A SWOT Analysis
To better understand the basis and characteristics of the economic system in which corporate managers and small-business owners operate, this chapter will provide you, the business decision makers, with information to understand, predict, and strategize to solve problems as they arise, especially during the boom-bust cycle.
The United States has a mixed economy, as do many nations around the world in contrast to a “pure” market economy, which is also known as free enterprise, the free market, laissez-faire, or capitalism. There are, however, several variants of a mixed economy, different degrees of government intervention coupled with relatively free markets. There are mixed economies where governments own some key industries and intervene extensively in business. France is probably one of the best examples of such an economy. There are mixed economies that have relatively minimal government ownership of businesses and varying degrees of government intervention, for example, the United States, Japan, Germany, and so on. And there is what is generally recognized as an unfettered market economy, also known as laissez-faire, which currently does not exist anywhere in the world.
To provide a better understanding of the U.S. market economy in which your company operates, we will perform a SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis in the following section. It will clear up the misconceptions and misinformation that are prevalent throughout our society about business and the economy. In addition, a SWOT analysis will reveal how even our “hampered” market economy provides an enviable standard of living for a substantial portion of the population.
Undergraduate business students typically learn how to analyze a company’s Strengths, Weaknesses, Opportunities, and Threats (SWOT) in a management course. When business students graduate, they have a tool that they either can introduce to the firm in which they are employed or assist managers who are already familiar with a SWOT analysis to gather the information to assess a company’s overall conditions.1
A company’s Strengths can be summed up succinctly: what gives it a competitive edge in the marketplace? The Strengths of a business are brand recognition, high market share, quality workforce, competent management, intellectual property, strong balance sheet, good corporate citizenship, seamless supply chain, clear strategic plan and vision, and other characteristics that make the business a “powerhouse” in the marketplace.
When a SWOT analysis is performed, a company’s Weaknesses may be obvious or subtle. Obvious weaknesses include the lack of a strategic plan, declining competitive position, insufficient cash reserves, operational bottlenecks, low employee morale and high turnover, declining workforce productivity, dubious marketplace image, and a “weak” managerial team. Other Weaknesses may be lack of intellectual property and poor inventory management. The matrix (Table 1.1) highlights many of these Weaknesses and a plan of action to deal with them.
Table 1.1 Weaknesses and solutions
Weaknesses |
Possible solutions |
• Lack of strategic plan • Declining competitive position • Insufficient cash reserves • Operational bottlenecks—inventory management • Low employee morale and high turnover • Declining worker productivity • Weak managerial team • Online challenges |
• Organize retreat of key management and/or hire management consultant • Evaluate products or services vis-à-vis competitors • Review expenses to reduce unnecessary costs • Eliminate obsolete inventory and install appropriate controls to balance sales and inventory levels • Provide incentives so they can be long-term employees thereby reducing hiring and training costs • Evaluate work flow to eliminate wasteful tasks • Hire managerial consultant to evaluate key personnel • Hire a web designer to improve online presence |
Companies could have a myriad of Opportunities—favorable external factors—to improve sales and profitability by entering new markets (especially overseas); by attracting successful management, marketing, and technical expertise; by introducing cost-saving techniques; by forming strategic alliances with new companies or competitors; by getting “ahead of the curve” as consumers’ tastes and preferences change; and being attuned to the unfolding political and macro-economic trends that could impact your operations. Overall, in the 21st century, companies may have to “reinvent” themselves by downsizing, reducing, or eliminating their brick-and-mortar stores and boosting their e-commerce. In short, astute and company business analyst or consultant must in effect be a “jack of all trades” who understand the economy’s Big Picture and can identify—and embrace—the Opportunities that propel businesses to greater success. Table 1.2 illustrates this approach.
If competition is a “war,” then there are plenty of landmines so to speak that could pose as lethal or debilitating Threats—factors that can harm performance and undermine a business’ future. An impending recession, foreign competition, financially stronger competitors, new technology, or obsolete product or service could threaten a company’s future, as well as competitors poaching its management and technical experts. Moreover, is the market for the company’s products or services decelerating? Are the marketing experts unaware of changing tastes and demographic shifts that are impacting the company’s sales and bottom-line?
Table 1.2 Opportunities and actions
Opportunities |
Possible actions |
• Expand locally, regionally, nationally, and overseas • Form strategic alliances overseas • Target new demographic market • Merge with a competitor or a firm in the supply chain • Purchase a successful or struggling competitor • Hire experienced managers |
• Research domestic markets and/or hire consultant for overseas expansion • Hire consultant who can investigate overseas firms for alliances • Evaluate marketing trends to expand into new demographics • Determine what firms would provide synergies, whether a competitor or a firm in the supply chain • Be on the look out for a competitor that may be for sale or a struggling competitor that may have valuable assets • Network with firms in your industry for a possible “star” to join your company and/ or use an online recruiter |
A SWOT analysis can help business decision makers pinpoint where they should focus their attention to improve their firm’s performance. The internal issues highlight the strengths and weaknesses of a company. Business decision makers should obviously build on the strengths and address as quickly as possible the weaknesses to improve the company’s prospects. By the same token, decision makers must be aware of the external factors—opportunities and threats—that would improve the business’ sales and profitability and be mindful of the threats that could undermine their companies’ permanency. The history of American business unfortunately reveals how one-time iconic companies—and products—have fallen by the wayside.
A SWOT analysis of the whole economy can provide business decision makers with the “macro” perspective about the ebbs and flows of the business cycle, which have widespread impacts on virtually all sectors. Thus, knowing where we are in the business cycle could provide valuable information for a business decision maker to plan appropriately and avoid the consequences of an economic downturn, which could turn profitability into substantial losses.
Examples of SWOT
Although SWOT provides an easily understandable general and easy-to-use method to highlight the internal and external factors affecting a business, additional information is needed to “drill down” to obtain the specific issues that should be addressed to create a better company.2 Nevertheless, by having an initial framework for distilling a company’s overall performance, analysts like Kenneth J. DeFranco, Jr. have used a SWOT to highlight, for example, Coca-Cola’s business strengths and challenges.3 DeFranco’s succinct analysis highlights the key aspects of each SWOT component after providing a brief history of the company. At that time, the author concluded that “conservative investors wanting a reliable source of income and a bit of capital gains exposure might want to give the Coca-Cola Company a glance.” Needless to say, a SWOT analysis is not a foolproof method for investor success but a good starting point to determine if the company’s stock is indeed a “buy” based upon a comprehensive evaluation of its Strengths, Weaknesses, Opportunities, and Threats.
A SWOT, therefore, can be used by internal analysts to improve the company’s prospects but also by financial analysts who provide guidance for investors. Additional SWOT analyses for 30 well-known companies—from Amazon to Facebook to Walt Disney—can be found at https://strategicmanagementinsight.com/swot-analyses.html. The website highlights a portion of the SWOT analysis and the rest can be purchased online.
The Market Economy: A SWOT Analysis
A Google search of a market economy and SWOT analysis does not provide any tangible results. However, a Google search of advantages and disadvantages of a market economy yielded more than 41 million results. It would take several lifetimes to review all the results of such a search. Nevertheless, a perusal of the common themes can be used to create a SWOT of the market economy.
A market economy’s Strengths, Opportunities, and Threats are obvious given some critical thought and examination of the subject. However, critics of a “pure” market economy assert there are Weaknesses that should be corrected by government policies, which will be cited in the SWOT matrix.
A free market economy nevertheless has many advantages over a command economy, where the government typically controls virtually all production and distribution of goods and services. The former Soviet Union and China before its economic reforms are examples of a command economy as is Cuba and North Korea today. All noncommand economies in the world today are mixed economies, where government owns or controls such sectors as railroads, airlines, utilities, highways, medical care, education, and other key activities. In a mixed economy, numerous government agencies, bureaus, departments, and so on regulate the private sector. The government intervenes in the economy with regulations that impact wages, prices, working conditions, and so forth. Most policy makers and many economists in the United States, Europe, and other regions typically support a mixed economy, claiming a mixed economy is preferable to a “hands-off” or laissez-faire economic system.
A SWOT of a free market economy (see Tables 1.3 and 1.4) resulted in the following analysis. The Strengths, Opportunities, and Threats and the subsequent discussion highlight how a free market economy would provide boundless opportunities for both large and small businesses and sustainable prosperity. The Weaknesses cited in the matrix are those of free market critics who claim that a mixed economy would eliminate the flaws they have identified (see Table 1.3).
Strengths
A free market’s Strengths can be summed up from the SWOT. In an unhampered market economy, entrepreneurs invest in productive enterprises to provide consumers with the goods and services that they value the most. Without burdensome regulations and low taxes, the theory of free markets asserts that an economy would achieve the highest living standards for both entrepreneurs and workers.4 Thus, according to the advocates of free markets, curbing government intervention in the economy would produce sustainable prosperity.
Weaknesses
Critics of the market economy assert that income and wealth inequality, business monopolies, pollution, the boom-bust cycle, and insufficient spending on education and public health are some of the negative consequences of laissez-faire economics. Economists in this camp generally support government policies to correct the “deficiencies” of a market economy. Other critics claim that a market economy lacks a firm moral foundation and therefore government intervention is necessary to combat what is viewed as the counterproductive “selfishness” and individualism of the free market. In short, according to this perspective, a free market does not promote a compassionate collective spirit and therefore should be tempered by enlightened social and economic policies.5
Natural income inequality occurs because some people have more talent, skills, or entrepreneurial drive than others. Professional athletes, entertainers, and self-made entrepreneurs as well as competent business executives—CEOs, CFOs, and other upper-level management—earn substantial multiples of the average individual income in our country. Individuals are highly compensated because of their talents. Interestingly enough, professional athletes and entertainers are rarely criticized for their multimillion-dollar annual incomes while corporate executives on occasion are excoriated—sometimes justifiably when they are fired for mismanaging a business with a so-called golden parachute—for their high salaries and stock options. Nevertheless, in a free market, “income inequality” is not a “weakness” but a reflection of reality that individuals with enormous talents in different fields are compensated handsomely.
Table 1.3 SWOT analysis of a free market economy
Free market economy Internal |
|
Strengths |
Weaknesses (according to critics of free markets) |
• Voluntary exchange • Price discovery • Private property rights assigned • Entrepreneurship • Capital investment and accumulation • Free trade • Financial markets • Competition • Higher real wages • Increasing living standards • Sustainable prosperity • Freedom to innovate • Peaceful international relations • Cooperation among market participants • Consumer sovereignty • Human capital development |
• Income inequality • Monopolies • Stagnant wages • Pollution • Underfunding of public sector • Health care disparities • Prone to boom-bust cycle • Unemployment crises • Market failure in some sectors • Insufficient regulations of business • Racism |
Opportunities |
Threats |
• Boundless penetration of domestic and international markets • Create quality products and services • alternatives to government services |
• Central bank manipulation of interest rates and creation of new money • Taxes • Regulations such as price controls, antitrust laws, minimum wage, professional licensing (to name a few) • Trade barriers • Tariffs • Eminent domain • Lockdowns • Political resource allocation |
External |
|
One of the most pervasive criticisms of a market economy is that it is prone to some businesses obtaining “monopoly power.” Historically, however, monopoly has meant a grant by the state to a company for the exclusive production or sale of a product or service in a specific geographic area. In other words, monopolies are not creatures of the free market but of government intervention. A business with substantial market share is not in and of itself proof of “monopoly power.” Even companies with a huge market share cannot dictate prices to consumers, because in the final analysis a business cannot raise prices more than what consumers are willing to pay. In short, in a market economy, consumers in effect “dictate” prices to businesses. Any business executive or small business owner knows that raising prices will tend to reduce demand for their product or service.
A free market economy, according to some critics, creates “externalities” such as pollution and therefore requires regulations to stop businesses from despoiling the environment. However, if pollution is considered a type of “trespass,” then the legal system should deal with this problem through lawsuits to prevent a polluter from committing noxious, toxic particles in the air and discharging water and other substances into rivers, lakes, and streams. In short, in a free market, property rights would be strictly enforced and the courts would punish polluters by making them pay for the damages they inflict on nearby property owners and the general public.6
A common complaint leveled at a market economy is that insufficient resources are “invested” in public education and health care. As far as public education is concerned, governments do not invest but spend other people’s money and therefore the money spent on public education is not a weakness of the free market but a criticism of the cost and structure of public education, namely, in some communities the cost per pupil is more than $25,000 per year.7
The cost of American health care as a percentage of GDP is the highest in the world. Our “hybrid” system of private employer-based insurance and government programs such as Medicare, Medicaid, and Obamacare subsidies now accounts for 18 percent of GDP, up from less than 7 percent 55 years ago, when both Medicare and Medicaid were enacted in the Johnson administration.
Opportunities
A market economy flourishes when entrepreneurs have the freedom to invest, innovate, produce, and trade—domestically and internationally—in order to meet consumers’ needs. Thus, fewer regulations, lower taxes, eliminating trade barriers, and financial stability create an environment for sustainable prosperity.
President Carter’s administration in the late 1970s undertook an extensive deregulation of major sectors of the U.S. economy, which unleashed the creativity of American entrepreneurs, and the slaying of the inflation dragon by then Federal Reserve Chairman Paul Volcker created conditions for a booming 1980s. For more than four decades since the Carter deregulation policies, consumers have benefited from the increase in competitive forces, which have led to lower prices in telecommunications, transportation, and other sectors that were stifled by the federal government’s interventionist policies.8
In the health care sector, even before the pandemic of 2020 revealed the weaknesses in the American health care system, physicians and entrepreneurs have begun to implement free market medical care all across America.
Physicians who were unhappy with the traditional medical practice where they would have approximately 2,000 patients and spend very little time with each patient opted out and created a Direct Primary Care (DPC) practice (https://www.aafp.org/home.html). In a DPC practice, a physician would typically have no more than 700 to 800 patients. Patients pay a relatively modest monthly fee and have access to the physician virtually 24/7. Neither patients nor physicians would have to file an insurance claim in a DPC practice, thus reducing the number of administrative staffers needed in office. At Forward, also a fee-only practice with offices in several major cities, innovative state-of-the-art diagnostic tests discover medical issues that could be treated before the onset of an irreversible chronic condition (see the Forward website, https://goforward.com).
Other free market innovations in health care include the Surgery Center of Oklahoma, which provides high-quality services at a fraction of the prices insurance companies pay in a typical hospital setting (https://surgerycenterok.com).
At Medibid.com, physicians literally bid for patients’ “business” bypassing insurance companies—the middleman—and charge much lower prices than a typical hospital-based procedure. And at Christian Ministries, individuals and families “pool” their funds to pay for the medical bills of their members. Although faith-based Ministries are not technically medical insurance, they are a throwback to the mutual aid societies of the 19th and early 20th centuries of community solutions to social and economic challenges (see https://www.chministries.org).
Although the pandemic of 2020—or more accurately the lockdowns throughout the country to halt the spread of the virus—caused businesses throughout the economy to close, from restaurants to mom-and-pop shops on Main Street to major retailers such as JCPenney and Lord & Taylor, new businesses emerged or expanded to meet consumer demands in the age of COVID.9 Companies such as Zoom, Etsy, Carvana, Restoration Hardware (now named RH), and dozens more engaged in e-commerce or filling a niche or void because of the disruptions have seen their common stock rise substantially throughout 2020.
Threats
Several years ago, Warren Buffett noted, “we will have periodic recessions and occasional panic but the good news is in the 20th century, we had two world wars, the flu epidemic, the Cold War, atom bomb, you name it. And the Dow Jones [Industrial Average] went from 66 to 11,004. All these terrible things happened, but America works.”10 We had the dot-com bubble, the housing bubble, and the deepest financial crisis since the Great Depression; the pandemic of 2020, which saw the U.S. economy contract by more than a 30 percent annual rate in the second quarter of the year and the unemployment rate jump to the highest level since the 1930s. Clearly, in the face of a public health crisis and periodic financial bubbles, the resiliency of the U.S. economy cannot be denied.
According to an annual survey published by the Competitive Enterprise Institute, Ten Thousand Commandments, an ongoing threat facing the U.S. economy is the more than $1.9 trillion cost of federal regulations (Crews, 2020). To put the costs of federal regulations in perspective, the annual survey points out that federal regulations cost each U.S. household $14,000 annually, which “equals about one-fifth (18 percent) the average pretax household budget as the second biggest budget item after housing.” The estimated $1.9 trillion regulatory cost is slightly less than the “$2.5 trillion COVID-19 Phase 3 stimulus bill Congress passed in April 2020.”A bright spot in the annual survey is that the number of pages in the Federal Register declined during the Trump administration to an average of 66,490 pages per year, substantially less than the annual average of 80,420 pages during President Obama’s presidency.11
Additional threats that could undermine rising living standards include trade wars, increased federal spending accompanied by huge budget deficits, and monetization of the federal debt by the Federal Reserve, all of which have the potential to cause higher price inflation and rising interest rates. The debt/GDP ratio has been on an upward trajectory since the dot-com bubble burst in 2000. Historically, rising debt levels and central bank monetization of the debt have created widespread dislocations in both production and the labor force.
The Mixed Economy: A SWOT Analysis
Although the United States has never been an unfettered, laissez-faire economy, our mixed economy has “delivered” the goods for several decades despite being hampered by interventionist public policies. Real GDP has increased markedly since the end of World War II even as periodic recessions put a temporary halt in the rise of goods and services. Suffice it to say, Warren Buffett’s observation at Berkshire’s 2019 annual shareholder meeting—billed as the Woodstock for Capitalism—was spot on, “I believe we wouldn’t be sitting here except for the market system.”12
A country that has an unhampered, unfettered, laissez-faire economic system is a “pure” market economy. All the Strengths of a market economy would be in full bloom if government intervention were kept at a minimum or nonexistent. Mises’ insightful book was written in 1940 and then translated from the original German decades later. His analysis highlights the so-called third way between capitalism and socialism, which he dubbed “interventionism,” and why it is not a viable alternative to a pure market economy. In contemporary economic discourse, interventionism is usually described as a mixed economy.13 I have described the internal and external characteristics of a mixed economy in Tables 1.3 and 1.4, respectively.
Sound economic analysis requires a thorough understanding of the effects of government intervention. Instead of asserting that a mixed economy is “superior” to a market economy by “smuggling” ethical judgments into their analyses, critics of free markets have left themselves open to a valid rejoinder. Namely, how would a mixed economy, which requires a vast bureaucracy to implement, create optimal outcomes in production, employment, and consumption?
Table 1.4 Mixed economy: Internal and external characteristics
Mixed economy |
|
Strengths |
Weaknesses (according to critics of mixed economy) |
• Voluntary exchange • Price discovery • Private property rights generally assigned • Entrepreneurship • Capital investment and accumulation • Free trade • Financial markets • Competition • Higher real wages • Increasing living standards • Freedom to innovate |
• Income inequality caused by monetary inflation and regulations • Monopolies (state sanctioned) • Stagnant real wages • Bloated public sector • Health care distortions • Prone to boom-bust cycle • Overbearing business regulations • Domestic and international trade restrictions |
External |
|
Opportunities |
Threats |
• Boundless penetration of domestic and international markets • Create quality products and services alternatives to government services |
• Central bank manipulation of interest rates and creation of new money • Persistent business cycles • Taxes • Regulations such as wage-price controls, antitrust laws, minimum wage, professional licensing (to name a few) • Trade barriers • Tariffs • Lockdowns • Eminent domain • Political resource allocation |
Proponents of a mixed economy do not address the weaknesses inherent in an interventionist economic system but instead rely on unwanted assertions and dubious ethical objections to criticize a pure market economy.14
Economist Robert Higgs applied insights about interventionism in his analysis of how government grows. As Higgs points out, “There was a time, long ago, when the average American can go about his daily business hardly aware of the government—especially the federal government. As a farmer, merchant, manufacturer, he could decide what, how, when, and where to produce and sell his products, constrained by little more than market forces.”15
Higgs reviews the theoretical underpinnings of the growth of government and then pivots to the historical changes that transformed America from a relatively laissez-faire economy in the 19th century to a mixed economy that has grown with every periodic crisis since then. Those crises include war and the Great Depression, and the ideological shift of policy makers to a more interventionist mindset that laid the foundation for President Johnson’s Great Society programs.
Innovation, Capital Formation, and Entrepreneurship
A mixed economy like the United States, even with the counterproductive interventions governments have imposed throughout our history, has had an incredible number of innovators and creative and forward-looking entrepreneurs, generation after generation. A robust financial system has provided the necessary capital to take ideas from the laboratory and the proverbial basement or garage to the marketplace. Next, we shall see how the essential factors of our economy have been able to create goods and services for the masses.
Innovation
Innovation, simply put, is doing things better; Henry Ford’s assembly line is probably the most well-known idea that was implemented and literally revolutionized the manufacturing process. As historian and journalist Harold Evans points out, “Innovation … has turned out to be a distinguishing characteristic of the United States. It is not simply innovation; it is inventiveness put to use.”16 Evans’ sweeping survey of America’s inventors, innovators, and entrepreneurs begins with John Fitch and the first steamboat in America and ends with Larry Page and Sergey Brin, cofounders of Google. In between, Evans highlights the enormous contributions of scores of men and women who transformed America from a vast untamed continent to the economic powerhouse it is today—in just over two centuries. Although other countries have also been endowed with natural resources—Russia, China, Australia, Canada, Brazil, Argentina, and South America—Evans attributes America’s success to what he calls the “genius for innovation.”
For example, Robert Watson Watt invented radar in England in 1935, which was instrumental in helping the British win the Battle of Britain in World War II. Nevertheless, it was American innovators who ran, so to speak, with the radar technology and created the electronics industry. Other British inventions and discoveries—penicillin (1928), jet propulsion (1930), and commercialization of computers (1951)—became the basis of American innovation and industrialization. Clearly, innovation is insufficient for ideas to be transformed into great companies and industries.
Another key feature of innovation is the “democratization” of goods and services. Evans points out how banking, photography, e-mail and the Internet, computers, and a host of other goods and services that originally were only available to the economic elites in the country became accessible to the so-called common man. Innovators not only were interested in profits but by a sincere desire to improve the lives of the masses by keeping prices affordable.
Forbes magazine has compiled lists of the most innovative companies, ideas, and American leaders.
In 2020, the five most innovative companies, according to the Boston Consulting Group (BCG), were household names—Apple, Alphabet, Amazon, Microsoft, and Samsung—as you would expect.17 Not surprisingly, the top five companies are all in the broad category of technology, either creating hard goods or applications or providing services for both consumers and businesses. Samsung, the only non-American company, was founded in 1938, while the four American companies were founded within the past 45 years. Other well-known international companies on the list of the 50 most innovative companies of 2020 include Alibaba, Sony, SAP, Hitachi, Tencent, and Volkswagen. Some of the U.S. companies that made the list include IBM, Facebook, Tesla, Walmart, Costco, and Dell.
According to the BCG report, the top innovative companies focus their strategies to take advantage of opportunities when economic downturns occur and thus have been able to provide superior returns to investors over the long term.18
Innovative companies would not be successful without farsighted leaders who take a long-term view of implementing their vision. Heading up the list are Jeff Bezos, Elon Musk, Mark Zuckerberg, Marc Benioff (Sales-force), and Reed Hastings (Netflix). The compiled list of America’s 100 top innovative leaders is based on several metrics but the one that stands out is creating both value for consumers and high returns for both investors.19 In short, the innovators of the current era are no different than the 18th-, 19th- and 20th-century innovators—they took an idea and transformed it into a valuable good or service by making it available to the masses.
Lastly, Forbes compiled a list in order of importance of the most innovative products and services of the past three decades based on the Public Broadcasting System show the Nightly Business Report on the celebration of its 30th anniversary on the air.20 Virtually everyone on the planet has been touched by a multitude of innovations both at home and in the workplace. Worker productivity has increased immeasurably as data and information have become easily accessible and stored efficiently. People have been able to communicate seamlessly through the Internet at a fraction of the costs in previous eras. In fact, in addition, countless lives have been saved and prolonged because of early diagnosis of diseases, which made effective treatment possible. Moreover, the pandemic of 2020 has increased the use of remote learning and conferencing as well as telemedicine. The events of the past three decades are a testimony to the endless innovations that have been a hallmark of the American experience.
Entrepreneurship
Inventors and innovators as brilliant as they are must also have the drive and perseverance to turn their ideas to products and services in the marketplace. The innovators on the Forbes list are also entrepreneurs, the “movers and shakers,” who act upon their vision to build a sustainable business until the next disruptor comes along. They had an idea, from Jeff Bezos who began selling books through the mail, which has since blossomed into an e-commerce behemoth, to Mark Zuckerberg who created a social media platform connecting billions of people from around the world who otherwise would probably never have met, to Reed Hastings CEO of Netflix, which began as DVD mail rental business and now oversees one of the most successful live streaming services in the world that also creates its own content.
One of the most well-known examples of an entrepreneur who took an already existing idea, the McDonald brothers’ San Bernardino, California, restaurant menu of only hamburgers, fries, and drinks and turned it into one of the most visible brands in the world, McDonald’s. Ray Kroc began franchising McDonald’s restaurants in the mid and late 1950s after he witnessed the quality and service of the brothers’ operation, and in 1961 bought the exclusive rights to the McDonald’s name and operating system. And as they say, the rest is history.
The McDonald brothers were both innovators and entrepreneurs. Their restaurant operating system became the model for other restaurant chains to emulate. But instead of joining Ray Kroc in taking McDonald’s to the next level, which eventually became one of the most iconic consumer brands in the world, the brothers were content to sell their rights to Kroc who became one of the great entrepreneurs in American history. Kroc in effect democratized fast food in the United States and brought his entrepreneurial vision to the rest of the world.21
Capital Formation
Capital can be described as simply as the “stuff” that makes other “stuff.” In other words, everything from machinery, factories, transportation equipment, and other “capital goods” which are essential to create products for eventual sale to consumers at the retail level constitute the capital goods sector. The factors of production include the following: Land—physical and natural resources; Labor—blue- and white-collar workers; Capital—factories, machinery, transportation equipment, materials, and intellectual property.
Another critical component not only for capital formation but also for an economy in general, without which industrialization would be impossible is money. At each step of the production process, money is exchanged to purchase raw materials, invest in capital goods, hire workers, pay for research and development, and pay dividends to shareholders. In addition, businesses need money to pay their taxes. A market economy is in effect a countless number of monetary transactions throughout the structure of production, from extracting resources to retail sales. In our $20 trillion economy, with a population of 330 million people, a reliable payments system is the “grease” that makes the economy run as smoothly as it does.
Capital formation occurs when individuals—and businesses—first save and then invest. The act of saving is an essential step in the capital formation process. Savings are then invested directly into businesses, which is better known as venture capital, as entrepreneurs use the funds to build or expand their enterprises. The founders of Apple, Google, Facebook, and other contemporary companies and the entrepreneurs—Ford, Carnegie, Rockefeller, and others—of bygone eras tapped the savings of friends and family and others who provided the financial resources they needed to get their businesses off the ground. Once a company is established, it can then tap the capital markets for additional resources, where the general public can invest their capital in an initial public offering (IPO) and/or purchase a company’s bond, which could be used for additional capital goods purchases. The banking system also channels the public’s savings into loans for entrepreneurs. In addition, a portion or all of a company’s profits can be plowed back into the business (retained earnings), another form of savings.
Capital formation therefore provides several major benefits for a market economy. It increases worker productivity and thus their real wages; it lowers the cost of production and thus helps drive down prices making more goods affordable for the masses; it makes possible for innovators to see their ideas become realities in the marketplace. In short, capital formation is indispensable for both innovators and entrepreneurs to satisfy the needs of the people and thus increase their living standards. Without capital formation, living standards would be near the subsistence level throughout the world. A free market, with a vibrant capital market, provides the framework for a growing economy. Any interference with the capital formation process lowers living standards from what they would otherwise be. Critics of the free market, who tend to ignore the consequences of their interventionist policy prescriptions, disregard the crucial role capital formation plays in the economy.
The private nonresidential fixed investment in the United States since the end of World War II has grown from $25,000,000,000 to more than $2.6 trillion today. In fact, it correlates step-by-step with the growth of real GDP (see Figure 1.1), revealing how an economy must invest in capital before goods and services can be consumed by the masses. There is no shortcut to creating consumer goods without an enormous investment in capital good, which is one of the most important lessons of economics and business.
Figure 1.1 The growth of real GDP and investment
Source: U.S. Bureau of Economic Analysis, Real gross domestic product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDPC1, March 24, 2021.
U.S. Bureau of Economic Analysis, Private nonresidential fixed investment [PNFI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PNFI, March 24, 2021.