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IN THIS ISSUE . . .
Capital Needs Projections: A Need for Per
spective
. . . Current concern over the threat of a
capital shortage is based on fallible human
predictions and value judgments. The
author takes a close look at these and related
issues.
Profit in a Free Economy
. . . Though small in percentage terms, corpo
rate profits are an effective incentive to eco
nomic growth. Society's task is to gain from
the beneficial uses of the profit mechanism
and to discourage the harmful ones.
On our cover: These portraits depict four men who managed the nation's financial affairs during
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George Clymer (1739-1813), upper left. Merchant, member of the Pennsylvania Assembly,
signer of the Declaration of Independence, and first president of the Philadelphia Bank. Portrait
by Charles Wilson Peale (1741-1827), courtesy of the Pennsylvania Academy of the Fine Arts.
Aaron Levy (1742-1815), lower right. Wealthy merchant and creditor to the Continental
Congress. Portrait by Robert Edge Paine (ca. 1730-1788), courtesy of the Historical Society of
Pennsylvania.
Robert Morris (1734-1806), upper right. Signer of the Declaration of Independence, Superin
tendent of Finance to the Continental Congress, and founder of the Bank of North America.
Portrait by Charles Wilson Peale, courtesy of Independence National Historical Park, Philadel
phia.
Haym Salomon (1740-1785), lower left. Financier who placed his private fortune at the disposal
of the Continental Congress. Anonymous portrait, ca. 1900, authenticated by the Haym Salomon
Foundation, courtesy of the Ford Times, Ford Motor Company.
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FEDERAL RESERVE BANK OF PHILADELPHIA
Capital Needs
Projections:
A Need for
Perspective
By James M. O'Brien
The epitome of a capitalistic state and we
can't even meet our capital requirements.
That's what many are saying. As a result of this
concern, a rash of studies forecasting U. S.
capital “ needs" over the next five to ten years
has caught the eye of the financial press as
well as high-level policymakers. While most
studies conclude our capital “ needs" can be
met, they suggest it's going to be a tight
squeeze. Expanding demands for factories
and machines could outstrip the supply of
investable funds. Some fear that such a result
would curb our rising standard of living.
Consequently Uncle Sam is being urged to
reduce his own borrowing and to enact poli
cies encouraging private citizens to save
more.
In judging the merits of these policy recom
mendations, some perspective on the capital
needs projections is essential. For example,
how reliable are the forecasts of capital
demands and supplies likely to be? An even
deeper question is whether encouraging cap
ital growth will really increase society's well
being. Indeed, a closer look at both issues
suggests that the need for government sup
port of capital accumulation is less obvious
than many have indicated.
PROJECTING CAPITAL NEEDS AND SUPPLIES
In most studies, future capital needs are
simply what the forecasters predict will be the
investment plans of households, businesses
and government over the next five to ten
years.1 Generally, the predictions have been
1The following description of capital needs studies is
based on a representative sample of recent reports on
capital adequacy and includes: Barry Bosworth, James S.
Duesenberry, Andrew S. Caron, Capital Needs in the
Seventies (Washington: The Brookings Institution, 1975);
Benjamin M. Friedman, “ Financing the Next Five Years of
Fixed Investment,” Discussion Paper Number 389 (Cam
bridge: FJarvard Institute of Economic Research,
November 1974); Allen Sinai and Roger E. Brinner, “ The
Capital Shortage: Near-Term Outlook and Long-Term
Prospects,” Economic Studies Number 18 (Cambridge,
Mass.: Data Resources, Inc., 1975); “ Capital Require
ments of Business, 1974-85” (New York: General Electric,
March 8, 1974); Robert Dennis, “ Clambering in the
3
MAY/JUNE 1976
BUSINESS REVIEW
(See Table 1 for nonresidential investment
projections.)
Capital outlay plans of households, mainly
expenditures for new homes, are not
expected to show the same strength as busi
ness spending.3 Despite continued support
from Uncle Sam, little growth and possibly
even some decline is predicted for housing
construction (as a share of GNP) over the next
decade (see Table 1). The main factor shaping
this picture is a predicted fall-off in the rate of
family formation. A second factor sometimes
cited is the increased popularity of lower-cost
apartments and mobile homes.
When projected capital demands of busi
nesses are added to those of households, we
get the total picture of private investment
demands for the next decade. The prognosis
generally appears to be for a sizeable (but not
extreme) increase in our capital "needs" for
the future (see Table 1). But will our savings be
sufficient to meet these capital demands?
The Uncertain Savings Picture. In the opin
ions of the capital needs forecasters, the
savings outlook is more clouded than the
future investment picture. Perhaps because
there is only a little to go on, the average
forecast for business savings tends to hover
pretty close to past trends. But there appears
to be a general concern that households may
be less inclined to save as much as in the past.
Various reasons are offered to explain this
darker picture for household savings. One is
the combination of a progressive Federal
income tax and rising incomes. As incomes go
up (partly because of inflation), our gradu
ated income-tax structure means that Uncle
Sam will be taking an increasingly larger tax
bite. Hence, families will have relatively less
income to save. Another factor cited by some
who see less growth in savings is the shift in
population mix toward young families. Since
they tend to save a smaller share of their
earnings than do middle-aged families, total
that "special considerations" will enlarge our
future investment demands (as a share of
GNP) relative to actual investment in the past.
If the supply of savings doesn't measure up to
these growing demands, interest rates will be
bid up as borrowers scramble for available
funds. Investors will then be forced to scale
back their spending intentions and actual
investment will fall short of initial plans. The
consequent capital "scarcity" will slow eco
nomic growth, making it difficult to maintain
our current standard of living.
Expanding Investment Demands. On bal
ance, capital-needs forecasters expect that
business firms and households will plan to
spend a growing share of GNP as investment
over the next five to ten years.2For businesses,
several considerations are expected to add
the extra thrust to planned investment expen
ditures. First, some industries will be trying to
"make up for lost time" in enlarging their
capacity. Primary material industries, for
example, are projected to need substantial
increases in plant and equipment after small
additions to capacity in recent years. Second,
businesses (as well as state and local govern
ments) are expected to be spending more to
meet pollution control requirements. How
ever, the fastest rising item on the investment
agenda is forecasted to be in the area of
energy—oil, gas, electricity, and nuclear
power. If energy supply is to keep pace with a
projected near doubling of demand over the
next decade, capital expenditures in the
energy industry may have to double their
(real) growth over that of the past ten years.
Eighties/’ Report Number 74-N-1 (Washington: National
Planning Association, 1974); “ The Capital Needs and
Savings Potential of the U. S. Economy: Projections
through 1985” (New York Stock Exchange, September
1974).
2Federal plus state and local government investment
projections will be implicit in the projections of (net)
government saving presented below. This procedure of
reporting projections only for the difference between
total receipts and expenditures of government is usually
followed in capital needs studies and for convenience is
used here.
Expenditures on consumer durables, such as autos,
are included in consumption expenditures. Hence, this
item figures into determining households’ savings.
4
FEDERAL RESERVE BANK OF PHILADELPHIA
TABLE 1
PROJECTIONS OF CAPITAL NEEDS AND SUPPLIES3
(As percent of GNP)
N a t io n a l
D a ta
H is t o r ic a l0
1 9 6 5 -7 4
A. Gross Private
Domestic
Investment
Nonresidential
Inventory
Residential
B. Total
Savings
Business
Personal
Government
Federal
State & Local
Other b
N e w Y o rk
P la n n in g
S to c k
A sso c.
Exchange
1 9 7 4 -8 5
1 9 7 4 -8 5
R e so u rce s
B e n ja m in
G e n e ra l
B r o o k in g s
In c .
F r ie d m a n
E le c t r ic
19 80
1 9 7 7 -8 5
19 77-81
1 9 7 4 -8 5
15.3
10.6
0.7
4.0
15.8
11.5
0.8
3.5
16.3
12.0
0.3
4.0
16.4
12.3
0.7
3.5
16.4
15.3
11.0
5.4
- 0.8
- 1.0
0.3
0.2
15.8
10.8
4.9
- 0.1
15.4
16.4
11.2
14.3
10.6
4.0
- 0.3
- 0.2
- 0.1
—
15.1
10.4
1.0
3.7
15.6
15.1
10.8
5.0
- 0.5
- 0.8
0.3
- 0.2
15.6
10.2
11.3
0.8
3.5
4.9
0.3
0.6
- 0.3
0.2
C. Capital Gap
—
- 0.1
0.2
11.2
4.4
- 0.3
N.A.
N.A.
0.1
0.9
d
4.8
0.1
0.1
—
0.3
—
12.1
0.3
4.0
2.1
a For full references see footnote 1 in text of article. Details in table may not sum to totals due
to rounding errors.
Statistical discrepancy less net foreign investment.
cSource: Economic Report of the President, February 1975, Appendix C. These historical averages of
private investment and savings (as a proportion of GNP) are slightly less than those calculated from Appendix
B of the Economic Report of the President, February 1976, which contains the revised series of national
income and product accounts. The old series is used here because they served as a basis on which the
(pre-1976) capital needs projections were made.
dln a more recent forecast ("Economic Prospects, 1975-85/’ March 14, 1975), General Electric predicts
that private investment will average only 14.4 percent of GNP between 1975 and 1985 and there will be no
capital gap (using benchmark periods between 1975 and 1985). This forecast appears to represent a predicted
realization of a capital "scarcity” in that high ex ante investment demands must be scaled down because of
"inadequate” finance. See discussion of Major Assumptions, p. 5.
5
MAY/JUNE 1976
BUSINESS REVIEW
cutting back the tax rate on capital gains. With
these tax inducements, businesses and house
holds will supposedly have an incentive to
save more. However, the wisdom of these
policy suggestions depends, in part, on the
importance we attach to the capital needs
forecasts.
personal savings may slow. Still others specu
late that recent years of high inflation could
adversely affect families' traditional savings
habits.
This savings outlook for businesses and
households indicates that total private savings
could be somewhat sluggish in the years
ahead relative to historical trends (see Table
1). Contrasting this savings picture with that of
rising investment demand has suggested to
capital needs forecasters an important role
for the Federal Government if a shortfall is to
be avoided.
Help from Uncle Sam? Most forecasters
visualize a continued growth in (real) Federal
expenditures—particularly for national de
fense, income security programs and Fed
eral pay raises.4 But with tax revenues also
projected to shoot up, and with judicious
management of expenses, Uncle Sam sup
posedly can come much closer to keeping his
budget in balance than in the past. Reflecting
this optimism, a significant drop in the Federal
deficit is seen by a number of forecasters for
the years ahead (see Table 1). Relatively less
Federal borrowing will leave more saving for
private investment, or so this argument goes.
With a greater restraint in Federal spending
and deficits, most forecasters feel that our
capital "needs" can be met (see Table 1). But
to help ensure that an adequate amount of
capital will be forthcoming, Uncle Sam is
further being urged to provide extra incen
tives to savers. These additional policy recom
mendations include establishing a larger and
more permanent investment tax credit,
reducing the corporate income tax rate, and
A NEEDED PERSPECTIVE
"NEEDS” FORECASTS
CAPITAL
Capital needs forecasts make an important
point: you can't have your cake and eat it too.
They emphasize that resources are scarce: the
more society wishes to consume today, the
less will be left over for investment. The
greater the amount of capital devoted to
cleaning up our environment, the less there
may be for more autos or more homes. In
setting our social priorities, it is thus impor
tant to consider what the capital (and other)
costs are likely to be.
However, as a basis for policy action, the
current studies and projections are deficient
in three important ways. First, measures that
might be appropriate for boosting capital
growth over the long haul may have a per
verse impact on an economy coming out of its
worst recession since the 1930s. Second, long
term forecasts of capital demands and sup
plies are subject to potentially large errors.
This could make them poor guides for policy
makers. And third, the studies offer little evi
dence on the critical issue of whether society
really benefits by encouraging capital growth.
The Policy Problem in a Time of Recession.
Currently more than 7 percent of our labor
force is out of work and our factories have
been operating with historically large
amounts of excess capacity. Some financial
writers have suggested that the slow pace of
investment and low economic growth
brought on by the recession make our capital
position even more precarious than was ear
lier anticipated. Their reasoning: we now
have further to go to get where we want to be.
But it should also be recognized that during a
recession our capital "needs" are smaller and
our capital stock is depleted more slowly than
4At the state and local government level, forecasters
generally see reduced capital expenditures in the impor
tant areas of highways and public education and
increased investment in pollution control and public
transportation. On current account, state and local
budgets are expected to remain in surplus. When pro
jected debt financing is added to this surplus, a relatively
small overall deficit is generally being projected. See, for
example, Barry Bosworth et al.. Capital Needs in the
Seventies, pp. 40-42, and the New York Stock Exchange,
“ Capital Needs and Savings Potential,” p. 11.
ON
6
FEDERAL RESERVE BANK OF PHILADELPHIA
when the economy is going at full steam.
Taking this view, it might be that we don't
have to go as far as previously thought.
More important, the problem of recession
can be one of too much rather than too little
savings. As spending slowed during the latter
part of 1974, production tapered off and
unemployment rose. The result was a snow
balling effect with spending slowing even
further and more jobs being lost. Currently,
an important problem facing policymakers is
getting people back to work and existing
plants and machines back into full gear. What
this calls for is a healthy spending pace by
consumers and government, as well as inves
tors. An increase in spending provides pro
ducers with an incentive to boost output and
pursue more optimistic investment plans.
Thus, during periods of high unemployment,
increased spending by consumers and Uncle
Sam may very well help to increase, not
reduce, private investment.
So whatever might be the merits of the
capital scarcity thesis over the long haul, now
may not be the best time to begin exercising
great restraint on government spending, or to
be implementing policies designed to
increase savings. But even as we get back to
full employment of our resources, there may
still be good reasons to treat the notion of a
capital scarcity with at least some degree of
reservation.
How Reliable Are the Projections? A criti
cal feature of any forecast is its reliability.
Capital needs forecasters have provided no
measures with which to judge their predic
tive abilities. However, several considera
tions suggest their predictions could easily
be far off the mark. For one thing, prediction
errors of near-term forecasts are often quite
large even when using the best of models.
The track record of one prestigious forecast
ing firm is particularly revealing (see Table 2).
Its average error in predicting economic
trends suggests that projecting capital needs
and supplies just two years out could easily
result in substantial errors.
Moreover, the longer we stretch the fore
cast horizon, the more prone to error the
forecasts are likely to become (as suggested
by Table 2), and capital needs projections
have generally stretched out to about ten
years. Even on the two-year forecast a word of
caution is suggested: “ The second year is only
meant to be indicative of the general direc
tion of the econom y.. . ' ' The forecast errors
“ show just how much accuracy can be
expected when we are as far away from the
forecast base as two years. It should be sober
ing to policymakers and economists."5
In addition, long-term forecasts, particu
larly the capital needs forecasts, face several
major obstacles in making accurate predic
tions. One, of course, is knowing the future
underlying forces that will be affecting our
economy. For example, the earlier capital
needs studies (made during 1973 and 1974)
assumed that the mid-seventies would be a
period when the economy was operating at or
near full employment rather than being in the
doldrums of a deep recession.6 But even if we
guess correctly on the basic forces, economic
behavior still remains hard to predict. For
example, it is suggested that households'
savings may be shrinking (relative to GNP)
because of rising tax rates, a shift in the
population mix toward young families, and
inf lation. However, the speculativeness of this
suggestion is indicated by the fact that each of
these forces has been operating since the
mid-sixties, yet personal savings rates have
been rising.7
More fundamentally, the forecasts take
only a limited account of the long-term inter
relationships of a market economy and its
5George R. Green and Lawrence R. Klein, “ The Whar
ton Forecast Record: A Self Examination,” Wharton
Quarterly (Winter 1972-1973), p. 27.
6See, for example, Bosworth et. al., Capital Needs in
the Seventies; and “ Outlook to 1985,” Quarterly Review
of Economic Prospects (General Electric, March 1974).
7Personal savings relative to GNP averaged 4.4 percent
between 1955 and 1959, 3.6 percent between 1960 and
1964,4.4 percent between 1965 and 1969, and 5.1 percent
between 1970 and 1974. See the Economic Report of The
President, 1976, Appendix B. For inflation, population
and tax trends also see Appendix B.
7
MAY/JUNE 1976
BUSINESS REVIEW
TABLE 2
FORECASTING ERRORS TEND TO GROW WITH LENGTH OF
FORECAST HORIZON
(Average Absolute Errors of Predicted Levels for Wharton
Forecasts, 1967:1-1972:111)*
(Billions of Dollars)
Quarters Ahead
8
2
3
4
5
(current $)
(1958 $)
3.47
2.34
7.21
4.88
8.50
6.32
9.25
6.49
12.12
7.08
16.80 20.60
7.52 10.87
24.58
15.24
(current $)
(1958 $)
2.22
1.85
4.33
3.25
6.05
3.98
7.57
4.59
11.20
5.06
14.18 16.76
5.73 6.10
19.31
6.20
(current $)
(1958 $)
2.23
1.81
3.11
2.57
3.68
3.08
4.64
3.55
5.55
3.45
7.05
3.70
7.82
3.69
9.00
4.00
Residential Investment
(current $)
(1958 $)
1.11
0.68
1.83
1.11
2.17
1.33
3.02
1.95
4.13
2.57
5.09
2.99
6.59
4.45
8.90
5.81
Inventory Change
(current $)
(1958 $)
2.26
1.60
3.30
2.98
4.48
3.61
3.81
3.07
3.22
3.64
3.52
3.48
2.94
2.69
2.39
1.87
Gross National Product
Consumer Expenditures
Nonresidential Investment
6
7
1
Variable
♦Source: George R. Green and Lawrence R. Klein, “ The Wharton Forecast Record: A Self
Examination,” Wharton Quarterly, Winter 1972-1973, pp. 22-28. A detailed report of the forecast evaluation
can be found in the article.
Note: The average absolute errors measure the average of the absolute value of the forecasted numbers
minus the actual numbers for the respective economic variables over the respective time horizons. Because
most of these variables tend to grow over time (inventory change being the exception), errors are likely to
expand with the forecast horizon due simply to an increasing scale. However, for most of these variables,
the size of the error growth suggests that even a relative measure, such as the mean absolute percentage
error (the absolute prediction error divided by the actual value of the respective variable), would also
be likely to exhibit growth. Finally, it should be emphasized that the forecast errors reported here are those
of a short-term forecasting model and are used primarily to illustrate the difficulty of accurate forecasting,
particularly as the forecast horizon expands. They are not intended to portray the likely size of prediction errors
of long-term forecasts since there is, in fact, little if any evidence on the likely accuracy of long-term forecasts.
response to changing demand and supply
conditions. For example, forecasts of sub
stantial growth in oil demands appear to be
little influenced by a sharp rise in the relative
price of oil.8*Such an assumption gives short
8See “ Energy Demand Studies: An Analysis and
Appraisal,” U. S. House of Representatives, 92nd Con
gress, September 1972. Also see Bosworth et. al., Capital
shrift to price-induced responses, such as a
possible trend to small gas-saving cars, devel
opment of less energy-intensive production
processes, or a substitution of less expensive
Needs in the Seventies, pp. 26-31. For a more general
discussion of the role of market prices in eliminating
“ shortages” see Donald L. Raiff, “ Shortages: A Necessary
Evil of the Future?” Business Review, Federal Reserve
Bank of Philadelphia, October 1974, pp. 13-23.
FEDERAL RESERVE BANK OF PHILADELPHIA
Hence, Uncle Sam should curb his spending
and provide special tax incentives to encour
age saving and investment, or so these ana
lysts contend. But even if investment de
mands do expand, the case for government
support is not all one-sided.
For one thing, the link between capital
accumulation and economic progress is much
less firmly established than is often presumed
in the capital needs thesis. Explaining what
makes a country more affluent is a tough nut
that economists have only begun to crack.
Obviously, the number and quality of
machines that laborers have to work with is
one important factor. But studies of economic
growth suggest it's not the only important
ingredient. Other factors also rated as impor
tant contributors to economic expansion are
technology, education, and production effi
ciency in resource use.10 Consequently,
whether a modest decline in the rate of
capital expansion would significantly pull
down our economic growth is uncertain.
Moreover, society's well-being can be
judged with a variety of yardsticks. The rate of
expansion in GNP is one important indicator
energy sources for oil. Yet, these responses—motivated by profit concerns—may in the end
help cut our investment demands.
Similarly, the procedure of simply adding
up the savings projections of households,
businesses and government may give rise to
errors in the total because of interrelation
ships among the components. If government
curbs its deficits by reducing expenditures on
goods and services (such as medical care) this
could cause households to increase their
consumption and cut back on savings. Tax
measures designed to encourage businesses
to increase their retained earnings may cause
a substitution of business savings for personal
savings.9 These possibilities are given little
attention in the capital needs studies.
In sum, what we know about forecasting
suggests that, beyond a few years, predictions
of components of investment demand and
saving may be subject to large errors. The
potential for error may be sufficiently great as
to question the meaningfulness of decadelong projections of our capital adequacy.
Capital Growth and Social Goals. Perhaps
the real issue underlying the concern over
capital scarcity is whether society benefits
from higher rates of capital growth. Those
seeing sharply expanding investment
demands warn that failing to finance them—
particularly business investment—will retard
our economic growth (and excerbate infla
tion and unemployment too—see Box).
10Studies of economic growth in the U. S. and Western
Europe have generally been able to explain only a minor
part of this growth in terms of capital accumulation.
Moreover, some of these studies indicate that the rela
tively high investment-GNP ratios and high economic
growth rates observed in Western European countries
(and often cited by capital scarcity proponents) are
misleading as an indicator of a cause-effect relationship.
For one thing, it is explained that capital goods in West
ern Europe have much higher price tags compared to
other goods than they do in the U. S. When account of
these relative price differences was taken for a number of
Western European countries, their investment-GNP
ratios turned out to be no greater than that in the U. S.
over the same time period. Second, at least one study
found that capital growth accounted for only 13 percent
of economic growth in Northwest European countries
between 1950 and 1962. The fact that these countries had
appreciably higher economic growth rates than the U. S.
was explainable almost entirely by differences in stages of
economic growth and a removal of international trade
barriers. For a review of these studies, see Flang-Sheng
Cheng, “ Investment Ratios and Economic-Growth
Rates,” Business Review, Federal Reserve Bank of San
Francisco, Spring 1974.
9Total private savings during the twentieth century has
averaged about 15.5 percent of GNP, exhibiting a remark
able stability despite rather significant variation in its
separate components: personal savings, durable expen
ditures and business savings. One explanation offered for
this observation is a (long-term) stable propensity for
society to invest its income and a treatment of business
and government savings as highly substitutable for per
sonal savings. The implication of this thesis for the capital
needs studies is that the procedure of simply adding up
individually estimated savings projections for house
holds, government and business is incorrect. For one
recent study of this issue see Paul O. David and John L.
Scadding, “ Private Savings: Ultrarationality, Aggregation,
and ‘Denison’s Law’,” Journal of Political Economy 82
(March/April 1974), pp. 225-49.
9
MAY/JUNE 1976
BUSINESS REVIEW
BOX
CAPITAL GROWTH, INFLATION AND UNEMPLOYMENT
Reducing inflation and unemployment are often cited as objectives for encouraging
capital growth. If a higher rate of investment increases economic growth, it might help
curb inflation. The basis for this contention seems to be that, with greater production,
families will have more goods and services on which to spend their incomes. With more
output per dollar of expenditure, prices (or inflation) will be forced down. There are,
however, at least two important uncertainties which are usually neglected in presenting
this argument. One is the amount of increase in investment it will take to measurably
expand our economic growth. The link between capital accumulation and economic
growth is more tenuous than often presumed in the capital scarcity thesis (see text of
article).
The other uncertainty is whether peoples' incomes will actually grow more slowly than
the higher rate of production. This will depend on how fast Uncle Sam is supplying money
to the economy. If monetary growth accelerated with economic growth, so too will the
amount of money people have to spend. Consequently, there will be no downward
pressure on inflation. In fact, many argue that accelerating monetary growth has been a
main ingredient in producing the rising inflation over the past 10 to 15 years.* While this
need not continue in the future, it does suggest the stability of monetary growth is not
something to be taken for granted.
Economic theory also suggests there may be some link between capital growth and
unemployment. High capital growth, which increases worker productivity, could over
the long haul increase employers' demands for labor, reducing the rate of unemploy
ment. But again, there are several caveats which make the argument somewhat tenuous.
One is, as before, the uncertainty of the precise relation between capital growth and
labor productivity. The other issue is the type of capital that would be more rapidly
accumulated. Different forms of capital can have different effects on the best way for
producers to combine their inputs. If the type of capital being accumulated was of the
labor-saving variety, it could have a long-term effect of substituting for labor. In this case,
more rapid capital growth need not reduce the unemployment rate. These uncertainties
need to be weighed when considering capital growth policies for the purpose of
reducing inflation or unemployment.
♦For a more detailed discussion of this view of the long-term relation between inflation and the money
supply, see James M. O'Brien, “ Inflation and a Role for Monetary Policy,” Business Review, Federal Reserve
Bank of Philadelphia, December 1973, pp. 3-11.
economic growth reach the higher rates of
many West European countries (prior to the
1974-75 recession) are apt to view our capital
growth as being too small and our consump
tion and social welfare programs as being too
large. But, just as certain, there are others who
would judge that a relatively strong demand
but there are others as well: the level of
(current) consumption (both private and
public), the welfare of the old or disadvan
taged, the quality of our environment, to
name a few. In the presence of scarce resour
ces, there are trade-offs among these various
objectives. Those who would like to see our
10
FEDERAL RESERVE BANK OF PHILADELPHIA
for consumer goods, social programs and
environmental safeguards more or less accu
rately reflects our preferences both as indi
viduals and as members of society at our
present stage of economic development.
In short, the debate over a capital scarcity is,
to an important degree, a debate over the
best uses of our scarce resources: investment
versus consumption and public versus private
spending. In the end, resource use should
reflect our individual and collective choices.
Only by a careful weighing of the arguments
for encouraging capital formation and the
accompanying costs can the most appropriate
governmental actions be expected. To date,
studies projecting capital needs have gener
ated more heat than light with respect to this
issue.
way for policymakers to plan ahead on the
costs of setting social objectives such as pollu
tion control or energy availability. But the
actual “ numbers" and, in some cases, the
coming squeeze on capital being predicted
by forecasters is subject to some serious reser
vations. First, the problem of the recent reces
sion and current recovery has been one of
excess capital or saving rather than a capital
deficiency. Second, there are substantial
methodological hurdles that need to be over
come before a good deal of confidence can
be placed in long-term forecasting. Current
capital needs and supply predictions are
much more speculative than definitive and
may not provide a firm foundation for build
ing policy. And finally, warnings of an
impending capital squeeze reflect, in part, the
personal judgment of forecasters or analysts
as to the value of private investment versus
private and public consumption. In consider
ing policy recommendations emerging from
the capital scarcity thesis, these reservations
ought to get their due if society's overall
welfare is to be served.
S
CAPITAL NEEDS PROJECTIONS: A USEFUL
START, BUT A LONG WAY TO GO
Capital needs forecasts emphasize that we
can't set national economic priorities willynilly of available resources. They point the
11
BUSINESS REVIEW
MAY/JUNE 1976
ECONOMICS
of INFLATION
Inflation is currently a major problem
facing the U.S. Can policymakers
curtail it? If so, how much w ill their
actions "cost" society? Is inflation
"b a d ," and if so, why? Are there
ways of "living with inflation" that
cushion its negative impact on the
individual and society? Six articles
reprinted from the Philadelphia
Fed's Business Review address
these questions in detail and
seek to promote an
understanding of the
problem for both
policymakers
and the general
public.
Copies are available free of charge. Please address all requests to Public Information,
Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105
FEDERAL RESERVE BANK OF PHILADELPHIA
Profit in a Free
Economy
By John ). Seater
revenue and cost.1In economic terms, it is the
return to the owners of capital—the capital
ists. Capital is any product used to produce
another product, such as a printing press or an
oil refinery. The owners of capital are those
having legal claim to the capital equipment;
for the most part, they are the stockholders of
the nation's companies. Stockholders receive
their profit in two forms. Some is received as
annual dividends. The rest is reinvested in the
company, thus building the value of the com
pany's stock; this profit is eventually captured
when the stock is sold.
How much profit do capitalists make? One
way to answer this is to look at the profit
Profit, like politics and religion, is a subject
that evokes strong feelings and hot argu
ments. At one extreme, profit is said to be the
fruit of shameless exploitation that cheats the
consumers, pollutes the environment, and
oppresses the workers. At the other extreme,
profit is said to be the reward for hard work,
risky investment, and clever innovation—
enterprises that have no undesirable conse
quences and that in fact are indispensable for
social welfare and progress.
Neither of these extreme views is accurate,
but each does contain elements of truth.
Fundamentally, profit is simply a tool for
achieving social goals. However, like a pistol
or a scientific discovery, the profit tool can be
misused. Thus society's task is to construct
safeguards that prevent, or at least discour
age, the objectionable uses of the profit
mechanism but that still allow society to gain
from the beneficial uses.
Actually, profit is not a simple concept. Throughout
this article, profit will be the difference between explicit
revenue and cost; this is often called the accounting
definition of profit. Explicit costs, for example, are
employees’ wages, raw materials costs, machine rentals,
taxes, and so on. Economists use a more subtle definition
of profit—the difference between revenue and costs,
both explicit and implicit. An implicit cost is, for example,
the salary that the owner of a business could have made in
his highest paying alternative occupation.
PROFIT: WHAT IS IT AND HOW MUCH IS
THERE?
Profit is simply the difference between
13
MAY/JUNE 1976
BUSINESS REVIEW
rate—that is, profits relative to production
costs. People generally estimate the profit
rate to be quite large. For example, in a recent
survey, the average person guessed the after
tax profit rate of manufacturing corporations
in 1974 to be 33 percent.2 In fact, however, the
after-tax profit rate in manufacturing was 5
percent. A second way to look at the size of
profits is to examine the share of the national
income earned as profit. In the United States,
after-tax corporate profits have averaged
about 6 percent of national income over the
last 45 years; even the before-tax rate has
been only 11.5 percent (see Table). Moreover,
a recent study argues that profits as a share of
national income have been falling since
World War 11.31n short, corporate profit rates,
on average, are smaller than many people
believe and may not even be growing as fast as
national income.
PROFIT: A VALUABLE SOCIAL TOOL
Profit has been defined as the monetary
Estimates of particular profit rates are even more
strikingly incorrect. For example, the average person felt
the after-tax profit rate of petroleum companies was 61
percent in 1974; in fact, it was 7.2 percent. The survey was
conducted by the Opinion Research Corporation of
Princeton, New Jersey. It is reprinted in New Jersey
Business, August 1975, pp. 25-27.
3See William D. Nordhaus, “ The Falling Share of
Profits,” Brookings Papers on Economic Activity, No. 1
(1974): 169-217. Nordhaus has adjusted the profit data
somewhat, so they are not perfectly comparable to those
presented in the table.
AFTER-TAX PROFITS HAVE AVERAGED ABOUT SIX PERCENT
AS A SHARE OF NATIONAL INCOM E
1929
1933
1939
1940
1945
1950
1955
1960
1965
1970
1971
1972
1973
1974
(A)
(B)
(C)
Net
National
Product
(Billions
of Dollars)
Net
Corporate
Profits
Before Taxes
(Billions
of Dollars)
Net
Corporate
Profits
After Taxes
(Billions
of Dollars)
$ 95.2
48.6
83.2
92.2
200.7
266.4
366.5
460.3
625.1
889.8
961.2
1055.1
1184.1
1277.2
$ 10.0
1.0
7.0
10.0
19.7
42.6
48.6
49.7
77.8
74.0
83.6
99.2
122.7
141.0
$ 8.6
0.4
5.6
7.2
9.0
24.9
27.0
26.7
46.5
39.3
46.1
57.7
72.9
85.2
Data from Economic Report of the President, 1975.
14
(D)
(E)
After-Tax
Before-Tax
Corporate
Corporate
Profit Rate
Profit Rate
(Column C
(Column B
Divided by
Divided by
Column A x 100%)Column A x 100%)
11%
2%
8%
11%
10%
16%
13%
11%
12%
8%
9%
9%
10%
11%
9%
1%
7%
8%
4%
9%
7%
6%
7%
4%
5%
5%
6%
7%
FEDERAL RESERVE BANK OF PHILADELPHIA
open a bank account unless the expected
return on the stock exceeds the expected
return on the bank account by enough to
make the extra risk worth taking. This extra
compensation for risk is another element of
what is called profit.
Third, part of profit is a reward for enter
prise and invention. Invention usually occurs
because the inventor sees it as a means of
earning money. So, part of profit is a compen
sation for the inventor's effort and insight.
Profits of this kind usually are temporary,
being ultimately competed out of existence as
rivals and imitators adopt the technique. But
as one source of innovational profit disap
pears, another arises somewhere else in the
economy so that there is always some innova
tional profit in existence.
Society's View. The pursuit of profits by
individuals also produces gains for society.
Profits provide the incentive for capital for
mation and hence for economic growth. By
providing interest on the capitalist's invest
ment, compensation for risk, and reward for
inventiveness, profits create incentives to
invest money in the machines and factories
needed for economic progress. In more gen
eral terms, profits signal to producers which
goods are most desirable to society. (As we
shall see shortly, the signal sometimes may be
imperfect.)
A timely illustration of this is the develop
ment of the energy industry. Before indus
trialization, fuel production was minimal.
Some coal and wood was used for heating
purposes and for forging tools, but most other
energy demands were met with wind and
water power and with the labor of men and
their beasts of burden. Petroleum was merely
an object of curiosity. With the emergence of
industrialization, however, energy demands
multiplied enormously. It quickly became
profitable to extract coal and petroleum in
huge quantities and refine them for various
uses. People wanted the products offered by
industrialization. In response to the profit that
those new desires made possible, resources
were diverted from other uses to the produc
tion of the energy needed to fuel the indus
return to the owners of capital. Why should
capitalists be rewarded at all? The answer is
simple. If a society decides that forcibly coerc
ing individuals to produce certain goods and
services is undesirable, then there must be
some other incentive to encourage people to
commit resources, such as time and money, to
production. Presumably, the probability of
earning a money return that exceeds the costs
of production (that is, of earning a positive
profit) will make production attractive. Thus
profit can act as the desired incentive. Fur
thermore, profit fulfills a broader social func
tion than simply encouraging production. It
also serves as a signal of the kinds of goods
and services that society deems most valua
ble.
The Individual's View. From an individual
capitalist's point of view, profit has three
functions. First, some of the profit is a pay
ment for investing his money in capital equip
ment instead of spending it elsewhere. The
capitalist's money is like the laborer's time. A
laborer can spend his time either relaxing or
working. FHe will work only if he is paid
enough to be compensated for not relaxing.
Similarly, a capitalist will buy a factory or a
machine only if he earns more that way than
by doing something else with his money, such
as depositing it in a bank. So, much of what is
called profit is merely interest on the capital
ist's money.
Second, some of the profit is compensation
for the risk a capitalist assumes in investing in
uncertain enterprises. Everyone knows that
buying stocks is riskier than putting money in
a bank account. The firm whose stock you buy
may suffer a decline in sales or, worse, go out
of business. Either way, the value of the stock
falls, possibly to nothing. No such thing
happens with a bank account. The money
value of a bank deposit cannot decline
(except possibly in the case of bankruptcy),
and it is possible to earn a guaranteed interest
rate. Moreover, deposits in amounts up to
$40,000 are insured against default at almost
all banks. Obviously, under these conditions,
no rational person will buy stock rather than
15
BUSINESS REVIEW
MAY/JUNE 1976
tition means that firms can restrict output and
create artificial scarcities to increase the price
of their product and thereby earn excess prof
its.6
If we can gauge the extent of noncompeti
tive enterprise in the U. S., we can get a rough
idea of the magnitude of excess profits in our
economy. The task is difficult, but some
attempts have been made. A study in 1951,
covering the years 1899 to 1939, found that
private noncompetitive industries produced
about 15 percent of the Gross National Pro
duct in the U. S.7 A more recent study found
that the extent of noncompetitive enterprise
in manufacturing industries showed no
marked tendency to increase or decrease
between 1947 and 1966.8*If nonmanufacturing
industries also experienced little change dur
ing this period and if there were no sharp
changes in the degree of competition in the
economy during World War II, then we can
estimate that noncompetitive enterprise con
tinues to account for about 15 percent of the
national product.
There is also some recent evidence that
even when businesses operate in a noncom
petitive environment, they are not very effec
tive in raising prices above the competitive
level. One study estimates that noncompeti
trial machine. Thus, it was the lure of profit
that organized resources so as to satisfy the
desires of society. Now petroleum is becom
ing scarcer, and petroleum prices are rising.
The result? Predictably, new profit opportuni
ties have developed. Oil companies now find
it profitable to pump out of the ground petro
leum that was formerly too expensive to
recover. Research is being devoted to pro
ducing petroleum products from nonpetro
leum sources, such as coal, and also to finding
alternative sources of energy. So profit once
again is leading businessmen and entrepre
neurs, through their own self-interest, to
satisfy some of the desires of society.4
PROFIT: A LESS-THAN-PERFECT MECHA
NISM
Thus it is clear that profit seeking can pro
duce desirable ends. However, the profit
mechanism can yield some undesirable out
comes as well. Social ills such as fraud and
pollution often are attributed to profitseeking, and the charge that profits are exces
sive and result in the exploitation of workers is
a familiar and long-lived assertion.
Are Profits Excessive? The term "excess
profits” is used frequently and is a corner
stone of some political ideologies. In a broad
sense, we can say that profits are excessive
when they are larger than is required to carry
out the functions of profit—to encourage
production and signal scarcities.
Excess profits arise whenever industries are
not effectively competitive.5A lack of compe-
purposes,” in which case it is said to be effectively or
workably competitive. See F. M. Scherer, Industrial
Market Structure and Economic Performance (Chicago:
Rand McNally and Company, 1970), pp. 36-38, for a
discussion of the criteria for workable competition.
6See Paul A. Samuelson, Economics, 9th ed. (New
York: McGraw-Flill Book Company, 1973), Chaps. 25 and
26, for a good discussion of the economics of noncom
petitive industries.
4A different way to see the importance of profit in
governing production is to examine the meat shortage of
1973. The price controls then in effect made it impossible
for producers to satisfy demand and still earn a profit.
Beef producers left their cattle to graze rather than bring
them to market at the controlled prices. Chicken raisers
even killed many of their young chickens rather than
bear the expense of raising them only to have to sell at a
loss at the artificially low prices. The moral is simple and
clear: no profit, no production.
7G. Warren Nutter, The Extent of Enterprise Monopoly
in the United States, 1899-1939 (Chicago: University of
Chicago Press, 1951).
aStudies by the Staff of the Cabinet Committee on
Price Stability (Washington, D. C .: U. S. Government
Printing Office, 1969). Note that the findings deal with
manufacturing only. Though not indisputably true, it
seems reasonable to assume that there was no marked
change in noncompetitiveness in nonmanufacturing
sectors as well.
5An industry may not be perfectly competitive but may
be “ perfectly competitive enough for all intents and
16
FEDERAL RESERVE BANK OF PHILADELPHIA
tive industries sell at prices that are on average
about two percent higher than they would be
if the industries were competitive. Such a
small effect on prices suggests that the effect
on the total size of profits is small, too.9
If these various studies are valid, it seems
fair to conclude that, though there are some
excess profits in the U. S. economy, they
probably are not large and by no means
dominate the corporate profit picture (see
Box). However, an absence of excess profits
does not let the profit system off the hook in
the minds of many. What about fraud, pollu
tion, and exploitation of labor?
Information Costs Allow the Profit System
to be Misused. Information about almost
anything is costly to obtain, usually requiring
expenditure of time as well as money. In
instances where the costs of gathering infor
mation are high, some firms may try to make a
profit by cheating, that is, by misinforming
consumers. A supplier may figure that if he
provides incorrect or incomplete informa
tion, customers will buy his product, believ
ing it better than it really is. Thus,thesupplier
could charge more than the product is
“ worth” and thereby earn an excess profit.
However, excess profits from cheating typi
cally will disappear over time. There are two
reasons why. First, the supplier may lose
business as people eventually learn he cannot
be trusted. Second, even if cheating pays in
the sense that people do not recognize the
deception, other fraudulent suppliers will
appear and drive the excess profit down to
zero.10 Eventually, then, business will settle
down to a state in which some suppliers are
frauds but in which there is no excess profit.
In the long run, then, excess profit stem
ming from deception is not likely to be a
problem, but deception itself may be a
burden. Here is an instance where it seems
reasonable to attack an undesirable use of the
profit mechanism rather than the mechanism
itself. One way to do so is to make the objec
tionable means of profit seeking unprofita
ble. For example, society makes fraud costly
by making it illegal and by imposing heavy
penalties.11
Pollution: An Uncounted Cost. Another
problem often associated with profit seeking
is pollution. Pollution is an example of what
economists call an external cost, which is a
cost not borne by those responsible for it. For
example, paper mills are notorious for emit
ting foul odors, which are a cost to the local
residents.
If there is no compensation for the emission
of odors, the paper mill evades one of its
costs, which is borne instead by the local
residents. This reduction in the mill's costs
tends to produce excess profits. However, as
with fraud, these excess profits are not likely
to last because they will induce other firms to
enter the paper mill business and force the
10The obvious exception is noncompetitive enterprise.
A monopolist, for example, does not have to worry about
other suppliers competing excess profit away from him.
Thus, he may be able to earn excess profits from fraud.
11However, even when providing incomplete or incor
rect information is legal, it is still undesirable. This is why
many economists agree that one social responsibility
businessmen have is to provide the best information they
have on their product, whether legally required to do so
or not. Information can be quite costly to provide,
though. If it is of little value, it probably is better not to
bother providing it. Thus either the businessman or the
government must decide whether to provide certain
information. In either case, the decision is a difficult one,
for the costs and benefits involved often are difficult to
determine. See Kenneth J. Arrow, “ Social Responsibility
and Economic Efficiency,” Public Policy, Summer 1973,
pp. 303-317; and Milton Friedman, Capitalism and Free
dom (Chicago: University of Chicago Press, 1962), p. 133.
9See Richard A. Posner, “ The Social Costs of Monop
oly and Regulation,” Journal of Political Economy 83
(1974): 807-27. A small total (or absolute) change in excess
profits could be accompanied by a large percentage
change. For example, suppose initially that excess profit is
zero when a firm manages to exploit its monopoly power
to raise prices by two percent and thereby create an
excess profit of one dollar. Then the percentage rise in
excess profit is infinite, even though the absolute rise of
one dollar is miniscule. This is why the percentage
change in profit can be a misleading indicator of the
change in the size of profit relative to national income.
17
BUSINESS REVIEW
MAY/JUNE 1976
BOX
WHY NONCOMPETITIVE INDUSTRIES
GET SO MUCH ATTENTION
There are several reasons why the man in the street might overrate the extent of
noncompetitive industries and their profits. First, noncompetitive industries—especially
monopolies—are newsworthy. Many people would be interested to learn that the
Justice Department is scrutinizing iBM for monopolistic behavior, but almost no one
would care to hear that this year, once again, saw and planing mills operated in a
competitive environment. It is something like traffic accidents—if someone is hit crossing
the street, it's news; if he crosses safely, no one cares.
Second, bigness is often confused with monopoly. In fact, however, a firm does not
have to be big to be a monopoly, and a big firm may belong to a competitive industry. For
example, the Besser Manufacturing Company was found guilty in 1951 of illegally
monopolizing the concrete-block machinery industry, even though it employed only 465
people at the time and had sales of less than $15 million. In contrast, Cities Service Oil
Company had sales of $1.2 billion in 1965 but accounted for less than 3 percent of U. S.
crude petroleum refining.A
Third, most people seem to have manufacturing in mind when discussing the extent of
noncompetitive behavior. Indeed, noncompetitive behavior apparently is more impor
tant in manufacturing and mining than in any other sector of the private economy, but
manufacturing and mining are not the whole story. Two-thirds of national output is
produced in other sectors, many of which are highly competitive.*8
People also may underestimate the natural economic forces tending to limit noncom
petitive behavior. The most important force is profit itself. If a noncompetitive industry
has excess profits, entrepreneurs enter that industry to capture some of the excess profits
for themselves. Incoming firms make the industry more competitive, however, and the
excess profit is driven down toward zero.c Other forces also limit noncompetitive
behavior—technological advances in transportation and communication, for example.
Cheap transportation enables consumers to visit distant stores where prices may be
lower. It also enables distant suppliers to ship their goods to new markets. Foreign cars in
the American automobile market are an example. In both cases, competition is increased.
There are situations, however, where these competitive forces are absent. One case is
“ natural monopoly," in which technical considerations make it much cheaper for one
A These examples are taken from F. M. Scherer, Industrial Market Structure and Economic Performance
(Chicago: Rand McNally and Company, 1970), p. 11.
8 Even in manufacturing and mining, noncompetitiveness may not be as extensive as popularly believed. Only
about a fifth of the output of this sector comes from industries in which four firms account for 60 percent or
more of sales. See Richard A. Posner, “ The Social Costs of Monopoly and Regulation,” Journal of Political
Economy 83 (1974): 819.
The railroads, for example, are no longer a monopoly; airplanes, buses, and automobiles have provided new
modes of transportation for people and airplanes and trucks have provided new modes of transportation for
goods.
18
FEDERAL RESERVE BANK OF PHILADELPHIA
firm to produce the industry's entire output. The telephone system is an example.0
Natural competitive forces also are restrained sometimes by the government, either
directly (for example, through legal entry restrictions) or indirectly (for example, by
protective tariffs). Some people argue that such government support is the major cause of
noncompetitive behavior in the United StatesT
0 It may be desirable to regulate such monopolies. However, Posner, “ The Social Costs of Monopoly and
Regulation/’ presents evidence suggesting that the costs of regulation exceed the benefits.
E See Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), pp. 125-132.
costs are essentially like the paper mill exam
ple and can be treated by similar policies. As
with fraud, the existence of external costs
usually does not lead to excess profits (with
the possible exception of noncompetitive
enterprise). Again, the appropriate policies to
combat these kinds of social problems do not
involve attacking profit itself but only certain
means of acquiring profit.
Exploitation and Income Distribution. It is
sometimes said that businessmen earn much
of their profit by exploiting their employees.
The most extreme version of this position is
that of Karl Marx and Friedrich Engels, who
asserted that all profit resulted from exploita
tion of the workers. How well does this view
fit the American economy?
If the buyers of labor services—the em
ployers—are competitive with one another,
there will be virtually no exploitation of labor.
Rather, workers will be paid what they are
economically worth, which means they will
be paid according to their ability to produce.
If an employer tried to exploit his workers by
paying them less, other employers would bid
the workers away by offering them higher
wages. The original employer would be
forced to match the higher wages or go out of
business for lack of labor. Thus, in such a labor
market, there can be no exploitation and
therefore no excess profit from exploitation.
The crucial question, then, is whether buyers
of labor services in the American labor market
excess profits down to zero. These new firms,
of course, will use the same polluting tech
niques as the original firm, for otherwise their
costs would be higher and they would not be
able to compete. Thus, the paper mill busi
ness will settle down to a state in which all
mills pollute but in which there is no excess
profit.
Again, the resulting situation is
undesirable—not because there is excess
profit, but because there is too much pollu
tion. The appropriate social response is to
institute tax or regulatory policies to reduce
pollution by making it costly for firms to
pollute. For example, society could require
the paper mill to compensate the local resi
dents, perhaps through an emission tax on the
mill's malodorous output. Such a tax forces
the mill to “ internalize" the cost associated
with bad odors by making the mill either pay a
tax for continuing its emissions or install
equipment to reduce the odors. In either case
the mill will face higher costs of production
and will respond by reducing output and
raising the price of the paper, just as itwould if
any other production cost were to rise. This
response is economically efficient; the buyers
of the mill's paper ultimately pay all the costs
of paper production, including the cost asso
ciated with the by-product odor.
Many external costs of firms are more con
sequential than the foul odors of a paper mill.
Some kinds of air pollution are injurious to
health, for example.12*But all cases of external
Analysis of the Association between U. S. Mortality and
Air Pollution,” Journal of the American Statistical Associ
ation 68 (1973): 284-90.
12For an attempt at measuring the mortal conse
quences, see Lester B. Lave and Eugene P. Seskin, “ An
19
MAY/JUNE 1976
BUSINESS REVIEW
as most people. And while these people live
in poverty, others live in luxury.
What is to be done? This is a difficult ques
tion, but in seeking the answer, it is important
to remember that in most cases economic
exploitation in contemporary labor markets is
not the cause of the unequal income distribu
tion. In a competitive labor market, those
who earn low wages do so because they do
not work in fields society values most. Some
lack the skills to do so, and others may prefer
not to work in such fields. It is economically
efficient that employers be allowed to pay
them a competitive wage, even if it is low. If
firms are forced to pay higher than competi
tive wages, economic logic dictates that they
will hire fewer workers and produce less.15
A preferable solution, when labor markets
are as competitive as in the United States, is to
let the market determine wage rates and
employment patterns and then for govern
ment to supplement the incomes of those
earning too little on their own. The debate
over the best way to carry out such public
assistance has not been settled. Many pro
grams have been tried, and there is now
interest in reforming the welfare system.
However, whatever redistribution scheme
is adopted, it is important that profit not be
viewed as inherently different from other
forms of income. To make profit a scapegoat
for the unequal distribution of income and to
tax it especially heavily would be an ironic
mistake indeed. Such treatment of profit
undoubtedly would hinder one of the most
important forces for alleviating poverty and
reducing
income
inequality—economic
growth.16
are competitive with each other. Apparently
they are, to a very high degree.
In determining whether an industry is non
competitive, economists often use a measure
called the four-firm concentration ratio. This
is simply the percentage of the industry's
output sold by the four largest firms in the
industry. The usual rule of thumb is that when
four or fewer firms control 50 percent or more
of the industry's output, the industry is
considered noncompetitive.13 It seems rea
sonable to apply a similar testto the American
labor market. A fairly recent study has done
just that by examining a large number of local
labor markets and determining how many
employers accounted for 50 percent or more
of the employment within those markets. It
was found that in only about five percent of
the local labor markets surveyed were four or
fewer firms hiring 50 percent or more of the
labor. In addition, only about two percent of
the labor force covered by the survey was in
these noncompetitive areas.14 These are
strikingly small percentages. If they are repre
sentative of the entire American labor
market, they strongly suggest that exploita
tion of labor is an insignificant problem in the
United States.
Despite this evidence, many people still
feel some antipathy toward profit. Why? Per
haps Paul Samuelson has said it best: “ Much
of the hostility toward profit is really hostility
toward the extremes of inequality in the
distribution of money income . . ." The prob
lem, then, is the equity issue of unequal
incomes, or more fundamentally, that certain
people are unable to earn incomes society
deems adequate. The undeniable fact is that
some people are born with mental, physical,
or social handicaps and, through no fault of
their own, do not have the same chance in life
15The minimum wage, for example, gives some people
a higher wage but leads to fewer people being hired in
the first place. Thus, the goods that the unemployed
would have produced are lost. The precise magnitude of
the employment reduction isdifficultto measure, butthe
existence of the effect has been confirmed by several
studies. See Robert S. Goldfarb, “ Quantitative Research
on the Minimum Wage,” Monthly Labor Review98, No. 4
(April 1975): 44-46, and the articles discussed there.
13The four-firm concentration ratio is by no means
infallible and is often supplemented by other considera
tions. See Nutter, Extent of Enterprise Monopoly, pp. 110, and Scherer, Industrial Market Structure, Chap. 2.
14See Robert L. Bunting, Employer Concentration in
Local Labor Markets (Chapel Hill: University of North
Carolina Press, 1962).
16See Samuelson, Economics, Chap. 6, and also Morton
20
FEDERAL RESERVE BANK OF PHILADELPHIA
undesirable behavior costly through antitrust
laws, fraud legislation, emission taxes, and the
like. Such policies help reduce the occur
rence of undesirable outcomes while retain
ing profit as a useful tool for organizing
economic activity.
Profit is not only the concern of those in
executive suites, for it affects all of society. It is
an inducement to the business world to inno
vate, bear risk, and perform efficiently. It also
is a means of allowing consumers to signal
which goods they want and in what amounts
while simultaneously rewarding producers
for complying with their demands. Certainly
the profit tool has some defects, but it seems
far more desirable to repair the defects than
to discard the tool.
THE BOTTOM LINE
There are three important instances when
profit seeking produces an undesirable out
come for society—when business is noncom
petitive, when the cost of acquiring informa
tion about products and producers is high,
and when business does not bear the full costs
of production. The first allows some firms to
earn excess profits, the second opens the
door to cheating and fraud, and the third
produces such social ills as pollution. All of
these problems can be combatted by making
Paglin, "The Measurement and Trend of Inequality: A
Basic Revision/’ American Economic Review 65 (1975):
598-609.
SELECTED BIBLIOGRAPHY
Feuer, Lewis S., ed. Basic Writings on Politics and Philosophy by Karl Marx and Friedrich
Engels. New York: Doubleday and Company, Anchor Books, 1959.
Friedman, Milton. Capitalism and Freedom. Chicago: University of Chicago Press, 1962.
Galbraith, John Kenneth. The New Industrial State. Boston: Houghton Mifflin Company,
1967.
Rand, Ayn. Capitalism: The Unknown Ideal. New York: The New American Library, 1967.
Samuelson, Paul A. Economics. 9th ed. New York: McGraw-Hill Book Company, 1973.
S
21
BUSINESS REVIEW
MAY/JUNE 1976
The Fed in Print
BANK LOANS—REAL ESTATE
Real estate lending increases—
Atlanta Dec 75 p 214
Business Review Topics,
Fourth Quarter 1975
Selected by Doris Zimmermann
BANK SUPERVISION
Statement to Congress,
October 8, 1975 (Partee)—
FR Bull Oct 75 p 636
Articles appearing in the Federal Reserve
Bulletin and in the monthly reviews of the
Federal Reserve banks during the Fourth
quarter o f 1975 are included in this compila
tion. A cumulation of these entries covering
the years 1972 to date is available upon
request. If you wish to be put on the mailing
list for the cumulation, write to the Publica
tions Department, Federal Reserve Bank of
Philadelphia.
To receive copies of the Federal Reserve
Bulletin, mail two dollars for each to the
Federal Reserve Board at the Washington
address on page 26. You may send for
monthly reviews of the Federal Reserve banks
free of charge, by writing directly to the
issuing banks whose addresses also appear on
page 26.
Revised year-end report forms
postponed to March 31, 1976—
FR Bull Dec 75 p 912
BANKING FOREIGN BRANCHES
Assets and liabilities of
overseas branches of member banks—
FR Bull Nov 75 p 823
BANKING HISTORY
Evolution of money and banking
in the United States—
Dallas Dec 75 p 1
BANKING STRUCTURE
Banking structure in Louisiana—
Atlanta Oct 75 p 158
Banking structure in Mississippi—
Atlanta Oct 75 p 164
Banking structure in Tennessee—
Atlanta Oct 75 p 169
BANK CRIMES
Statement to Congress,
November 19, 1975 (Leavitt)—
FR Bull Dec 75 p 844
BANKING STRUCTURE IN THE SIXTH
DISTRICT STATES available—
Atlanta Nov 75 p 196
BANK FAILURES
Bank failures and public policy—
St Louis Nov 75 p 7
BUCHER, JEFFREY M.
Statement to Congress,
October 9, 1975 (Fair Credit
Billing Act, 1974)—
FR Bull Oct 75 p 638
Statement to Congress,
December 9, 1975 (bank services)—
FR Bull Dec 75 p 855
Resigns effective January 2, 1976—
FR Bull Dec 75 p 911
BANK HOLDING COMPANIES
Holding company developments in
Michigan—
Chic Oct 75 p 10
A Florida case study—
Atlanta Dec 75 p 202
BANK LOANS—FARM
A decade of growth in Southeastern
agricultural loans—
Atlanta Nov 75 p 182
BURNS, ARTHUR F.
Statement to Congress,
September 25, 1975 (fiscal policy
and inflation)—
FR Bull Oct 75 p 625
Statement to Congress, October 2,
Bank lending to agriculture: An
overview—
Kansas City Nov 75 p 11
22
FEDERAL RESERVE BANK OF PHILADELPHIA
1975 (recovery and inflation)—
FR Bull Oct 75 p 628
Statement to Congress,
October 8, 1975 (municipal finance)—
FR Bull Oct 75 p 632
Statement to Congress, October 2, 1975
(business cycles)—
FR Bull Oct 75 p 640
Statement to Congress, October 20, 1975
(Federal Reserve independence)—
FR Bull Nov 75 p 730
Statement to Congress, October 23, 1975
(municipal finance)—
FR Bull Nov 75 p 736
Statement to Congress, November 4, 1975
(business cycles)—
FR Bull Nov 75 p 744
Statement to Congress, November 12,
1975 (information disclosure)—
FR Bull Nov 75 p 750
COMMERCIAL POLICY
How useful are export promotion
programs?—
Chic Dec 75 p 9
CREDIT RATIONING
Letter re-restrictive foreign
trade practices by banks—
FR Bull Dec 75 p 913
CROPS
1975 crop production—
Atlanta Dec 75 p 210
DEBT PUBLIC
The Federal debt and commercial
banks—
Chic Oct 75 p 3
DISCOUNT OPERATIONS
The impact of discount activity on
Federal funds borrowings—
Atlanta Dec 75 p 206
BUSINESS FORECASTS AND REVIEWS
Financial developments in the
third quarter of 1975—
FR Bull Dec 75 p 829
The business and financial
outlook for 1976—
Kansas City Dec 75 p 3
ECONOMIC STABILIZATION
Slowdowns and recessions:
What's been government's role?—
Phila Oct 75 p 17
The postwar economic system in
Germany: Creation, evolution,
and reappraisal—
St Louis Oct 75 p 16
BUSINESS INDICATORS
An evaluation of economic forecasts—
Bost Dec 75 p 3
EMPLOYMENT
Jobs in Philadelphia:
Experience and prospects—
Phila Dec 75 p 3
CAPITAL
New benefit plan proposed—
Dallas Nov 75 p 1
Inflation, finance and capital markets—
San Fran Dec 75 p 5
FARM CREDIT
Farmers Home Administration—
Chic Dec 75 p 3
CAPITAL EXPENDITURES
Capital spending lags the upswing—
Chic Nov 75 p 12
FARM OUTLOOK
The economic recovery:
Will agriculture follow in 1976?—
Kansas City Dec 75 p 10
CERTIFICATES OF DEPOSIT
See note under time deposits
quarterly survey—
FEDERAL RESERVE BANKS—FINANCIAL
STATEMENTS
GLOSSARY available—
NY Dec 75 p 279
COLDWELL, PHILIP E.
Statement to Congress,
October 23, 1975 (Federal
Reserve banks direct purchase)—
FR Bull Nov 75 p 741
FEDERAL RESERVE—FOREIGN EXCHANGE
Treasury and Federal Reserve foreign
23
MAY/JUNE 1976
BUSINESS REVIEW
exchange operations—interim report
NY Dec 75 p 290
St Louis Dec 75 p 18
Inflation and financial markets—
San Fran Dec 75 p 3
FEDERAL RESERVE MONETARY POLICY
The Fed in a political world (Eastburn)—
Phila Oct 75 p 3
INTEREST RATES
The term structure of interest
rates and inflation uncertainty—
San Fran Dec 75 p 27
FEDERAL RESERVE SYSTEM—PUBLICATIONS
Subscription rates capital markets, etc.—
FR Bull Oct 75 p 708
JACKSON, PHILIP C.
Statement to Congress,
October 28, 1975 (real estate
settlement)—
FR Bull Nov 75 p 742
FINANCE INTERNATIONAL
Developments in international
financial markets—
FR Bull Oct 75 p 605
FISCAL POLICY
Crowding out and its critics—
St Louis Dec 75 p 2
The capital market crowding
out problem in perspective—
San Fran Dec 75 p 36
MITCHELL, GEORGE W.
Member National Commission on
Electronic Fund Transfers—
FR Bull Oct 75 p 708
Statement to Congress,
October 18, 1975 (municipal finance)FR Bull Nov 75 p 728
Statement to Congress,
December 12, 1975 (foreign banks)—
FR Bull Dec 75 p 859
FLOAT
A primer on Federal Reserve float—
NY Oct 75 p 245
GOVERNMENT EXPENDITURES
Federal government
purchases of goods and services—
Kansas City Nov 75 p 3
MODELS (STATISTICS)
Minnie: A small version of the
MIT-Penn-SSRC econometric modelFR Bull Nov 75 p 721
The Philadelphia region
econometric model—
Phila Dec 75 p 40
GRAIN
Grain supplies and food prices—
Atlanta Nov 75 p 178
HOLLAND, ROBERT C.
Statement to Congress,
December 8, 1975 (bank supervision)—
FR Bull Dec 75 p 851
MONETARY POLICY
The dilemmas of monetary policy
(Volcker)—
NY Dec 75 p 274
HOUSING—FINANCE
The rising cost of buying a new home—
Phila Oct 75 p 11
Housing construction and
residential mortgage markets—
FR Bull Nov 75 p 711
MONEY SUPPLY
The relationship between
monetary base and money:
How close?—
St Louis Oct 75 p 3
Selection of a monetary aggre
gate for economic stabilization
(Andersen)—
St Louis Oct 75 p 9
Aggregating the monetary
aggregates: Concepts and issues—
Rich Nov 75 p 3
INFLATION
A monetarist model of the
inflationary process—
Rich Nov 75 p 13
The origin and impact of
inflation (Francis)—
24
FEDERAL RESERVE BANK OF PHILADELPHIA
FR Bull Nov 75 p 804
Amendment October 22, 1975—
FR Bull Nov 75 p 824
MORTGAGES, VARIABLE
Is there a future for variable rate
mortgages?—
Chic Nov 75 p 3
MUNICIPAL FINANCE
Statement to Congress,
October 21, 1975 (Partee)—
FR Bull Nov 75 p 735
New York City's economy—some
longer term issues (Debs)—
NY Nov 75 p 258
REGULATION Q
Amendment October 2, 1975
(savings deposits)—
FR Bull Oct 75 p 708
Amendment November 10, 1975—
FR Bull Nov 75 p 769
Amendment December 4, 1975
(individual retirement accounts)—
FR Bull Dec 75 p 912
PETROLEUM INDUSTRY
Enhanced recovery may slow
declines in production—
Dallas Nov 75 p 4
Oil price controls: A counter
productive effort—
St Louis Nov 75 p 2
REGULATION T
Amendment September 30, 1975—
FR Bull Oct 75 p 649
Same-day credit restriction for
stocks November 3, 1975—
FR Bull Oct 75 p 707
Amendment November 13, 1975—
FR Bull Nov 75 p 825
Amendment November 13, 1975—
FR Bull Dec 75 p 880
RECESSIONS
Recession has less impact in
Southwest than in nation—
Dallas Oct 75 p 6
REGULATION B
Equal Credit Opportunity Act
implemented October 16, 1975—
FR Bull Oct 75 p 705
Open market purchases of bills of
exchange revoked April 1, 1974—
FR Bull Nov 75 p 762
REGULATION U
Amendment September 30, 1975—
FR Bull Oct 75 p 649
REGULATION Y
Amendment December 1, 1975—
FR Bull Dec 75 p 880
Amendment November 24, 1975—
FR Bull Dec 75 p 911
REGULATION D
Definition of savings deposits
amendment October 2, 1975—
FR Bull Oct 75 p 708
Admendment October 16, 1975—
FR Bull Nov 75 p 769
REGULATION Z
Amendment October 28, 1975—
FR Bull Oct 75 p 650
Amendment September 15,1975—
FR Bull Oct 75 p 708
Amendment October 28, 1975—
FR Bull Nov 75 p 825
Interpretation—
FR Bull Dec 75 p 881
Interpretation—
FR Bull Dec 75 p 912
REGULATION F
Amendment December 1, 1975—
FR Bull Nov 75 p 770
Amendment October 23, 1975—
FR Bull Nov 75 p 824
REGULATION G
Amendment September 30, 1975—
FR Bull Oct 75 p 649
RESERVE REQUIREMENTS
Change effective October 30, 1975
FR Bull Oct 75 p 705
REGULATION H
State member banks as transfer agents—
25
MAY/JUNE 1976
BUSINESS REVIEW
SAVINGS
Effect of inflation on savings behavior—
San Fran Dec 75 p 21
SUGAR
Sugar production in Texas Valley—
Dallas Oct 75 p 1
SELECTIVE CREDIT CONTROLS
Selective credit policies:
Should their role be expanded?—
Phila Nov 75 p 3
STUDIES IN SELECTIVE CREDIT
POLICIES available—
Phila Nov 75 p 23
WALLICH, HENRY C.
Statement to Congress,
November 21, 1975 (small
business credit)—
FR Bull Dec 75 p 848
s
FEDERAL RESERVE BANKS AND BOARD O F GOVERNORS
Federal Reserve Bank of Kansas City
Federal Reserve Station
Kansas City, Missouri 64198
Publications Services
Division of Administrative Services
Board of Governors of the
Federal Reserve System
Washington, D.C. 20551
Federal Reserve Bank of Minneapolis
Minneapolis, Minnesota 55480
Federal Reserve Bank of Atlanta
Federal Reserve Station
Atlanta, Georgia 30303
Federal Reserve Bank of New York
Federal Reserve P.O. Station
New York, New York 10045
Federal Reserve Bank of Boston
30 Pearl Street
Boston, Massachusetts 02106
Federal Reserve Bank of Philadelphia
Box 66
Philadelphia, Pennsylvania 19105
Federal Reserve Bank of Chicago
Box 834
Chicago, Illinois 60690
Federal Reserve Bank of Richmond
P.O. Box 27622
Richmond, Virginia 23261
Federal Reserve Bank of Cleveland
P.O. Box 6387
Cleveland, Ohio 44101
Federal Reserve Bank of St. Louis
P.O. Box 442
St. Louis, Missouri 63166
Federal Reserve Bank of Dallas
Station K
Dallas, Texas 75222
Federal Reserve Bank of San Francisco
San Francisco, California 94120
26
The Philadelphia Fed’s Research Department occasionally publishes RESEARCH PAPERS written
by staff economists. These papers deal with local, national, and international economics and
finance. Most of them are intended for professional researchers and therefore are highly technical.
To order copies, simply mark which ones are desired, detach this order form, place it in an
envelope, and send it to the Department of Research, Federal Reserve Bank of Philadelphia,
Philadelphia, PA 19105. Your copies will be sent to the address on the mailing label overleaf.
MARK HERE
D
1. Intradistrict Distribution of School Resour
ces to the Disadvantaged: Evidence for the
Courts, Philadelphia School Project by
Anita A. Summers and Barbara L. Wolfe
CD 2. Branching Restrictions and CommercialBank Costs by Donald J. Mullineaux
D 3. Economies of Scale of Financial Institutions
by Donald J. Mullineaux
D 4. Required Reserve Ratios, Policy Instru
ments, and Money Stock Control by Ira
Kaminow
□ 5. The Information Value of Demand Equa
tion Residuals: A Further Analysis by James
M. O ’Brien
D 6. Equality of Educational Opportunity Quan
tified: A Production Function Approach,
Philadelphia School Project by Anita A.
Summers and Barbara L. Wolfe
D 7. Pennsylvania Bank Merger Survey: Sum
mary of Results by Cynthia A. Glassman
□ 8. Manual on Procedure for Using Census
Data to Estimate Block Income, Philadel
phia School Project by Anita A. Summers
and Barbara L. Wolfe
D 9. Block Income Estimates, City of Philadel
phia: 1960 and 1970, Philadelphia School
Project by Anita A. Summers and Barbara
L. Wolfe
http://fraser.stlouisfed.org/
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_
_
_
CD 10.
CD 11.
□
12.
CD 13.
CD 14.
CD 15.
CD 16.
Optimal Capital Standards for the Banking
Industry by Anthony M. Santomero and
Ronald D. Watson
A Unified Model of Consumption, Labor
Supply, and Job Search by John J. Seater
Utility Maximization, Aggregate Labor
Force Behavior, and the Phillips Curve by
John J. Seater
Economies of Scale and Organizational
Efficiency in Banking: A Profit-Function
Approach by Donald J. Mullineaux
On the Role of Transaction Costs and the
Rates of Return on the Demand Deposit
Decision by Anthony M. Santomero
Spectral Estimation of Dynamic Economet
ric Models with Serially Correlated Errors
by Nariman Behravesh
Empirical Properties of Foreign Exchange
Rates under Fixed and Floating Rate
Regimes by Janice Moulton Wsterfield
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