Basic Economics – Part 4 – Creating Wealth

This is the fourth post in a series inspired by Thomas Sowell

I would postulate that most people look at the wealth of the world as a giant pie of which everybody has a slice, large or small. If one person has a larger slice, , that means he or she is taking pie from others, forcing others to have less pie. When one person gets richer that means somebody else must get poorer. This assumption is the underlying argument in the whole income inequality debate.

This assumption is also totally false. Wealth is not a fixed size pie. For example, lets say a sculptor takes a plain rock worth nothing and carves it into a beautiful statue and sells it for $1000. The sculptor now is wealthier, but has she made anybody else poorer? Obviously, she hasn’t. She has increased the wealth of the world by the value of the statue over the rock. She has created wealth.

Wealth is the total value of all of the goods and services. Money is not wealth. Money is the total claim against wealth. If you own one one trillionth of the money in the world, you can claim one trillionth of the wealth. Let’s say tomorrow the United States government implemented a new policy where for every dollar a person owned, he or she would receive an additional dollar. If you owned $10,000 before, you now own $20,000. This would not double wealth. It would not create any new wealth. This creates no new goods or services. It just doubles the claim against existing wealth so each dollar would now be worth half of what it was before. If something cost $10 before, it would cost $20 after.

I once had an economics professor burn a dollar bill in front of the class. He stated that in doing so he did not destroy any wealth. By removing his claim of $1 worth of wealth, he made everybody else an infinitesimally tiny amount richer.

If a person becomes richer without creating any value in exchange, this means he or she is taking a larger slice of the same sized pie and is in fact making somebody else poorer. On the other hand, if the person becomes richer by creating additional value, he or she is making the pie bigger. Not only is this person not making anybody else poorer, but if this person takes less pie than he or she creates, the person is making other people richer as well. So how can we say if value is created? We can say value is created when someone voluntarily pays for it. If our sculptor creates an ugly statue that nobody will pay for, she has created no economic value. If she creates a masterpiece that she sells for one million dollars, she has created a lot of economic value.

In our previous example, we know the coffee shop has created value, created wealth when someone is voluntarily willing to pay for the coffee. When someone works for an hour and someone voluntarily pays for the work, there is value. If on the other hand someone works for an hour and the government says the boss has to pay the person, then we really have no idea if the person created value. The person could have done just what the boss wanted or the person could have done absolutely nothing. When a transaction stops being voluntary on both sides, we no longer have any way to measure value, to determine if wealth is created.

People only participate in a voluntary transaction if they perceive the value of what they receive is greater than the value of what they pay. If the boss has to pay you $10/hour and the boss perceives that in doing so he can’t generate at least $10 an hour in additional income, then the boss isn’t going to hire you. There is no reason for the boss to hire you. If, however, the boss thinks he can make an additional $20 by hiring you, then the boss hires you. You make $10 and the boss makes $10 and both of you are better off.

Steve Jobs made billions of dollars through his innovations with Apple. In making his billions, did he make the rest of the world richer or poorer? The answer here is obvious.

At the beginning I stated that most people have the false assumption that when somebody makes more money, he makes other people poorer. I am showing here that the reverse is true.

If someone makes more money, he makes other people richer!

Now I know this is not always true. There are holes in this argument. I will address these holes in the next segment.

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