After nearly 14 weeks of classes, I think some of our students finally appreciate the importance of (and sources of) wealth creation. However, an unexpressed theme or concern seems to run through many of the questions and comments I get from students. My interpretation goes something like this:
“Professor Rizzo, I understand that expanding trade through the expanded use of specialization and the division of labor makes participants in those trades richer. But doesn’t all that wealth creation make those who are not part of this expanding circle worse off?”
I don’t actually get the questions phrased this way, but I sense it is there. How can we reply to this concern briefly?
One reason for this concern is that students think that when one person gets wealthy, he “gets” more money, and what that does is dilute the purchasing power of the money that existing poorer people have. Is this a good way to think about increases in wealth? Well, consider one way a fellow might get wealthy (call him Joe). Right now Joe is largely self sufficient, and he has a part-time job selling newspapers. However, Joe is a funny fellow, and in his spare time he manages to write some very funny books that sell really well. Joe makes a million dollars from these sales.
Many folks think that since Joe has a million dollars, he will use those dollars to purchase movies, computers, clothes, vacations, etc. and that in turn will increase the prices of each. And if the prices of all of these things increase, then it must be the case that poorer people who used to buy them are worse off because Joe has become rich. Students may even call this an “externality” (it is not, but I am trying to characterize the thinking I see). Since Joe’s actions produce external costs for others, there is perhaps a justification for mitigating these actions.
Note however that if that were true, then no economic progress would be possible. Ignoring that, the actions of Joe and his customers in no way hurt anyone, especially those folks that are not parties to the transaction. Ignoring for the time being the correct micro-economic analysis – from a social standpoint, if higher prices did, in fact, prevail from the activities above – these would not be compensable externalities. Why? Because there is no net social loss from those higher prices. There are sellers on the other sides of those markets. So if it is true that some lower income buyers must pay higher prices for movies or vacations, then it is also true that sellers will be receiving higher prices for those goods. So, from a social standpoint, there is no net loss – and hence no reason to mitigate the (pecuniary) “externality.” In fact, we permit this sort of a thing every single time we transact.
But think more deeply about whether the creation of a new product by Joe can actually be bad for anyone. It does not pass the smell test. Before Joe started writing, the world had some amount of goods and services available to it. After he writes his comedy books, the world still has all of the original goods and services PLUS a bunch of funny, enjoyable books to read. There are more resources available after the creation than there was before.
How does this play out when money is involved? Well, where does Joe get his million dollars of money from? Not from thin air? That money (which represents claims on goods and services already produced) has to come from other consumers who value the comedy more than they do the other goods and services that they would have purchased with the money. So they are clearly better off. But our concern here was with people that are not party to the transaction – non-book buyers. Well, since the book buyers now have less money or claims to goods and services, it must be the case that the prices of all of the things that they would have purchased were it not for the comedy books must have fallen in response to their reduction in those purchases. In that sense, non-parties are no worse off than they were before the comedy books were created.
But it is even better than that. When the new books are created, it will tend to “force” down the price of all of the other goods and services for sale in that economy! How? Well, money prices are simply a numeric measure of the tradeoffs that one must incur to secure a good or service. When there are few goods and services around, customers must sacrifice a great deal of other goods and services to purchase a milkshake. In a world of money, when there is a lot of money in people’s hands, it will require a lot of money to secure the milkshake. But when there are more goods and services available, and a fixed amount of exchange media (money), then some of the “money” that would have been used to secure milkshakes is now being used to secure comedy books. Thus, there is the same amount of money “chasing” a larger pool of goods – meaning that each good will require less money to be purchased.
It is in that sense that the production of new goods and services not only enriches the parties to that original transaction, but it also enriches people that are NOT party to those transactions. It is hard to see these effects in a multi-trillion dollar economy when one or two new goods are created, particularly when the monetary authories are burning the motors of the dollar printing presses at the same time. But those effects are there. And for evidence that those effects are there, simply look at what has happened to the real cost of securing goods and services over time as new goods and services have proliferated. Even for goods that were available in 1800, 1850, 1900, 1950 and today (such as eggs, cheese, t-shirts, etc.) the real tradeoffs customers must make to secure them have declined substantially. One reason for this is that we are able to produce cars, iPhones, eyeglasses, etc. with the same amount of resources that we used to only be able to produce food, shelter and clothing. And as a result, there are more resources available for consumers – just as in the case when Joe authors his new comedy books.
For simplicity, I would probably start at three islands and three Robinson Crusoes. How would the fact that Crusoe A and B start trading effect Crusoe C who is still isolated on his island?
“…but it also enriches people that are NOT party to those transactions.”
Sorry I overlooked that point. you should save it for your first bestseller.
So much money is spent on overhead, some of it wisely, much of it wasted. Most of us are willing to spend money on the military, which, regardless of how effectively they spend it, is all overhead to protect us from many threats.
But then our township manager is pure overhead, as opposed to the people on the road crew who actually fix potholes. Our government servants are all overhead, people managing our lives, creating nothing but cost to provide services to us, who have calculated that somebody else will pay, in part or in full, for our servants.
The key to prosperity, as you have put in other words in your essay, is to work to produce goods and services that people will pay freely for with money, which has to be a credible proxy for their goods and services.
I know I stuck in “freely,” but it distinguishes us from them. It happens that without freedom, everybody in history has failed, where we have prospered.