14 June 2012

Where Does Wealth Come From?

This post is a part of an ongoing discussion of innovation policies at the conceptual level, which will eventually lead into a much more empirically focused set of discussions. For me, these posts are about ensuring that I am clear on the concepts that I am discussing, which draw upon a wide literature in (so far) economics, sociology, policy sciences and S&T policy.

Last week I presented a definition of wealth as the accumulation of valued outcomes. Here I ask, where does wealth come from?

This question is necessary to ask and answer if we wish to make collective decisions that lead to greater wealth. Any one who offers a judgment on questions of policy -- that is, decisions focused on attaining valued outcomes -- operates with some conception of the mechanisms through which we attain wealth, whether explicitly or implicitly held. This post is my attempt to lay out a coherent and simple explanation of how I would answer this question.

In a particular context or setting, wealth comes from four sources:
Effort -- This is closely related to the conventional economics concept of labor (and perhaps some economists define labor exactly in this manner), but by effort I mean work not workers. Effort is action.

Resources -- Tangible and intangible assets, which include (importantly) energy, and other environmental and human attributes. This is closely related to some conceptions of "capital" as used by economists (and, again, perhaps some economists use exactly this definition).

Luck -- There are some consequences that are simply the result of factors beyond our intentional actions. These would include, for the individual, a genetic predisposition to good health or a Monet found at a garage sale, and for a nation, bountiful energy resources. Luck can be good or bad with respect to valued outcomes.

Innovation -- Here I mean the Solow residual (in economics terms). In plain language, it is what Peter Drucker defined as "change that creates in a new dimension of performance" or what Joseph Schumpeter defined as "any “doing things differently” in the realm of economic life."
I emphasize the importance of context or setting, which is characterized by some existing combination of effort, resources, luck and innovations (i.e., wealth). From a policy perspective, we do not get to choose the initial context from which decisions are made, that setting is the consequence of history and contingency. What matters is what we do given a particular context.

From the perspective outline here, should we wish to attain greater wealth the most important lever is innovation, which of course can influence effort and resources (i.e., thereby changing aspects of the current context). Luck is largely (but not entirely) not subject to such influence.

The purpose of outlining such a conceptual model of where wealth comes from, in the words of Karl Marx, " is not merely to understand the world, but to change it." Comments, criticisms welcomed and encouraged.

20 comments:

  1. I'm not sure about the "effort" category. Specialization enables each worker to produce more per unit effort. Are you lumping concepts like that under innovation? That's not typical since the workers are doing things the same way, it just requires less effort.

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  2. I agree with Bret. Effort (as an "action") is a flow of work from a certain worker. The resource is not the effort but the worker with all her innate and acquired skills and capabilities, that may or may not be put to use and may or may not display their maximum "effort" when mobilized.

    Nor, increasing the stock of "human capital" (in the sense of the whole stock of skills and capabilities) and improving the mechanisms and incentives that put them effectively to work. Wealth can be created by addition of more labor, or improvements in the skills of labor, or making workers display more "effort" when they are working, but "effort" here does not mean physical exertion: it means fuller use of capabilities.

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  3. -1-Bret and -2-Hector M.

    Thanks much.

    Here is an illustration of effort -- A farmer may value having food in the winter months. To achieve that outcome he needs to work 16 hours a day rather than 8 hours. The additional effort leads to the desired outcome. In this constructed case the output scales with the effort. I think "fuller use of capabilities" is a fine descriptor.

    Specialization is a form of innovation -- see my post of the Hooters girls for a specific example of this.

    Thanks!

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  4. Received via email:

    "I think wealth is also 3 other things that you left out:
    1) Knowledge. We now know how to treat many diseases instead of just letting people die (which also by the way is part of why health care costs rise more in wealthy countries--there are treatment options instead of just becoming blind or crippled and people are willing to pay for it).
    2) Infrastructure. The www increases my wealth, as does the highway system and sewage system, by making things work better. The "innovation" of plumbing does not help people in many 3rd world countries because they lack the infrastructure.
    3) Institutions. You can't have plumbing without a functioning civil government. Obviously. But also libraries, fire departments, schools are institutions that add to wealth.
    Craig Loehle, Ph.D."

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  5. -4-Craig

    Thanks ... some replies:

    1. Knowledge is an intangible asset. When turned into practice it is an innovation.

    2. Infrastructure that leads to a new dimension of performance is an innovation.

    3. As are institutions.

    Thanks!

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  6. So how do you fit the actions of robots into your scheme ? If that effort ? Or resources ? or ....

    Luck is more an explanation for why free markets do not result in a strict meritocracy, rather than an element in wealth creation. Luck explains why him and not me, all other things being equal, but I am tempted to suspect that luck or probability is either zero sum or not far from it.

    Knowledge can be wealth - if we value it, as can institutions.





    Freedom is important. I think effort and innovation derive from it.
    Further so long as we are free to create wealth, precisely where it comes from is not particularly important. Given that we have needs and wants, and the freedom to meet them, we will find a way to create wealth.

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  7. -6-dlhii

    Thanks ... robots are an innovation, if they result in change that results in a new dimension of performance (post on this in quantitative terms comes soon).

    Agreed that knowledge can be wealth, institutions too. One person's ends are anothers means, which is one factor that makes both the economics and politics so complicated.

    Thanks!

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  8. I think part of what Dr. Loehle refers to wealth in regards to infrastructure is the effect on productivity.

    Perhaps I am being caught up in semantics, but 'outcomes' to me speaks of results. Infrastructure in the sense of enablement is not innovation nor is it money (except in the sense of rent seeking), but rather is investment in order to improve productivity.

    Thus while a new process improves productivity via innovation, infrastructure improves productivity via environment change.

    It can also be said to be a creation of resources, though obviously not natural - a road system, dam, or bridge is very much a resource once created.

    Once the first irrigation project was built, subsequent irrigation projects are not innovative in the sense of creation of a new process, but are enabling in the sense of bringing water to improve the farming capability of areas otherwise too dry.

    I believe Dr. Tol refers to the above proliferation as innovation, and perhaps you do as well, but if so then innovation encompasses such a broad spectrum as to be largely useless in economic terms, because for one thing infrastructure requires huge capital investment while innovation, strictly speaking, does not.

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  9. Perhaps you should add management as a fifth category. In order to generate wealth, it is necessary to have a coordination of effort. In its simplest form, management is comprised of individual initiative. In its most complex form, management takes the form of a national government or another administrative body.

    It's notable that arguments over central vs distributed systems are often a core feature of ideological debates.

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  10. Now that I think about it, I suppose management would be considered an "innovation" as individuals elected to collaborate in order to achieve a common purpose. Still, at what point does an innovation earn its own category? Management (or coordinated effort) has arguably been a central and natural feature of wealth generation (and survival), beginning with the the primary social structure, "family," managed by the father and mother.

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  11. Roger,
    you seem to run into difficulties of not getting mutually exclusive terms. Classical political economy distinguished between production factors (land, capital, labour) or focussed on labour only (as Marx did with his labour theory of value). And marginal utility theory left all this behind proposing a different ontology.

    If you think about it, the 'sources' of wealth are not predictive of wealth as any poor country with loads of natural resources illustrates. Likewise, abundance of labour (or 'effort') does not lead necessarily to wealth. Working too long on a given task is a sign of inefficiency.

    What seems to matter most, is the social organisation of the production process and the institutions which govern it, inside and outside of the site of production.

    Accordingly, 'innovation' has to be seem as an outcome of the organisation of the production process.

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  12. -11-Reiner

    Thanks ... I actually don't think that it is theoretically possible to get mutually exclusive terms in such a theory, with the except of the start ... as shown here:

    http://rogerpielkejr.blogspot.com/2012/01/how-it-begins.html

    I agree 100% that the sources of wealth are not predictive, hence the Marx quote ;-)

    The social organization of the production process is itself .... innovation, change with a new dimension of performance.

    More on the production process soon. Thx!

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  13. Roger, Reiner,

    I think that what you call innovation, and others have called here management, is termed in economics total factor productivity

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  14. The most interesting aspect of focusing on wealth is that such a focus is a rejection of the flawed Keynesian focus on flows. Keynesian analysis leads to foolishness such as Algore's comments that Hurricane Andrew was good for the Miami economy or the destruction of functioning autos in 'cash for clunkers' was good for the economy. Destroying wealth is counterproductive.

    Also note -- law and the protection of property rights is a critical part of wealth production and accumulation. See DeSoto. Tax policy and regulatory processes can destroy wealth (in the aggregate, not just for an individual) and cause the failure to produce wealth.

    Finally, it is really important to note that the innovations that lead to greater wealth production will almost always benefit society far more than the innovator. Wal-Mart, credited with efficiency enhancements which accounted for one quarter of the productivity improvement in the entire US over a decade, did far more to create wealth for its low income customers than it created for itself.

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  15. "Where Does Wealth Come From?"

    The easiest way to answer that is to ask the question: Suppose homo sapiens did not exist,,,how much wealth would the world have?

    The human mind is the source of all wealth.

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  16. Your paradigm -- Effort, Resources, Luck, and Innovation (ERLI) as ingredients to wealth-creation -- works in the classical liberal context where rule of law, private property, and liberty / individual rights prevail. The once-wealthy farmers of Zimbabwe (Rhodesia) prospered through their efforts and innovations tilling rich soil until their luck ran out. Those associates of Zimbabwe Bob Mugabe who took over the farms thought that mere possession of the land and capital was enough to assure their success, but of course it was not.

    That classical liberal context provides the incentive for private profit and accumulation of wealth, and wealth is unlikely to happen at anywhere near the rate it would in such a free system.

    We all fail to appreciate how fragile the conditions are for wealth-creation, or how stubborn, downright pigheaded, most folks have to be to succeed. We focus too often on the business stars like Gates, Jobs, Walton, or Buffett and fail to appreciate how much wealth has been created by so many less well-known characters who faced greater obstacles to their success.

    I don’t know how to define excessive regulation or taxation, but there are plenty of instances where these seem to have played a significant role in stifling wealth creation. Add corruption, and you’ll understand why Wal-Mart has had such a tough time building a store within the city limits of Chicago.

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  17. Throughout history, poverty is the normal condition of man. Advances which permit this norm to be exceeded — here and there, now and then — are the work of an extremely small minority, frequently despised, often condemned, and almost always opposed by all right-thinking people. Whenever this tiny minority is kept from creating, or (as sometimes happens) is driven out of a society, the people then slip back into abject poverty.

    This is known as “bad luck.”

    Robert A. Heinlein

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  18. Roger,

    At first reading your four sources seem reasonable. The more I think about them, however, the more problematic the list appears. Why this list and not another? You have already admitted that the categories are not mutually exclusive. In addition, some of the categories (like innovation) are defined so broadly as to lose much of their significance. They seem to be reduced to nearly meaningless placeholders.

    The biggest problem, though, is that they appear to have no obvious relation to your given definition. If these are sources of WEALTH, shouldn't they have clear connections to the defined concept? Otherwise, what's the use of the definition in the first place? How do we know these are sources of wealth, as opposed to something more general?

    Suppose we decide to increase the amount of horse manure, not because we value it but just to prove a point. Effort helps to gather more of it. Increased resources, such as more horses, helps. Luck plays as role, as some horses just naturally crap more than others. Finally, innovation can play a role, such as developing new foods that produce more waste. But in doing all this, I haven't created any wealth (by your definition). Some important sources must be missing.

    Let's look at the definition: "accumulation of valued outcomes." Which of the sources aid accumulation? Are they enough? What about the vital role of property rights and rule of law, as pointed out in #16? These would appear to be more important than your listed sources.

    What about value? How do your sources lead to that? How do we KNOW that something is valued? Your sources give no clue. Knowledge, as mentioned in #4, seems crucial in this context, but it can't be dismissed as intangible or as needing to be applied. ALL of your sources need to be applied for them to accomplish anything. Nor can knowledge be reduced to innovation, since it's not just about doing things differently but also about evaluating what already is.

    Your exercise of laying out various "sources" of wealth seems like a lot of whistling in the wind without any attempt to connect them to the definition of wealth.

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  19. -18-Brian

    Thanks ...

    A first response is that the outlined framework seems to work pretty nicely in your horse manure example;-)

    I believe that what you are asking is about the mechanics or mechanisms of wealth creation. A good and fair question, and I'm moving in that direction ... stay tuned, Thanks!

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  20. The reason for the ambiguity, and incompleteness in your sources of wealth, is because of the same ambiguity in the definition of wealth.

    If the definition of wealth is not the same or atleast very similar for all people, then the its sources are not likely to be either.
    If wealth itself is subjectively determined, it will be impossible to objectively ascribe sources.

    If one person values watching a sunset with their spouse and another a diamond ring, what are the shared sources ?

    Wealth is anything we want or need. It can be anything on Maslow's heirarchy of needs, or any other scheme that describes our values.

    several posts have noted that we actively seek to minimize the effort necessary to create wealth, that the less effort the better. But we also try to minimize resources, and luck. And with innovation we return to something subjective.

    I did not ask about robots to get you to classify them. But to demonstrate that the only critical contribution of humans is establishing whether the outcome is wealth and what value it has.

    Robots can produce without little human effort.
    In the future they may be able to innovate.
    The creation of wealth has always actively involved minimizing everything you are describing as a source of wealth.
    The history of man is the production of more and more wealth with less and less, effort, resources, and luck. innovation is subjective.

    Effort resources, and luck are not sources of wealth. They are at best common attributes in the production of wealth.

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