construction in the near future.
Manufacturing jobs tell you manufacturers’ confidence level. When factory orders rise, companies need more workers right away. That happens long before the goods show up in GDP. Similarly, when manufacturers hire fewer workers, it means a recession could be on its way. Data on manufacturing jobs is available from the Bureau of Labor Statistics.

Note

A rise in manufacturing also benefits other industries, including transportation, retail, and administration.

The stock market often predicts what the economy will do in the next six months. That’s because stock traders must research economic trends and business performance to make the most profitable trades possible.
Interest rates are how the Fed influences growth. Low interest rates create more liquidity for businesses and consumers. Cheap loans spur demand. Rising interest shrinks the money supply, making loans more expensive and weakening demand.

Use these benchmarks to make informed judgments about how the economy is currently doing and what might happen next. Understanding these signs of growth and contraction will help you manage your money and protect your financial future.

The size of a nation’s overall economy is typically measured by its gross domestic product, or GDP, which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting up the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total dollar value.

The numbers are large, but the task is straightforward:

Step 1: Take the quantity of everything produced.

Step 2: Multiply it by the price at which each product sold.

Step 3: Add up the total.

In 2014, the GDP of the United States totaled $17.4 trillion, the largest GDP in the world.

It’s important to remember that each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured by the total dollar value of what is purchased in the economy or by the total dollar value of what is produced.

Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

GDP measured by components of demand

$17.4 trillion is a lot of money! Who buys all of this production? Let’s break it down by dividing demand into four main parts:

Consumer spending, or consumption
Business spending, or investment
Government spending on goods and services
Spending on net exports

[What does investment mean exactly?]

The table below shows how the four above components added up to the GDP for the United States in 2014. It’s also important to think about how much of the GDP is made up of each of these components. You can analyze the percentages using either the table or the pie graph below it.

	Components of GDP on the demand side in trillions of dollars	Percentage of total
Consumption	$11.9	68.4%
Investment	$2.9	16.7%
Government	$3.2	18.4%
Exports	$2.3	13.2%
Imports	–$2.9	–16.7%
Total GDP	$17.4	100%

Source: http://bea.gov/iTable/index_nipa.cfm

This pie chart shows the percentage of components of US GDP on the demand side as follows: consumption is 68.4%; investment is 16.7%; government is 18.4%; exports are 13.2%; and imports are −16.7%.

Image credit: Figure 1 in “Measuring the Size of the Economy: Gross Domestic Product” by OpenStaxCollege, CC BY 4.0

This image includes two line graphs: Graph A and Graph B. Graph A shows the demand from consumption, investment, and government from the year 1960 to 2014. In 1960, the graph starts out at 61.0% for consumption. It remains fairly steady around 60% until 1993, when it is at 65%. By 2014, it is at 68.5%.

In 1960, the graph starts out at 22.3% for government. It remains steady around 20%, and by 2014, it is at 18.2%.

In 1960, the graph starts out at 15.9% for investment. It rises gradually to 20.3% in 1978, then generally goes down to 16.4% in 2014.

Graph B shows imports and exports from the year 1960 to 2014. In 1960, the graph starts out at 4.2% for imports. It rises fairly steadily with only a few drops, such as from 14.3% in 2000 to 13.1% in 2001. By 2014 it is at 16.5%.

In 1960, the graph starts out at 5.0% for exports. It remains steadily around 5% until 1973, when it jumps to 6.7%. By 2014, the exports line is at 13.4%.

Image credit: Figure 2 in “Measuring the Size of the Economy: Gross Domestic Product” by OpenStaxCollege, CC BY 4.0

A few patterns are worth noticing here. Consumption expenditure by households was the largest component of the US GDP 2014. In fact, consumption accounts for about two-thirds of the GDP in any given year. This tells us that consumers’ spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant—when viewed over time, it doesn’t jump around too much.

Investment demand accounts for a far smaller percentage of US GDP than consumption demand does, typically only about 15 to 18%. Investment can mean a lot of things, but here, investment expenditure refers to purchases of physical plants and equipment, primarily by businesses. For example, if Starbucks builds a new store or Amazon buys robots, these expenditures are counted under business investment.

Investment demand is very important for the economy because it is where jobs are created, but it fluctuates more noticeably than consumption. Business investment is volatile. New technology or a new product can spur business investment, but then confidence can drop, and business investment can pull back sharply.

If you’ve noticed any infrastructure projects—like road construction—in your community or state, you’ve seen how important government spending can be for the economy. Government expenditure accounts for about 20% of the GDP of the United States, including spending by federal, state, and local government.

It’s important to remember that a significant portion of government budgets are transfer payments—like unemployment benefits, veteran’s benefits, and Social Security payments to retirees—that are excluded from GDP because the government does not receive a new good or service in return or exchange. The only part of government spending counted in demand is government purchases of goods or services produced in the economy—for example, a new fighter jet purchased for the Air Force (federal government spending), construction of a new highway (state government spending), or building of a new school (local government spending).

And finally, we must consider exports and imports when thinking about the demand for domestically produced goods in a global economy. First, we calculate spending on exports—domestically produced goods that are sold abroad. Then, we subtract spending on imports—goods produced in other countries that are purchased by residents of this country.

The net export component of GDP is equal to the dollar value of exports, XXstart text, X, end text, minus the dollar value of imports MMstart text, M, end text. The gap between exports and imports is called the trade balance. If a country’s exports are larger than its imports, then a country is said to have a trade surplus. If, however, imports exceed exports, the country is said to have a trade deficit .

If exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another.

Based on the four components of demand discussed above—consumption, CCstart text, C, end text, investment, IIstart text, I, end text, government, GGstart text, G, end text, and trade balance, TTstart text, T, end text —GDP can be measured as follows:

GDP=C + I + G + (X – M)GDP=C + I + G + (X – M)start text, G, D, P, end text, equals, start text, C, space, plus, space, I, space, plus, space, G, space, plus, space, left parenthesis, X, space, negative, space, M, right parenthesis, end text

GDP measured by what is produced

Everything that is purchased must be produced first. Instead of trying to think about every single product produced, let’s break out five categories: durable goods, nondurable goods, services, structures, and change in inventories. You can see what percentage of the GDP each of these components contributes in the table and pie chart below.

Before we look at these categories in more detail, take a look at the table below and notice that total GDP measured according to what is produced is exactly the same as the GDP we measured by looking at the five components of demand above.

Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced.

	Components of GDP on the supply side in trillions of dollars	Percentage of total
Goods
Durable goods	$2.9	16.7%
Nondurable goods	$2.3	13.2%
Services	$10.8	62.1%
Structures	$1.3	7.4%
Change in inventories	$0.1	0.6%
Total GDP	$17.4	100%

Source: http://bea.gov/iTable/index_nipa.cfm

The pie chart shows that services account for almost half of US GDP measured by what is produced, followed by durable goods, nondurable goods, structures, and change in inventories.

Image credit: Figure 3 in “Measuring the Size of the Economy: Gross Domestic Product” by OpenStaxCollege, CC BY 4.0

The graph shows that since 1960, structures have mostly remained around 10% but dipped to 7.7% in 2014. Durable goods have mostly remained around 20% but dipped in 2014 to 16.8%. The graph also shows that services have steadily increased from less than 30% in 1960 to over 61.9% in 2014. In contrast, nondurable goods have steadily decreased from roughly 40% in 1960 to around 13.7% in 2014.

Image credit: Figure 4 in “Measuring the Size of the Economy: Gross Domestic Product” by OpenStaxCollege, CC BY 4.0

Let’s take a look at the graph above showing the five components of what is produced, expressed as a percentage of GDP, since 1960. In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods—like cars and computers. By far the largest part of GDP, however, is services. Additionally, services have been a growing share of GDP over time.

You are probably already familiar with some of the leading service industries, like healthcare, education, legal services, and financial services. It has been decades since most of the US economy involved making solid objects. Instead, the most common jobs in the modern US economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.

Even if we look only at the goods category, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing.

The category of structures includes everything from homes to office buildings, shopping malls, and factories.

Inventories is a small category that refers to the goods that have been produced by one business but have not yet been sold to consumers and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected or to rise if business is worse than expected.

The Problem of Double Counting

GDP is defined as the current value of all final goods and services produced in a nation in a year. But what are final goods? They are goods at the furthest stage of production at the end of a year.

Statisticians who calculate GDP must avoid the mistake of double counting—counting output more than once as it travels through the stages of production. For example, imagine what would happen if government statisticians first counted the value of tires produced by a tire manufacturer and then counted the value of a new truck sold by an automaker that contains those tires. The value of the tires would have been counted twice because the price of the truck includes the value of the tires!

To avoid this problem—which would overstate the size of the economy considerably—government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations. This means that in the example above, only the value of the truck would be counted. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.

What is counted in GDP	What is not included in GDP
Consumption	Intermediate goods
Business investment	Transfer payments and non-market activities
Government spending on goods and services	Used goods
Net exports	Illegal goods

Take a look at the table above showing which items get counted toward GDP and which don’t. The sales of used goods are not included because they were produced in a previous year and are part of that year’s GDP.

The entire underground economy of services paid “under the table” and illegal sales should be counted—but is not—because it is impossible to track these sales. In a recent study by Friedrich Schneider of shadow economies, the underground economy in the United States was estimated to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone.

Transfer payments, such as payment by the government to individuals, are not included, because they do not represent production. Also, production of some goods—such as home production as when you make your breakfast—is not counted because these goods are not sold in the marketplace.

[Want to learn more about how GDP is calculated?]

Summary

The size of a nation’s economy is commonly expressed as its gross domestic product, or GDP, which measures the value of the output of all goods and services produced within the country in a year.
GDP is measured by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total.
GDP can be measured either by the sum of what is purchased in the economy or by what is produced.
Demand can be divided into consumption, investment, government, exports, and imports. What is produced in the economy can be divided into durable goods, nondurable goods, services, structures, and inventories.
To avoid double counting—adding the value of output to the GDP more than once—GDP counts only final output of goods and services, not the production of intermediate goods or the value of labor in the chain of production.
The gap between exports and imports is called the trade balance. If a nation’s imports exceed its exports, the nation is said to have a trade deficit. If a nation’s exports exceed its imports, it is said to have a trade surplus.

Self-check questions

Country A has export sales of $20 billion, government purchases of $1,000 billion, business investment is $50 billion, imports are $40 billion, and consumption spending is $2,000 billion. What is the dollar value of GDP?

[Show solution.]

Which of the following are included in GDP, and which are not?

The cost of hospital stays
The rise in life expectancy over time
Child care provided by a licensed day care center
Child care provided by a grandmother
The sale of a used car
The sale of a new car
The greater variety of cheese available in supermarkets
The iron that goes into the steel that goes into a refrigerator bought by a consumer

[Show solution.]

Review questions

What are the main components of measuring GDP with what is demanded?
What are the main components of measuring GDP with what is produced?
Would you usually expect GDP as measured by what is demanded to be greater than GDP measured by what is supplied, or the reverse?
Why must double counting be avoided when measuring GDP?

Problem

Last year, a small nation with abundant forests cut down $200 worth of trees. $100 worth of trees were then turned into $150 worth of lumber. $100 worth of that lumber was used to produce $250 worth of bookshelves. Assuming the country produces no other outputs, and there are no other inputs used in the production of trees, lumber, and bookshelves, what is this nation’s GDP?

In other words, what is the value of the final goods produced including trees, lumber and bookshelves?

What two economic factors determine the value of something?

Principle of Supply and Demand

Buyers and sellers tend to set the price or value of a good based on the supply of a good and the demand for that good. If the supply of a good is stable, and demand for that good increases, sellers of that good tend to increase the price.

The value of real property can be influenced by many factors, such as location and type of use; however, when appraisers make/render an opinion of market value, they must also take into consideration how typical buyers and sellers are responding in the market. Appraisers emulate what informed buyers and sellers will do in an open market. Therefore, we begin this lesson by first reviewing some of the basic concepts of real estate economics that affect how typically informed buyers and sellers respond in an open market, and then reviewing some concepts and principles applicable to the income approach.

Based on observation and analysis of real estate markets, appraisers have developed principles to describe how real estate markets operate. These underlying appraisal principles are important in understanding the foundation of the income approach to value and the actions of typical buyers and sellers in the real property market. Although these principles are individually listed, many of the principles are interrelated or affect the other in determining real property value. This lesson discusses the following:

Concept of Highest and Best Use
Principle of Anticipation
Principle of Substitution
Principle of Supply and Demand
Principle of Change
Principle of Conformity
Principle of Contribution
Principle of Increasing and Decreasing Returns
Principle of Balance

Concept of Highest and Best Use

The concept of highest and best use requires that each property be appraised as though it were being put to its most profitable use (highest possible present net worth), given probable legal, physical, and financial constraints. This entails identifying the most appropriate market and the most profitable use within that market.

The highest and best use of a property is the reasonable and probable use that will support the highest present value as of the effective date of the appraisal. The use must be:

Legally permissible:The highest and best use must be a use that is allowed by government. The property tax appraiser must consider the effect that any enforceable government restrictions, such as zoning regulations, have on the value of property.* However, an improved parcel with land uses that are not permitted under current regulations may have been constructed prior to current regulations. These improvements are recognized as legally (grandfathered) nonconforming uses.* “Unrestricted” ownership of property is actually subject to the necessary powers and rights of government – local real estate taxation, the power of eminent domain (condemnation, at a fair price), police power (such as building codes, health requirements, traffic regulation, and zoning), title by escheat, and control of air space (at a reasonable height).
Physically possible:The highest and best use depends on physical factors. The proposed or existing use must fit the size, shape, topography, and other specific characteristics associated with the parcel or location. For example, a use that requires a larger site than the subject property, or needs utilities that are not available to the subject property, should be eliminated from consideration.
Financially feasible:The highest and best use must not be too speculative. There must be a demand for the use in the market that will generate and sustain sufficient income to cover the costs of construction, to have enough money for maintenance during the economic life of the property, and to provide both a return of and a return on the investment. This can include costs to maintain or improve the remaining economic life. All uses that produce a positive return are regarded as financially feasible.
Maximally productive:The highest and best use must be the most productive use. Of all the financially feasible uses, the one that produces the highest residual land value (yields the highest net return to the investor) is the highest and best use. For example, if it is physically possible, legally permissible, and financially feasible to construct an apartment complex, an office building, and a restaurant on a particular parcel, but the office building would yield the highest value to the real property, then the office building is considered the maximally productive use.

In general, the proposed use that an appraiser determines would yield the highest and best use from a particular real property must pass all four criteria, or the proposed use (either the current use or an alternate use) cannot be considered the highest and best use of the real property. There are exceptions to this general rule. For example, if a parcel is currently improved with a dry cleaner, but zoning would allow an office building that could yield a higher value, the costs associated with cleaning up the property (remediating the property from any potential contaminates) would be cost prohibitive or cost so much as to leave the current or existing use as the highest and best use.

Unless otherwise stipulated in the scope of work, when appraising an improved property, an appraiser will consider the highest and best use as it is improved and the highest and best use as if were vacant. Highest and Best Use as Improved addresses how an already improved property should be utilized. Highest and Best Use as if Vacant considers, among all reasonable, alternative uses, the use that yields the highest present land value. Any existing improvements can be torn down. In fact, demolition is economically appropriate when the market value of the land as if vacant exceeds the market value of the land as if improved.

A consequence of the concept of highest and best use is the Principle of Consistent Use – that, for an improved property, both the site and improvements must be evaluated as the same use. This principle is violated when the appraiser seeks to assign a value to the land based on one highest and best use, and a value to the improvements based on a different highest and best use. It is permissible, however, to consider time adjusted highest and best uses where neighborhoods are transitioning from one use to another, usually “higher”, use, recognizing the interim and ultimate highest and best uses.

Principle of Anticipation of Future Benefits

Property is valuable because of the future benefits it is expected (anticipated) to provide. A property’s value may be defined as the present worth of the rights to all prospective future benefits, tangible and intangible, accruing to the ownership of real property. Therefore, investors buy income-producing properties today for the future benefits, or income, that is anticipated they will produce in the future.

One of the responsibilities of an appraiser is to interpret attitudes of persons trading in the real estate market. Thus, an appraiser is obligated to consider both the likelihood of future trends and the impact that such trends will have on buyers, sellers, and tenants, as expressed in present market transactions. For example, changes in anticipated demand caused by off-site improvements in the form of highways, freeways, bridges, schools, and parkways have an important impact on value even though such improvements may be in the planning stage and not visible at the time of the appraisal. Because the present value of real estate depends on expected future benefits, the principle of anticipation requires the appraiser to be fully informed of community affairs and economic changes anticipated in the market area in which the subject property is located.

It is the future, and not the past, with which an appraiser must be concerned. The history of operation of the subject, or like properties in a market area, is important only in ascertaining a trend in anticipated earnings over the remaining economic life or holding period of the property being appraised. Past operations and other than typical management practices may hinder or, in the case of accumulated goodwill, accelerate (at least for a time) income production. Such assets or liabilities of a property must be considered in the measure of present value. For property tax purposes, we are required to measure the full value of the property; that includes good management, maintenance, and typical interaction with the market place.

Principle of Substitution

The principle of substitution states that the upper limit of value tends to be set by the cost of acquiring an equally desirable substitute, assuming no untimely delays. A prudent investor would pay no more for an income-producing property than it would cost to build or purchase a similar property. Likewise, a prudent lessee would not pay more rent than they would pay to rent an equally desirable property.

When several commodities or services with substantially the same utility or benefit are available, the one with the lowest price attracts the greatest demand and widest distribution. In the income approach, value tends to be set by the cost necessary to purchase a property offering an equally desirable income stream. This theory provides the basis for using comparable properties in the income approach to value.

From The Appraisal of Real Estate, the prices, rents, and rates of return of a property tend to be set by the prevailing prices, rents, and rates of return for equally desirable substitute properties. The principle of substitution is found in each of the three approaches (income, comparative sales, and cost) to value.

All properties, no matter how diverse their physical attributes or how varied in geographic location, are substitutable economically in terms of service utility or in income productivity, provided such can be fashioned without undue (costly) delay. When there is a significant delay in acquiring the substitute, the cost of the delay must be taken into consideration; a significant delay, in effect, raises the cost. The principle of substitution is closely related to the economic concept of opportunity cost, which holds that the true cost of an economic choice is measured by the opportunity foregone because of the choice.

Principle of Supply and Demand

Interaction between the supply of goods and the demand for goods establishes both the price and the quantity of goods demanded. Demand, the amount of a good or service that would be purchased at various prices during a given period, is created by a product’s utility and the ability and willingness of people to buy it. Buyers and sellers tend to set the price or value of a good based on the supply of a good and the demand for that good. If the supply of a good is stable, and demand for that good increases, sellers of that good tend to increase the price. Supply in the real estate market takes a long time to create; therefore, if the demand for real estate increases, the price of the real estate will also increase, because the supply of real estate will be slow to adjust.

Principle of Changes in Socioeconomic Patterns

Nothing is static; change is constantly occurring. The principle of change recognizes the dynamic nature of real estate markets. In real estate, change affects not only individual properties, but also neighborhoods, communities, and regions. The effects of prospective change are reflected in the market. Change is fundamentally the law of cause and effect. Individual properties, districts, neighborhoods and entire communities often follow a four phase life span:

Growth: a period during which the area gains in public favor or acceptance.
Stability: a period of equilibrium without significant gains or losses.
Decline: a period of diminishing demand and acceptance.
Renewal: a period of rejuvenation and rebirth of market demand.

The principle of change is closely related to the principle of anticipation. Past income experiences may indicate a certain trend, and present income flow may substantiate this trend; nevertheless, the anticipated future income expectancy may radically differ because of important changes in national, regional, and local business activity of which the real estate market is a part.

Principle of Conformity

The principle of conformity states that maximum value is realized when a reasonable degree of architectural homogeneity exists and land uses are compatible. This principle implies reasonable similarity, not monotonous uniformity, tends to create and maintain value. The highest and best land use is generally realized under circumstances of conformity or harmony. The principal purpose of zoning regulations and private deed restrictions is to maintain conformity.

Principle of Contribution, AKA Principle of Marginal Productivity

The principle of contribution, also known as the principle of marginal productivity, applies the principle of increasing and decreasing returns to property components. This principle holds that the value of a property component is measured in terms of its contribution to the value of the total property rather than as a separate component. Note that the cost of an item does not necessarily equal its contributory value. For instance, it may cost $30,000 to build a pool in a 20 unit apartment complex; however, it may only add $20,000 to the overall value of the complex.

Principle of Increasing and Decreasing Returns

The principle of increasing and decreasing returns recognizes that increments of the agents of production produce greater net income (increasing returns) up to a point (surplus productivity). The point of maximum contribution of the agents in production (point of decreasing returns) attests to the proper combination of agents, resulting in the highest and best use. Any further increase in the amount of the agents of production will decrease the margin between the cost of agents and the gross income they will produce, resulting in a decrease in the proportionate net income returns.

Increasing and decreasing returns applies to the maximum size apartment building that should be placed on a parcel of land. Adding stories to an apartment building may result in property value exceeding costs until the point is reached that the structures must be framed with steel on top of foundation piles driven down to the bedrock. At this point, the added cost, over wood framing on top of a concrete podium, may not result in added value commensurate with the cost – this would be the point of decreasing returns.

A decreasing, or diminishing, return is the proportional decrease in the amount of return as a single element of production is increased, all other factors remaining constant. This Law of Decreasing Returns is also known as the Law of Variable Proportions.

Principle of Balance in Land Use and Development

The principle of balance is closely related to the principle of increasing and decreasing returns; it holds that maximum value is achieved and maintained when all elements in the agents of production are in economic balance. The value of a property depends on the balance of:

Land
Labor
Capital
Entrepreneurship

Land includes the ground, the airspace, and the natural resources found on the surface or in the sub-surface of the earth. Labor includes human work directed toward production—that is, all wages and other operating expenses involving human work. Capital is composed of goods (e.g., equipment and buildings) and intangible assets and rights (e.g., working capital and franchises) used in the production process. Unlike other factors of production, capital must be produced before it can be utilized in the production process. Human capital is the productive power of individuals developed through education and training. Entrepreneurship is the act of visualizing needs and taking the necessary action and risk to produce products that fulfill such needs. In real estate development, entrepreneurship is synonymous with the development function.

Elements both internal and external to a property must be in balance for maximum value to be attained. Internally, the proper combination of land and building is critical to economic balance. Externally, a property should be in balance with surrounding properties. For example, an expensive home built on a low-value lot in a modest neighborhood may not sell for its full cost of production.

Resources

usa.usembassy.de, ” How the U.S. Economy Works.”; thebalancemoney.com, “How Does the U.S. Economy Work?” By Kimberly Amadeo;

Measuring the U.S. Economy

Note

Components of GDP

Note

Measuring GDP

Note

Forces That Affect the U.S. Economy

Supply and Demand

The Supply and Demand Cycle

The Business Cycle

Inflation and Deflation

Note

Government Influences on the Economy

Fiscal Policy

Note

Trade Policy

Note

Monetary Policy

Note

Business Influences on the Economy

Understanding the Current Economy

How the Economy Is Doing

Note

Predicting What the Economy Will Do

Note

Note

GDP measured by components of demand

GDP measured by what is produced

The Problem of Double Counting

Summary

Self-check questions

Review questions

Problem

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