Saturday, October 10, 2009

A catalog of wealth-creation mechanisms

One of the guest lecturers aboard the ship [1] (Donald Gibbs, of Pearl-Harbor conspiracy-theory infamy) gave a very interesting talk a few days ago about some of China's semi-recent history. He opened with a little pop-quiz, which I thought set the stage particularly well, so I'll co-opt it here to make a different point:

1. Why was the Panama Canal built?

2. Why was the Lewis-and-Clark expedition funded?

3. Why was the transcontinental railroad built?

The popular answer to these questions, taught to schoolchildren throughout the U.S., is: to link the east and west coasts of the United States. But that answer is wrong, as can be shown by examining historical records of the time. The real reason for all three of these mammoth endeavors was to link the east coast of the United States with China. And the reason for linking the east coast of the United States with China was that a ship full of goods from China (including, for example, high quality china with a lower-case 'c', which at the time was produced nowhere else) could be sold in the east-coast cities of the U.S. at about a 300% profit. The wealth created by this trade ultimately financed the industrialization of the U.S., so this is no mere historical trifle. (Bonus question: what did the U.S. give to China in exchange for its china?)

But the point I want to draw attention to is that at the root of all wealth creation are a very few, very simple and easy-to-understand core mechanisms. It's easy to lose sight of this in today's complex technological world, so I thought I'd draw up a catalog of them.

It's important to keep in mind that there is a distinction between wealth and money. Wealth is a measure of how much stuff people have that they actually value for its own sake. Food, housing, clothing, shelter, and artwork, are all examples of wealth. Money, by way of contrast, is merely an accounting mechanism that humans have invented in order to facilitate trade. Money and wealth often go together, but they are completely different things. You can transform money into wealth, and vice versa (which is the whole point of having money), but you can have money without wealth and vice versa. And you can make (or earn) money without creating wealth, and vice versa. But historically, the most reliable and the most socially beneficial way of making money is to create wealth. So to help encourage that, here's a more or less comprehensive list of fundamental mechanisms of creating wealth.

1. Move things from one place to another. Most things have value only when they are in a particular place. Food, clothing, and shelter only have value for you if they are close to where you happen to be. So you can create wealth simply by moving something from somewhere that it isn't useful to somewhere that it is. It sounds simple, but this is the basis for the shipping industry, which is what more or less what financed the industrialization of the United States of America.

2. Store things. Just as the values of things are often bound to their location, value is also often bound to a particular time. A winter coat, for example, is more useful in winter than summer. Keeping things in serviceable condition until they become useful is often a non-trivial exercise (consider the problem of keeping fruits and vegetables available when they are out of season). So you can create value simply by holding on to something and maintaining it in working order until it becomes useful to someone. Just as moving things around is the basis for the shipping industry, storing things is the basis for the retail industry. Stores are called stores because they used to be places where things were stored, not necessarily places where things were sold.

3. Transform things, either chemically or mechanically. This is the basis of the manufacturing industry. I don't think I need to say any more about that. [Update: actually, it turns out I do need to say more about it. This is indeed the basis of manufacturing, but it's also the basis of a lot of other things, including service industries like automobile repair, plumbing, cooking, hairdressing, painting and sculpture, carpentry, etc.]

4. Farm. Technically, farming could be considered a subset of #3, since you're transforming water, carbon dioxide and fertilizer or animal feed into other, more useful things like crops and livestock. But I put this in a separate category because it relies so much on natural processes. Some day we may be able to engineer entirely artificial crops, but until then I think it's useful to think of farming as an endeavor separate from manufacturing.

5. Build buildings. This could also be considered a subset of #3, but I put it in a separate category because buildings are not easily moved from one place to another, so they have to be manufactured in situ. This fact makes real estate development significantly different enough from manufacturing that it deserves its own category.

6. Extract natural resources from the earth or space. This category includes things like mining, oil drilling, and fishing. It used to include hunting (the answer to the question I posed above about what the U.S. traded to China in the 19th century is "fur") but no longer.

7. Cure disease, or at least ameliorate the symptoms. This is medicine.

8. Find entirely new ways of doing any of the above more efficiently or effectively. This is "research" or "invention." (Note that this is decidedly not the same thing as "having a brilliant idea".)

And finally, the granddaddy of them all for the 21st century:

9. Provide people with useful information.

This one can be broken up into a number of major sub-areas:

9a. Help match supply and demand. The world is so complex and diverse that you can create wealth simply by identifying sources of supply and demand and matching them up. This is the basis of modern markets. I say "modern" to distinguish them from "old-fashioned" markets where merchants display their wares directly. In this case, the information about what is available is tightly bound to the physical goods themselves. Of course, "old-fashioned" markets of this sort are still common. All brick-and-mortar stores are "old-fashioned" markets. But modern commerce decouples information about goods from the physical goods themselves. It is not uncommon nowadays to buy something without ever laying eyes on it. Amazon, EBay, ECNs and Google are all examples of "modern" markets.

A sub-category of 9a is entrepreneurialism. A company is nothing more than a bunch of people providing goods and services for each other with the matching of supply and demand being coordinated by a central planner (management) rather than by a market.

9b. Help people figure out the rules. Modern economies operate by an often byzantine set of laws, regulations, customs and conventions. Lawyers and management consultants fall into this category.

9c. Provide information that is useful in and of itself. This includes journalism and creative writing. Most blogs are an example of 9c.

This last category is of particular note because so many people seem to focus on it. Every scholar, blogger, reporter, novelist, screenwriter, composer and choreographer is working on 9c. A lot of wealth gets created this way, but of all the ways to make money it is arguably the least effective. It is very hard to transform information directly into money. Once upon a time, information was strongly bound to physical objects like books or vinyl records, and you could make money by producing these things because they were instances of #3. But with modern computer technology you can reproduce information essentially for free without doing any physical transformation. The result has been an unprecedented, almost overwhelming creation of wealth, but very little of it gets translated into money because the marginal cost of production is so close to zero. There's a reason Google doesn't charge for its search services. Google makes money via 9a, not 9c.

There is one sub-category of 9c where it is possible to make money, and that is providing information that is difficult to obtain and useful to a narrow vertical market segment. The Y-Combinator company Octopart is an example of this.

I'm pretty sure this is a comprehensive list. Can anyone think of anything I've left out?

---

[1] For those of you coming from Hacker News, I'm on a cruise ship going through Asia at the moment.

21 comments:

Prateek Sharma said...

I am not sure which category services fall into.
Maybe add a category "Do stuff that people want done" Example: hairdresser , car mechanics etc.

Ron said...

I thought about that, but came to the conclusion that all services are really instances of one of the other categories. Hairdressing and fixing a car, for example, I put in category 3.

There is one major category of wealth-producing activity that I just thought of that I did leave out. I'll leave it as an exercise to see if anyone can figure it out :-) I'll post it in a couple of days if no one gets it.

Vitriolic said...

Services don't create wealth.

Providing services is equivalent to being employed -- doesn't create wealth, but sure feeds you well.

This is because there is no, or almost none, barrier to entry, and without barriers to entry prices fall to the competitive mean very quickly -- and as such they don't create a producer surplus or 'wealth'

Ron said...

> Services don't create wealth.

Of course they do. A broken widget has less value than a working widget, so fixing a widget (which is a service) creates wealth. Likewise for all other services. If services didn't create wealth no one would pay for them. However...

> Providing services is equivalent to being employed

This isn't true (many service providers are independent contractors), but even if it were it would be irrelevant. Whether you are employed or not has nothing to do with whether or not what you are doing creates wealth. This is precisely the common -- and mistaken -- conflation of wealth and money. They are NOT the same thing.

Vitriolic said...

Ron:
> Whether you are employed or not has nothing to do with whether or not what you are doing creates wealth.

Absolutely agreed.

In fact I was saying that for an employee to create wealth for himself solely off his salary is unlikely.

My point was wealth is the accumulation of producer surplus [http://en.wikipedia.org/wiki/Economic_surplus]. If you are selling your service or product at the point of equilibrium, you could yet make money, but are not likely to become really wealthy. Generating 'wealth' requires that you consistently sell at a price much higher than it costs you, and if you're selling at the market equilibrium then just because of regular market dynamics you are unlikely to be making a large enough margin (if you were, someone else would/could too, and could reduce his prices a little to take over more market share, so on and so forth).

However if you're a former west-coast china trader, who now manage to sell on the east coast, without increasing his cost too much (maybe by floating his wares down a canal), you can now charge significantly over your west-coast market's equilibrium. And this will get you true wealth.

For employees however, because companies always benchmark pay to market equilibrium, you will make a fair amount of money for your market -- but wont create wealth for yourself.
(NOTE: This applies to a general employee, not to executive management or to people with super exclusive know-how that is not available to anyone else. Also, This does not comment on whether your company creates wealth in general or not)


The only way for true wealth creation is to be able to monetize scarcity.

You can definitely create wealth by being the only hairdresser in a big town, or by being the the only person who a company can employ for a mission-critical role. But these opportunities are few and far between, and the average service-person or employee is not likely to be creating wealth.

Prateek Sharma said...

Umm... I thought that 'services' are a fundamental wealth creation method. Doing activity 'X' for person 'Y' because 'Y' doesnt want to or know how to do activity 'X'. Thus it is essentially an exchange of money for time, expertise.

Don Geddis said...

Vitriolic, you seem confused about Ron's point. You seem to be using "wealth" in the sense of an individual "getting wealthy", like becoming a millionaire. And you're making a reasonable observation that it's hard to become a millionaire if you're a low-level service employee. True enough.

But that's not what Ron was talking about at all. Ron was talking about how the world as a whole accumulates more wealth. In other words, how humans transform the earth so that they find it more valuable after the transform, than before.

That's Ron's distinction between wealth and money. You're basically saying that it's hard for a service employee to accumulate a lot of excess money. But Ron's point is that, when a mechanic fixes a car, then the world is a wealthier place, and the mechanic has created that wealth. Whether the mechanic himself acquires cash as a consequence is a completely separate point.

Don Geddis said...

Ron said: Some day we may be able to engineer entirely artificial crops, but until then I think it's useful to think of farming as an endeavor separate from manufacturing.

If you enjoy imagining that "some day" scenario, you might like Neal Asher's novels, e.g. the Cormac/Polity series, or Cowl.

It's not the main point of any of the novels, but as a minor subplot Asher imagines a future technology that blurs the lines between biology and manufacturing (plus AI). The future civilization makes all sorts of fantastic things, but at one point they explain it as the ability "to grow a microwave oven".

It's interesting when growing an organic lifeform is just another manufacturing process, fully integrated with all the existing ones.

Curtis said...

10. Providing incrementally more productive or profitable labor, by individuals, methods, management, or machine.
11. Supplying capital to cross success thresholds.
12. Demolition/disposal/recycling to create space from obsolescence.

bueno said...

There is also slavery and prostitution, though I suppose slavery could fall under "farming". We don't like to talk about them much but they are always with us.

I would argue that protection, or risk-reduction, is also a major wealth-creator. If I don't have to worry about armed gangs, or if I know I will be made whole after a disaster, I will take bigger risks for bigger rewards.

I'm not sure where banking falls in your taxonomy. Some of banking is storage, some of it is arbitrage, moving things around, or moving information around. But where does lending come in? Is it a form of wealth creation?

Curtis said...
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jb said...

How about the wealth associated with increasing human happiness at a level other than just providing medicine (health), food, clothing, etc.?

So this would be art, literature, comedy, entertainment, games, etc.

MaysonicWrites said...

You ought to read Jane Jacobs[1] on the distinction between being rich and being wealthy (especially as applied to economies). Money and stuff are pretty much fungible: if you have a lot of stuff, you can usually trade it for a lot of money and vice versa. What is necessary for an economy to be truly wealthy (as opposed to just rich), is the human capital needed for your category 3 - transformation. This is why Argentina was rich for quite a while (late 19th c to WWII) but is now poor - and why the Gulf oil states are rich, but not wealthy - when their oil runs out, or the price of oil tanks, they're going to be in trouble. It's also how countries like Japan, Taiwan, and Singapore, with very few natural resources, have gone from poverty to wealth.

[1] The Economy of Cities and Cities and the Wealth of Nations

abraham said...
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Trevor Blackwell said...

You don't mention education, which creates vast wealth in the form of capable people.

Ron said...

Education is a sub-category of 9c. It does indeed create wealth, but like blogging and journalism, it's generally hard to convert that wealth into money.

V said...

Ron:

I get the point now -- what you are calling wealth creation, I call 'value creation' and yes now I get your point about services.

@Don Geddis:
Thanks for hitting me over the head with a clue-stick. Needed that :)

dalas v. said...

I loved this post. Thank you for it.

Ron said...

Thanks, Dalas! You made my day.

Anonymous said...

Would teaching go with providing useful information? I think of it more as a process that turns a skilled person into an unskilled one, and as something more involved than just providing information.

NealAbq said...

10. Entertaining, providing pleasure. This covers a lot of elective consumption and the service industry. Some "entertainment" brings about long-term happiness and enrichment, increasing cultural wealth.

11. Insurance, risk reduction. Is this already covered?

12. Military and police services?