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Nov 16

Economic Scale and Income Inequality

Dietz VollrathFor years I’ve been grappling with a question. How is it that technology and infrastructure affect the amount of money a business owner makes. According to most people on the right, a person’s or company’s value is exactly (or very nearly so) based on the amount of money they make. But think about a man who makes hammers. If he lives in 1750, it doesn’t matter how cheaply and quickly he can make hammers, there will be distinct limits on the number that he can sell because of distributional limitations. But this same man living today would have almost no limitations and so could make vastly more money. What’s more, because he was selling so many more hammers, there are various scaling effects that would also bring his costs down and his profits up.

This example highlights the fact that the man is not necessarily making what he is worth. The modern hammer maker is paid more not because of anything he is doing but simply because of the existing technology and infrastructure that he was gifted. The greater profits are therefore not due to individual achievement, and therefore should not go to the individual — at very least, not entirely. This strikes me as a devastating argument and so I’ve wondered why I don’t hear economists making it. But I figured it had to be floating around.

I think the reason the argument isn’t more widely discussed is because it is easier to simply assume an economy without Sam Walton and then compare it to the economy with Sam Walton. The difference is what Sam Walton is worth. It is much more complicated to consider what actual value he adds. To me, it is as simple as considering one of the most basic economic ideas: the opportunity cost. The question is not how much Walmart adds to the economy, but how much Walmart adds to the economy compare to other options.

Consider the world of classical music. What if the best violinist in the world had never been born. He makes millions of dollars. Would all those CDs not be sold? Would all those concerts not occur? No. Instead, the second-best violinist would have a better career. And the world would be negligibly worse off, because the difference in ability between and the best and the second-best is razor thin. If you want it quantified, consider the 100 meter run: if Usain Bolt had never been born, the world record would be 9.69 instead of 9.58 and Yohan Blake would be doing those Puma commercials.

I have found someone who is talking about this kind of stuff. Recently, Dietz Vollrath wrote, Scale, Profits, and Inequality. His primary interest is in regard to taxation and its effects on innovation. As you know, I think most arguments about innovation are just cons. The idea that people innovate in order to make billions of dollars defies human psychology. Everyone wants to make money, but billions of dollars is out of the range of normal thinking. And regardless, no one considers how much their marginal tax rate will go up before creating something new. “I was going to invent a cold fusion reactor, but then they raised the top tax bracket to 39.6% and I said, ‘No, no, no!'” What rubbish.

Vollrath noted that the quantity of a product sold “depends on the aggregate size of the economy.” He continued:

The scale term… does not depend on genius. It depends on the size of the market you have to sell to. If we stuck Steve Jobs, Jon Ive, and some engineers on a remote island, they wouldn’t earn any profits no matter how many i-Devices they invented, because there would be no one to sell them to.

I would go further, of course. I think that the “genius factor” is greatly over-prized. It too is constrained by social factors. For example, Linus Torvalds’ genius was entirely dependent on the genius of Richard Stallman and the creative environment he established. I’ve always found Stallman to be a rare singularity in the history of innovation because he is so idiosyncratic. There is no question but that Torvalds is brilliant, but eventually some programmer was going to do what he did; I’m not as certain about that when it comes to Stallman. Regardless, people like Jobbs and Walton were not singularities.

This issue is more difficult to argue. What isn’t difficult to argue is that when Sam Walton was computerizing his distribution system he was not thinking, “This is worth doing because long after I’m dead my family will have more money than they could ever spend!” But even if he had been thinking this, all he was doing was harnessing a collective resource that our current system allows to be taken entirely as individual profit. Vollrath noted:

The value-added of “the Waltons” is particularly relevant here. Sam Walton innovated, but the profits of Walmart are almost entirely derived from the scale of the US (and world) economy. It’s the presence of thousands and thousands of those janitors in the US that generates a huge portion of Walmart’s profits, not the Walton family’s unique genius.

The reason we don’t see more of this kind of thinking is that macroeconomics is largely apologetics. (See Economic Apologetics and The Myth of the NAIRU and Its Purpose.) Ideas that push against the interests of the powerful are ignored or held to ridiculously high standards of proof. Ideas that flatter and enrich the powerful are true until proved otherwise. But I’m glad that there are economists out in the world that are talking about issues like scale effects. I will continue to look for more.

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