The creation of economic wealth – providing goods and services for the benefit of the population – is the engine of an economy.
As represented earlier, in the schematic representation of an economic system (3.1.3), wealth is created when the amount paid for goods and services exceeds the costs of the supplies consumed in producing them – in other words, when a profit is made by delivering to a customer. Customer demand is essential for wealth creation.
An obvious example of wealth creation is a company which has been set up to make profits by meeting customer demand, but anyone who is paid is creating wealth – including politicians and public servants who are paid by the population to provide a service. The total wealth created in a country is usually referred to as its ‘Gross Domestic Product’ (GDP): “the standard measure of the value added created through the production of goods and services in a country”. The average prosperity of a country's inhabitants can be measured as GDP per head of population.
The creation of economic wealth is a multi-layered process, with some companies supplying other companies, but ultimately it converts work and raw materials into products and services that people want to buy and use. A manufacturing business, for example, might purchase a range of goods and work upon them before selling them at a profit. Other companies might provide essential services for the distribution, retail and after-sales support of the goods produced. All these activities add to the cost of the output and the consumer (or the taxpayer) pays. Value is added at every level. All employ labour, which is paid for: the wealth earned by employees.
In a capitalist economy, the wealth produced is shared between the owners (or shareholders), the workers, taxes paid to the government and an amount that might be retained for re-investment. The negotiation of what proportion each receives is discussed later (3.5.6). Everyone involved must judge that the reward justifies the effort: the owners want a return on their investment and the employees want money to spend as consumers. Without such incentives, less effort would be expended, less innovation would be brought to bear, and less wealth would be produced. Francis Fukuyama quoted a striking example of the motivating effects of property rights in his essay The End of History?:
“Beginning with the famous Third Plenum of the Tenth Central Committee in 1978, the Chinese Communist Party set about decollectivizing agriculture for the 800 million Chinese who still lived in the countryside. The role of the state in agriculture was reduced to that of a tax collector, while production of consumer goods was sharply increased in order to give peasants a taste of the universal homogeneous state and thereby an incentive to work. The reform doubled Chinese grain output in only five years…” [p. 7]
People create more wealth if they can keep most of it. Almost every society now accepts the need to protect property rights – although there is no private property under pure communism, and land is held in common in countries inhabited by nomadic tribes.
The creation of economic wealth is stimulated by the demand for goods and services. Wealth cannot be created unless a customer is prepared to pay for what is being provided: a consumer, the government, or another business that requires the supply of goods and services. The wealth which people create enables them to buy goods and services, thereby providing opportunities for other people to create more wealth in a virtuous circle of economic growth, governed mainly by market forces (3.3.2). As noted later, government attempts to direct the creation of wealth are less successful (3.3.6).
In practice there is a limit to economic growth. An economy’s maximum capacity to produce wealth is determined by the resources available to it: labour, natural resources, finance, and the facilities and infrastructure it requires. An economy is said to be ‘efficient’ if it is fully utilising the available capacity; Samuelson and Nordhaus define an efficient economy as one whose output is close to its ‘production-possibility frontier’ [Economics, pp. 8-12].
Governments can affect the capacity of the economy, for example by investment in infrastructure and the training of labour; they can also affect its efficiency, by regulation (3.3.1); but private enterprise produces most of the world’s wealth – in response to market forces rather than to instructions from governments.
This section has given a summary of the workings of wealth creation that would be described as 'classical economics', as first described by Adam Smith in his book An Inquiry into the Nature and Causes of the Wealth of Nations. It depends upon the mythical 'homo economicus', or rational self-interested man. It is a useful first approximation, but it ignores several important deviations from classical theory – as described later (3.3.5).
It also ignores an enormous amount of unpaid essential work, often performed by women historically, including housekeeping and caring; these tasks are increasingly performed by paid people, so economic models need to take account of them. Katrine Marçal, among others, has described this issue; she also pointed out that it has led to economic thinking being tilted in favour of men and tending towards inequality; her book ‘Who Cooked Adam Smith’s Dinner?’, was reviewed in Prospect Magazine.
(This is an archive of a page intended to form part of Edition 4 of the Patterns of Power series of books. The latest versions are at book contents).