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Economics101

Innovation, Efficiency, and Competition:

The Invisible Hands of Wealth Creation

August 2012

 

Jobs and the economy.  Being an election year there is plenty of talk about jobs and the economy, about the price of fuel and food, about the balance of trade amongst nations, accusations of misguided policies of incumbents and past administrations, and about the appropriate amount of taxation going forward.  What has frustrated me is the fact that these discussions are incredible shallow, and virtually nobody can explain how wealth and value actually gets created in the first place. 

 

How does wealth get created?  Where do jobs come from?

 

This note attempts to explain the basics of wealth creation in society.  Its purpose is to offer the reader a guide to a basic understanding of economics. It does not talk about wealth accumulation or how to get rich.  My goal is to help you interpret the issues being discussed in an election season.  Longer term, it will help you understand the path that society needs to stay near in order to dig itself out of this hole we’re in.  I could walk the reader through introductory concepts, but I’m hoping to keep this note accessible by teenagers, so I’m going to dive right in and get to the point:

 

·         Wealth is not money; wealth is the set of things people create, provide, want, or consume, usually using money as the exchange medium. Money is a way of moving wealth around.

·         Wealth distribution and redistribution for occurs in the transaction of the marketplace.

·         The essential sources of new wealth creation are efficiency and innovation.

·         The free market inherently redistributes wealth toward innovation and efficiency

·         Competition inherently redistributes wealth away from providers and  toward consumers.

·         Market controls and price manipulation are subject to the laws of supply and demand and reduce the amount of resources that would have otherwise been available for wealth creation.

·         The Government takes a piece of every transaction

·         The data shows that 20 percent is the most the government can take before the invisible hands of wealth creation are tied.

 

 

Money is a way of moving wealth.

 

If you want to create wealth, it will help to understand what it is. Wealth is not the same thing as money. Wealth is as old as human history. Money is a comparatively recent invention.

 

Wealth is the fundamental thing. Wealth is stuff we want: food, clothes, houses, cars, gadgets, travel to interesting places, and so on. You can have wealth without having money. If you had a magic machine that could on command make you a car or cook you dinner or do your laundry, or do anything else you wanted, you wouldn't need money. Whereas if you were in the middle of Antarctica, where there is nothing to buy, it wouldn't matter how much money you had.

 

Wealth is what you want, not money. But if wealth is the important thing, why does everyone talk about making money? It is a kind of shorthand: money is a way of moving wealth, and in practice they are usually interchangeable. But they are not the same thing, and unless you plan to get rich by counterfeiting, talking about making money can make it harder to understand how to make money.

 

Money is a side effect of specialization and division of labor. In a specialized society, most of the things you need, you can't make for yourself. If you want a potato or a pencil or a place to live, you have to get it from someone else. [1]

 

Wealth is distributed through the transaction.

The source of all wealth distribution is in the transactions that take place amongst individuals and amongst groups of individuals.  That transaction occurs at some price.  If the buyer and seller both think they are getting a good deal, then there is wealth being created for both parties.  There is plenty more one can say about the subject but yes, it’s that simple.  I’ll say it again in other words: as long as the transaction price is between actual cost to the provider and maximum value to the consumer, then the transaction represents a little bit of wealth creation for both parties.

 

Innovation and efficiency is the source of new wealth creation.

The total value of a transaction is the difference between the maximum value the consumer places on a product or service and the actual cost to the provider to deliver the product or service.  If the provider can do things more cheaply, then total value can increase without changing the transaction price,  Similarly, if a new product or service has features or quality that exceeds what was available in the past, then total value of the new product or service is greater than that of the old product or service.

 

The transaction and the role of innovation and efficiency in wealth creation can be illustrated via the following figure:

 

Figure 1. When the price of a product or service floats between the maximum value placed by the recipient and what it costs the provider to deliver that product or service, then the transaction puts a little wealth into the pockets of both parties.  Innovation leads to things of greater value, while efficiency increases the amount of money or resources available to do other things.

 

 

Innovation creates new products and services that consumers are more interested in.  Resources thus flow in the direction of the most valuable innovations.

 

Figure 2. The invisible hand of innovation-based wealth creation

 

Competition on price is the “invisible hand” of the marketplace that pushes prices lower, thereby redistributing wealth from producers to consumers.    Simultaneously, more efficient producers can deliver at lower cost, thereby gaining more wealth with each transaction.  These concepts can also be illustrated:

 

Figure 3. Wealth redistribution due to competition and due to efficiency

 

Market Manipulation: Supply, demand, and the source of wealth destruction

 

Now we can turn our attention to the laws of supply and demand.  Before I do I need to say something about price.  The price of anything is like a butterfly.  The seller might want to be in control of the price but, like the butterfly, it is forced up and down by a number of forces that interact in complex ways.  There is competition, but there is also intentional and unintentional manipulation by government, by groups of providers, and by groups of consumers.  Sometimes this manipulation is called exploitation, and it’s usually enabled by a lack of timely knowledge on the part of the exploited.

 

Forcing prices lower will generally increase demand but without finding ways to do things more efficiently, producers start to walk away - pushing supplies lower and create shortages.  Conversely, pushing prices higher decreases demand but can lead to increased supplies and wasteful surpluses.  We can and should view shortages and surpluses as an indicator that the price is being manipulated one way or another, and when the transaction wealth for either the buyer or the seller gets too small, people just walk away.

 

Figure 4.  Supply and Demand in the face of price manipulation. If the value of the transaction for the seller gets too small, supplies shrink and shortages occur (top).  As the transaction value for the buyer shrinks, supplies grow and useless surpluses exist (bottom).

 

The Government Takes from Every Transaction

Now I want to address the role of taxation and regulation.   It does not matter if you are the consumer or the provider, the government always gets a piece of both sides of that transaction.  If you think of it in terms of the transaction wealth as being shared with the government, we can see that wealth is being redistributed from private parties to the government.  In terms of the role the transaction plays in the concept of the pursuit of happiness, we see that private entities compete with the government.

 

Figure 5. While transaction price determines incremental wealth for producers and consumers, the government takes a chunk of that wealth from both parties.  It’s a different amount taken from both sides, depending on myriad factors.

 

A note about the government as a provider and a consumer: When the government takes from the transactions it gets a pot of money to invest.  It generally becomes a consumer that gets to influence what goods or services it wants to consume.  The government then gets the opportunity to redirect resources toward innovation it wants to see, and as long as it encourages or enforces competition, it will also help generate new wealth from the invisible hand of efficiency.  As a service provider, the government is generally known for inefficiency, and that is probably connected to the lack of competition in government-provided services.  Conversely, if the government throws your money away on loans to Solyndra , then there is a good chance it’s just redistributing wealth without any new wealth creation.  That’s incompetent at best, corruption at worst.

If the total value of all transactions is called the Gross Domestic Product (GDP), then according to data spanning the last 60 years, the federal government alone gets, on average, about 20% of each and every transaction.  Here’s the evidence:

 

Figure 6. Federal revenues are essentially a fixed income at 20 percent of GDP.  State and local taxes (not shown) add another 15 percent or more.  They can’t get any more because I believe that’s the point at which incremental wealth creation in the transaction becomes so small that the buyer or the seller walks away from the transaction.  That’s just a hypothesis on my part and requires more study to validate. (Source: http://reason.com/blog/2010/11/29/the-remarkably-stable-amount-o)

Listening to so-called experts about this stuff is mind-boggling.  Some of them argue about what we should do to increase GDP, some want to increase revenue.  Some want to increase or decrease how the consumers get taxed, while others want to increase or decrease how producers get taxed.  Finally, there’s the Federal Reserve and the effect of it’s ability to simply print money or otherwise influence the number of transactions.  It’s very confusing, and in the end it’s my opinion that they rarely say anything that makes much sense or is of much use to anyone.

One thing we know for a fact: federal revenues seem to be maxed out at 20% of GDP.  I don’t know why, but that’s the way it is. That’s a fixed income.  The federal government wants to spend more, so what does it do?  It pulls out your credit card and keeps spending!  Day after day for nearly 40 years the federal government keeps racking up credit card debt and pretends that it doesn’t matter.  It does matter, and nothing is too big to fail.  That irresponsible behavior is morally wrong and financially stupid for individuals, for families, and for entire federal governments.

 

Figure 7. Federal revenue is influenced by many factors but seems to be capped at 20 percent of total value of all the transactions (i.e. GDP).  This illustration is similar to what is called a Laffer Curve, that basically says there is some sweet spot of taxation that maximizes revenues.  I think it’s a simple and truly flat 10% tax on all incomes, personal and corporate, regardless of income level.  This frees up maximum resources for innovation and efficiency, the source of new wealth.

 

 

Jobs and the economy.  It’s an election year and the factors influencing job creation and improving the economy is the main topic of discussion.  What I’ve described here tries to explain that wealth creation comes from innovation, efficiency, and competition.  If you want a strong economy and lots of jobs, then you need to maximize the resources available for individuals on both sides of the transaction to decide what is efficient and useful and quit screwing around with the current shell game of price manipulation and inefficient, complex taxation policies.  In my mind that implies lower uncertainty via Look for a president and for representatives who acknowledge the 20% hard limit on federal spending and the need to pay down the debt.  Look for a president who seeks high efficiency in government functions and low uncertainty via simplified taxation policy. 

 

End notes

[1] this section adapted (mostly plagiarized really)  from http://paulgraham.com/wealth.html

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