reflection #3

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Thinking about Industrialization

Produce Value, Consume Value To study industrialization is to study economic development. There are three categories of economic development: 1) underdeveloped, 2) developing, and 3) developed. To understand these categories, this point is key: a society must first produce value before it can consume value. This means:

• A society must first produce valuable goods and services – goods like food and housing; services like education and health care – before it can consume valuable goods and services.

• Producing valuable goods and services creates wealth.

• When this wealth is used to consume valuable goods and services, the standard of living goes up.

Let’s pause here and explore the second bullet point above. Let’s consider what it means to “create wealth.”

• Recall the graph here from the first lecture in the course. It is a graph of “GDP per capita” for the years 1 to 2000. GDP per capita means wealth per person.

• The graph shows that NO significant wealth was created from the year 1 to about 1750. Then wealth – GDP per capita – begins to rise in the late 1700s, when industrialization starts.

In other words, the graph shows that throughout human history, it was normal for humans to live in poverty. Poverty is the normal state of human affairs – the normal condition of human life. The creation of wealth is abnormal – it is not the normal state of human affairs. The creation of wealth only began in the last several centuries.

• Consider this famous book: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Look at the title and look at the date.

• Smith tried to explain the causes of wealth in 1776. He understood that wealth had to be explained because it was abnormal. He did not write a book about the causes of poverty. Poverty did not have to be explained – it was simply the normal condition of humans in human history. Smith wrote this book in the late 1700s, when the creation of wealth was beginning.

• You and I have inherited the wealth creating process of the last couple centuries. We are part of a tiny fraction of all humans in human history who do not simply accept poverty as the inevitable condition of human beings. We have inherited a relatively new process of wealth creation which has heavily influenced the way we think about wealth and poverty.

As we talk about the creation of wealth, we have to be clear. Creating wealth is not the same as creating money.

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• Creating money is easy. Government can create or print money and send it to everyone. Imagine government sends us all a million dollars. We are all millionaires. However, the money will be worth less than before because prices will go up (inflation). So you have a million dollars, but a gallon of milk might cost $60. The prices of other goods and services will also go up. This course might cost $10,000. Everyone having more money doesn't necessarily mean everyone’s standard of living goes up.

• Creating wealth is different. When wealth is created, there is more money in the economy but the money is not worth less than before.

• The second bullet point at the beginning of this lecture is key: Producing valuable goods and services creates wealth.

• It is necessary to produce valuable goods and services. The production of value means more money without that money losing value – i.e., the production of value creates wealth. When we use wealth to consume valuable goods and services, the standard of living goes up.

Now that we have clarified what it means to create wealth, and that wealth is abnormal in human history, let’s return to three categories of economic development: 1) underdeveloped, 2) developing, and 3) developed.

Three Categories of Economic Development An “underdeveloped” society produces too few valuable goods and services. As it produces too little value, the population consumes too few valuable goods and services. The population on average is thus poor – the standard of living is low.

• When you think “underdeveloped,” however, do not just think “poor.”

• Rather, think “poor” for a reason – the society produces too few valuable goods and services.

• Examples include North Korea and Cuba. Unfortunately, Venezuela also seems to be increasingly slipping into this category.

A “developing” society is one that has begun in recent memory to produce valuable goods and services. As it produces value, the population can consume valuable goods and services. The population on average thus experiences a rise in its standard of living. Examples include South Korea and India. These countries were underdeveloped when I was born, but began rising into the “developing” category in the late 20th century – began in recent memory to produce valuable goods and services. Think of the valuable goods of South Korean companies we are familiar with – Samsung, LG, etc. These goods didn’t exist when I was in high school. A “developed” society is one that has for a long time produced many valuable goods and services. Having long produced value, the population has long consumed valuable goods and services – food, housing, education, health care, etc. The population on average thus has a high standard of living.

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• This does not mean no one in developed societies is poor. Rather, it means the following two things:

• The average standard of living is high compared to the rest of the world, and extremely high compared to what most humans throughout history have experienced.

• To be poor in a developed society is usually better than to be economically higher in an underdeveloped or developing society. In other words, many considered poor in a developed society have a higher standard of living than many considered middle income in a developing society.

• Examples include Great Britain, the United States, and Germany. Developed societies were the earliest to industrialize. Great Britain industrialized first, followed by the United States and Germany.

Produce Value, How? Notice that producing value is the first step to economic progress. Producing value leads to the other goods things – creating wealth, consuming valuable goods and services, raising the standard of living. The obvious question is this: How does a society produce valuable goods and services? A key part of the answer is technology. Industrialization includes textile machines like the power loom, engines like the steam engine, transportation like railroads, and inventions like the Bessemer Converter. These are examples of technology. So now the question is this: How does technology produce value? The answer is: technology increases productivity. Productivity means producing more in less time. • Don’t confuse productivity with production. As an employee, I could produce twice as much

by working twice as long. This is an increase in production. This is not an increase in productivity because I did not produce more in less time.

• Same point, different example:

o I own a shirt factory with 5 employees making 15 shirts per day – 1 employee per 3 shirts produced (1:3).

o I double the employees to 10 to produce double the shirts, 30 – still 1 employee per 3 shirts (1:3).

o I have increased production, but not productivity. The employees are not producing more in less time.

• However, I reduce the number of employees to 3 and they produce 60 shirts in a day – 1 employee per 20 shirts produced (1:20). I’ve increased productivity. Employees are

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producing more in less time. How did I do this? I used technology to increase the productivity of employees.

Follow the logic: • technology increases productivity (1 employee making 20 shirts rather than just 3 shirts)

• the increased productivity is increased value (1:20 is more valuable than 1:3). – i.e., technology produces value, which is wealth.

The second part of the logic is perhaps abstract – increased productivity is increased value. Let’s break it down: • When employees use technology to increase productivity the value of the company goes

up.

o The 1:3 company has 10 employees making 30 shirts per day – lower productivity.

o The 1:20 company has 3 employees making 60 shirts per day – higher productivity. This company has more shirts to sell and fewer employees to pay.

o Because the 1:20 company has better productivity – thus more shirts to sell – it can sell each shirt at a lower price and make a profit. It will sell more, make more money, and can pay its employees a higher wage – it will be a more valuable company.

• If you had to invest your money in one of these companies, you would probably sense that the 1:20 company with 3 employees making 60 shirts is a better investment – a more valuable investment – than the 1:3 company with 10 employees making 30 shirts. You would sense that higher productivity means higher value.

Let’s summarize: when employees use technology to increase productivity in making goods and services, they increase value, which is wealth. Economists call this “wealth creation.” It is economic progress. A society which creates wealth goes from underdeveloped to developing, or developing to developed.

The Circle Let’s draw a circle to visualize the information above. Technology (T) is at the top of the circle. A clockwise arrow from T a quarter way around the circle goes to productivity (P). The arrow from P another quarter way around goes to wealth (W) at the bottom of the circle. From W at the bottom of the circle, complete the circle by drawing an arrow clockwise back up to T. The point is that as technology increases productivity, and productivity increases wealth, parts of the new wealth get invested in creating newer technology. And the process starts over. See the circle below:

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This cycle is the “Self-Sustaining Growth of Capitalism.” It is the primary reason for economic progress since the late 1700s, when industrialization began. Indeed, the beginning of industrialization was based on the discovery of the self-sustaining growth of capitalism. First the British and then Americans industrialized their economies by learning and applying this cycle of economic development for the first time in human history.