Voluntary Exchange, Wealth Creation, and Value Added

By Mississippi Center for Public Policy
June 23, 2018

While we tend to think of our wealth in dollars, true wealth has nothing to do with paper money itself. Total wealth in a society is not a fixed pie waiting to be divided among us. Wealth, instead, is constantly being created by each of us; the ‘economic pie’ grows each day. Wealth is created through both production and exchange. An example will help to illustrate.

Suppose that two neighbors trade a bushel of hay for a load of wood. Both are now better off; after all, they were only willing to trade with each other because each wanted what the other person had more than what they traded away. Both have become wealthier in every sense of the word even though no new money has been printed, nor existing money passed around.

On an everyday basis, money only represents wealth to people because it measures the quantity of these trades—or purchases—we can undertake when we exchange money that we earn from producing at our jobs for the goods and services produced by others. A man on a deserted island with $1 million is very poor indeed without anything to purchase with the money. On the other hand, a man deserted on an island with no money, but a group of other people, will be much wealthier because of his ability to produce and exchange with others—even in the absence of paper money on the island.

Taking the example further, suppose a group of island castaways decided that half of them should dig holes and the other half should fill them in. After a full-day’s work, they would have nothing to show for this effort; nothing was produced. Holes were dug and filled again. No wealth was created, even though people worked very hard.

Wealth would be created if instead half the tribe collected coconuts and the other half fished. Now they would have dinner. Suppose one castaway invents a new tool that increases the number of fish she can catch. This invention would further increase wealth; there is more food at the dinner table. In fact, the new tool might increase productivity so much that only half as many castaways are needed fishing, and the extra castaways are free to labor at a new task such as building a shelter, further increasing wealth. As these examples illustrate, there is a close link between prosperity, or ‘wealth,’ and the quantity, quality, and value (or usefulness) of the output produced. Prosperous places—those with high levels of income and wealth—become that way by producing large quantities of valuable goods and services.

One difference between this castaway analogy and our daily economic lives, however, is that we might anticipate the castaways sharing the fruits of their labor, for example, splitting the fish caught that day. In a large and advanced economy it no longer works this way. Instead, each of us gets paid in dollars, or money income, for what we produce at our jobs. We then go to stores and exchange that money for the goods and services produced by others at their jobs.

The amount of income we earn is determined by both the prices people are willing to pay us for what we are producing and how many units of it we can produce. For individuals, states, and nations, income is determined by the value of output. A worker with a backhoe will be more productive than a worker with a shovel and will earn more as a result. An entrepreneur producing apple pies will be more prosperous than one producing mud pies because people place a higher value on apple pies (and thus are willing to pay more for them).

This logic leads to one obvious, and simple, litmus test that can be used to decide if a suggested new policy or law is good, or bad, for the Mississippi economy—does it increase, or decrease, the net amount or value of output (of goods and services) produced in the state. Regulations, such as those adopted in some European nations for example, which restrict the workweek to 35 hours clearly result in reduced output, and reduced standards of living as a result. For a tax-funded government program, this principle must be applied by looking at the net change in output—that is, one must properly account for the reduced output caused by the taxes or other resources necessary to fund the policy.

One of Adam Smith’s insights in his previously mentioned 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, is that labor productivity, the main determinant of wage rates, is increased through specialization and the division of labor. When labor is divided into specific tasks, like workers in an assembly-line, they can produce more as a group than could have been produced individually. The same holds true when individuals specialize across different occupations and industries.

However, according to Smith, our ability to specialize, thereby increasing our productivity and enhancing our wages, depends on the size or ‘extent’ of the market to which we sell. When consumer markets are larger in size, smaller specialized stores can survive that could not have survived in a smaller marketplace. Oxford’s population, for example, is able to support two general purpose pet stores, each carrying a broad line of products. In a place like Jackson, however, a dozen or more such stores can flourish, with a greater extent of specialization, some focusing on saltwater fish, while others may focus on birds and other reptiles. Increasing the size of the markets to which Mississippi’s goods and services sell could increase wealth by allowing Mississippians to specialize more specifically in areas where they do best.

Population growth in metropolitan areas would be one way of increasing market size. But another way to increase market size is to enact policy reform that better enables the businesses in Mississippi to sell and compete in larger national and global marketplaces and expand their customer base. To compete in these markets Mississippi businesses need to be on a level playing field with their competitors. Mississippi’s taxes and regulations are a competitive disadvantage to firms located in the state. The higher prices Mississippi businesses must charge for their products greatly limits the markets in which they can compete. If these tax and regulatory costs could be reduced through policy reform, firms could offer more competitive pricing, increasing their market shares and the extent of their markets. This would allow both the businesses themselves, and their workers, to become more specialized and earn higher incomes as a result.

In addition to specialization and the division of labor, capital investment also increases labor productivity. Higher levels of education (more ‘human capital’) and better machinery, buildings, and tools to work with (more ‘physical capital’) can help our citizens produce more output and generate more income. Recent capital investments in the auto industry provide a good example of this. Modern robotics and automation allow workers to position, spin, and move the parts they are assembling much more easily and quickly. With this new capital equipment workers are more productive and earn higher wages as a result.

But new factories, better machinery, and equipment are expensive. They require large investments in assets and property. In Mississippi, taxes (such as property taxes on capital equipment), regulations, and lawsuits decrease the return from capital investment and thereby lower the inflow of capital into the state. And Mississippi has among the highest property taxes in the nation on a representative manufacturing facility’s equipment and machinery. This results in Mississippi’s workers being less productive—and earning less as a result.

The income a state produces from its output depends not only on how much is produced (which can be expanded through specialization, division of labor, and capital investment), but also on the price per unit, or value, of the goods and services produced. A company trying to sell mud pies will generate less income than one producing apple pies. Income can be increased not only by increasing labor productivity, but also by raising the value per unit—or ‘value added’—of Mississippi labor.

However, the answer to the question of which specific uses of Mississippi’s resources create the most value, and thus income, is not obvious. In fact, the answer is so complex that it is not something any one person or group of people knows, not even a group of expert economic planners. It is an answer that must be discovered by individuals in the private sector through the decentralized process of entrepreneurship, a process of private trial and error. This is the topic of our next section.

Before moving on, however, let us complete our discussion of the process of wealth creation started above. As we pointed out, in a real-world economy things work a bit differently than in the castaway example because we must first earn income by producing goods and services. Only then do we use that income to acquire the goods and services produced by others. The ability to turn our income into prosperity and wealth through exchange is the second important part of this process.

As consumers, we turn income into wealth through the acquisition of goods and services like food, clothing, shelter, and recreation. In our shopping, we search out and negotiate with potential sellers from around the globe. We spend time and effort on this search because maximizing the value we get from our limited budgets makes us wealthier. Finding a product we want to buy at a lower price increases our wealth because we now have more money to spend on other things.

This is the reason why restrictions on the ability of citizens to freely engage in trade with people from other geographic areas through tariffs, quotas, taxes, and other restrictions, destroy wealth. Individuals cannot generate as much value and happiness from their limited incomes. Not only are there fewer options to select among, but also the taxes and regulations make things more costly for us to purchase, reducing our ability to stretch our budgets and turn our income into wealth. This is one reason to avoid adopting policies that interfere with, tax, or restrict Internet purchases.

Our well-being is the result of both production and exchange. Becoming more prosperous can be accomplished by increasing the amount of wealth created in the state through: (1) increasing in the quantity, quality, and value of goods and services the state’s citizens produce, and (2) increasing the number and value of the voluntary exchanges the state’s citizens make, both with other Mississippians and with people from around the world.

Policy reform that lowers taxes and regulations can help achieve these goals because it results in: (1) increased specialization of labor and increased capital investment—increasing labor productivity and wages; (2) increased ability of residents and businesses to buy and sell with individuals from across the state, nation, and globe; and (3) more private sector entrepreneurship that allows the decentralized decisions of workers and business owners—rather than government planning—to help search out and identify the ever-changing bundle of goods and services that creates the most value and income for Mississippi.

This is an excerpt from Why Capitalism Works by Russell S. Sobel and J. Brandon Bolen. It was published in Promoting Prosperity in Mississippi.


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