How is Wealth Created?

What is wealth?

Wealth is often misunderstood. 

When the word “wealth” is spoken, people often bring to mind images of opulence.  For me, it used to conjure up images of a cartoon I enjoyed as child, Duck Tales, in which Scrooge McDuck would swim through gold coins in his money vault.  So, if these are the images that come to our minds then it might be natural that when we speak of increasing wealth, one might assume that we are speaking of adding a few more coins to the vaults of those wealthy like Scrooge McDuck. 

This isn’t the case.  Merriam-Webster gives one definition of wealth as “abundance of valuable material possessions or resources, abundant supply, all property that has a money value or an exchange value, all material objects that have economic utility; especially: the stock of useful goods having economic value in existence at any one time.”

This definition is more appropriate. We are not only talking about the rich getting richer, but also, much more importantly, about the poor getting richer.  It is true that under certain circumstances the rich and poor may improve their positions at different rates.  This can cause contention, but let’s save that important discussion for another time.  First let’s discuss how wealth originates.

But before we move on, note that money is not wealth and wealth is not necessarily money.  Money, however, can be a measure of wealth.

So how is wealth created?

Wealth is not like energy or matter, which cannot be created or destroyed (although, many in our culture do believe this fallacy).  Fortunately for us human beings, the world was created so that wealth can grow constantly (and this is a different phenomenon than what happens when money is printed constantly).

Unfortunately, it can also be destroyed.

Although many seem to resist this, it isn’t difficult to demonstrate.  World GDP (Gross Domestic Product) has increased exponentially in just last the last 200 years.  A quick Google search readily provides multiple sources on this.  A couple are pasted below:

Source: Statista

                                    

There are two ways one can obtain more wealth. It can be taken from someone else, or it can be created.  The former has been too common in world history. Members of one village or country would march over to pillage another village or country.  This explains how village A might get wealthier at the expense of village B as shown below.

                                      

But this doesn’t explain what has been happening to net wealth in history.  Net wealth has increased throughout history, especially in the last two hundred years despite the population of the world increasing dramatically. 

 Image. 

If wealth were fixed then we would have the same resources constantly redistributed among more and more people.  Thus, each person would receive fewer things as the population increased, and we would all become poorer and poorer.  However, in terms of our village graph above, we have seen net wealth increase (Village A plus Village B) that couldn't be explained by pillaging.  Something more like what is shown below.

                                    

So how does this happen?

It can be explained by voluntary exchange between people who can benefit from things the other has produced.  This exchange can happen through barter or by using money as a medium of exchange.  Both increase wealth, but the use of money drastically increases the number of wealth creating transactions that can happen. (This is because money overcomes the requirement of a double coincidence of wants that is necessary for barter. I’ll write more on the advantages of money over barter in another post.)

Suppose you wake up in the morning and realize that you need a nice shirt (or blouse) for an event you will be attending that evening.  You walk down the street to a local clothing store and begin to browse the aisles.  After a few minutes, you find a shirt that you think would really make an impression at your event.  You think to yourself “Wow, this shirt is just what I wanted!  I’d pay up to $50 for this shirt.” So you decide to buy it if the price is right.  You flip the shirt’s tag over to search for the price and, wow, it’s on sale. It’s only $30 dollars.  Now you would have paid $50 for this shirt but you don’t have to.  You’ve just found something for $30 that you would have paid $50 for. So, you gladly part with your $30 and start walking home with your shirt.  Are you better than before you entered the store?  Absolutely.  Economists call this difference between what you would have paid and what you actually paid Consumer Surplus.  Before you entered the store you only had $30. After walking out of the store you have something that you would have traded $50 for. You are better off.

Similarly, the seller of the shirt would have sold the shirt for something less than $30. But because of market prices they were able to sell it for $30.  Before you walked into the store, the seller only had a shirt into which they had invested, say $20.  Now they have $30. The seller also is better off.  Both the buyer and seller are better off than they were before the transaction took place.  

Keep in mind that we are only talking about voluntary, informed transactions between buyers and sellers here. Wealth creation doesn’t happen when one of the participants in the transaction cheats or deceives the other.  This also doesn’t apply when one party outright steals from the other. If Party A steals from Party B, that is certainly a way for Party A to increase its wealth, albeit an unethical one.  But this is not wealth creation. This is theft.  Cheating and stealing do not lead to wealth creation, only wealth redistribution.

So when we are looking at ways to increase the wealth of those around us, perhaps we can start by looking at ways to make voluntary, informed transactions happen more frequently.  Wealth creation is as simple as that.  This works in the poorest societies in the world and in the most developed ones.

I once explained this to a friend who quickly countered that if what I was saying was correct then he could sell something to me and I could sell it back to him, and we could continue this millions of times and generate enormous wealth.  

Oh... if only he were correct. Life would be much easier. What is the issue with my friend’s counter?  It’s the same trap that organizations and governments all over the world have fallen into.  If I sell something to you and create value and then you return the item – the value creation is undone.  Transactions for transaction’s sake don’t create wealth or stimulate our economy, they just spend money on things people don’t need and mis-allocate resources in our economy.  It is important that the transactions occur between a willing buyer and a willing seller. 
  

For example, if a government agency, in the name of economic stimulus, decided to create a local factory and hire 10,000 employees in order give them jobs, a disaster would likely ensue.  At first the 10,000 people getting jobs would seem to be a very good thing. But unfortunately, they would be working to make widgets that would not be desired by society.  Thus, after some time passes the factory would not be self-sustaining and would end up continuing to prop up these artificial jobs only for as long as it is able to take money from other tax payers and re-distribute it to these tax payers.

A much better solution would be to put into place what is needed for a market to function efficiently and let buyers and sellers come together, making each others' lives better off.

Exactly how might one to do that? More to come in another post…

While we at Emerge Dynamics don't spend much client time on the essence of wealth creation.  A proper understanding of how wealth is created leads to  an ability to maximize our clients' company value because we can help them maximize their clients' value.