Throughout this section of the course, we’ve been trying to solve a complicated economic puzzle—why are some countries rich and others poor? There are various

Throughout this section of the course, we’ve been trying to solve a complicated economic puzzle—why are some countries rich and others poor?

There are various factors at play, interacting in a dynamic, and changing environment. And the final answer to the puzzle differs depending on the perspective you're looking from. In this video, you'll examine different pieces of the wealth puzzle, and learn about how they fit.

The first piece of the puzzle, is about productivity.

You'll learn how physical capital, human capital, technological knowledge, and entrepreneurs all fit together to spur higher productivity in a population. From this perspective, you'll see economic growth as a function of a country's factors of production. You’ll also learn what investments can be made to improve and increase these production factors.

Still, even that is too simplistic to explain everything.

So we'll also introduce you to another piece of the puzzle: incentives.

In previous videos, you learned about the incentives presented by different economic, cultural, and political models. In this video, we'll stay on that track, showing how different incentives produce different results.

As an example, you'll learn why something as simple as agriculture isn't nearly so simple at all. We'll put you in the shoes of a hypothetical farmer, for a bit. In those shoes, you'll see how incentives can mean the difference between getting to keep a whole bag of potatoes from your farm, or just a hundredth of a bag from a collective farm.

(Trust us, the potatoes explain a lot.)

Potatoes aside, you're also going to see how different incentives shaped China's economic landscape during the “Great Leap Forward” of the 1950s and 60s. With incentives as a lens, you'll see why China's supposed leap forward ended in starvation for tens of millions.

Hold on—incentives still aren’t the end of it. After all, incentives have to come from somewhere.

That “somewhere” is institutions.

As we showed you before, institutions dictate incentives. Things like property rights, cultural norms, honest governments, dependable laws, and political stability, all create incentives of different kinds. Remember our hypothetical farmer? Through that farmer, you'll learn how different institutions affect all of us. You'll see how institutions help dictate how hard a person works, and how likely he or she is to invest in the economy, beyond that work.

Then, once you understand the full effect of institutions, you'll go beyond that, to the final piece of the wealth puzzle. And it's the most mysterious piece, too.

Why?

Because the final piece of the puzzle is the amorphous combination of a country’s history, ideas, culture, geography, and even a little luck. These things aren't as direct as the previous pieces, but they matter all the same.

You'll see why the US constitution is the way it is, and you'll learn about people like Adam Smith and John Locke, whose ideas helped inform it.

And if all this talk of pieces makes you think that the wealth puzzle is a complex one, you’d be right.

Because the truth is, the question of “what creates wealth?” really is complex. Even the puzzle pieces you'll learn about don't constitute every variable at play. And as we mentioned earlier, not only are the factors complex, but they're also constantly changing as they bump against each other.

Luckily, while the quest to finish the wealth puzzle isn’t over, at least we have some of the pieces in hand.

So take the time to dive in and listen to this video and let us know if you have questions along the way. After that, we'll soon head into a new section of the course: we’ll tackle the factors of production so we can further explore what leads to economic growth.

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We now return to the core question of this part of the course. Why are some countries rich and other countries poor? I'm going to lay out various pieces of the puzzle keeping in mind that it's - it's a complex question with many factors at play which are still being debated.


Let's start with a simple example. How does a farmer goes from this to this? The most immediate reason that some countries are rich is that their workers are very productive. So how do workers become productive? Well, they work with more and better factors of production. That's the first piece of the puzzle. Rich countries - they have a lot of physical capital and a lot of human capital, and that capital is organized using the best technological knowledge. By physical capital, economists mean tools in the broadest sense: shovels, tractors cell phones, roads, buildings.... More and better tools make workers more productive. Human capital is tools in the mind or the stuff in people's heads that makes them productive. Human capital - it's not something we're born with. It's produced by an investment in education and training and experience.


Technological knowledge is knowledge about how the world works, such as an understanding of genetics, soil composition, chemistry. This is the research that informs the books that our farmer reads. The final factor, a factor which is often taken for granted - is organization. Human capital, physical capital and technological knowledge - they've gotta be brought together, they've got to be organized in a way that produces valuable goods and services. In a capitalist society, it's the entrepreneurs who bring ideas, people and capital together in order to produce valuable products.


So rich countries - they have a lot of factors of production. But that's a bit too easy. Why do the rich countries have more factors of production? We've got to go back to the basics. Incentives matter. That's the next piece of the puzzle. Let's give an example. In China during the Great Leap Forward of the late 1950's and early 1960's, private farms were confiscated and consolidated into collectives. Collective property meant that the incentive to invest and to work hard was low. Imagine that if you invest and you work really hard you can produce an extra bag of potatoes in, say, a day. If you're part of a 100-person collective, you don't take home an extra bag of potatoes, but only one, one-hundredth (1/100) of a bag.


What would be the incentives to work hard, to invest? When effort is divorced from payment there's very little incentive to work productively. In fact, there's a incentive not to work and to free ride on the work of others. As a result of this and many other errors on the part of the Chinese leadership, some 20 to 40 million Chinese farmers and workers starved to death during this terrible time. China did not begin to take off as an economic powerhouse until farmers were allowed to keep the product of their efforts. As one Chinese farmer observed, "You can't be lazy when you work for your family and yourself." If you're curious to learn more about China, do check out our website. So, incentives are important.


But now we've gotta ask, "Why?" Why do some countries have good incentives? And the answer is that they have good institutions. So which institutions create incentives that spur prosperity? Well the good news here is that there is considerable agreement about what the key institutions for economic growth are. For example, if you buy a piece of land and you build a farm, do you have an official deed of ownership? ...one that will stand up in a court if someone tries to build, say, a corporate headquarters on top of your farm? Property rights allow you to protect your investment. Our farmer also has to think about our government. She might have to bribe government officials to get permits or worry about the outright seizure of her farm. So honest government is another key institution that allows our farmer to invest.


In some places the legal system is of such poor quality that it can be difficult to resolve disputes, such as collecting on a debt, or even determining the ownership of a piece of property. A dependable legal system lets our farmer enforce contracts and borrow and lend money. But our farmer still needs more. Sometimes the problem isn't too much government but too little. Political instability and the threat of anarchy are reoccurring problems in many countries. Who wants to invest in the future when civil war threatens to wash away all of your plans? Political stability is needed to give investors confidence to invest. We're almost there now, but our farmer still has to worry about inefficient and unnecessary regulations - regulations which can create monopolies and impede voluntary cooperation. Competitive and open markets let market signals do their work, and they let the farmer innovate and grow her business. So, we've covered the key institutions that allow our farmer to prosper: property rights, honest government, political stability, a dependable legal system, and competitive and open markets.


But now we've gotta ask, "Well, why?" Why do some countries have good institutions? This is perhaps the most actively debated question in all of development economics. And here we must answer with a mysterious combination of history, ideas, culture, geography, even a little bit of luck. Take for instance the United States. The US Constitution was fortunately written at a time when the ideas of John Locke and Adam Smith were popular. And it inherited a tendency towards a market economy and democratic institutions from its colonial parent, Great Britain. An open frontier, and plenty of freedom to try new ideas and new ways of living, to leave the old ways behind and to go to the frontier. This idea of the frontier perhaps influences America's entrepreneurial culture even today. And we were also very lucky that George Washington had the virtue to stop at two presidential terms rather than trying to become the next king.


So, what makes some countries rich and some countries poor? Well it's complicated, and the answer differs depending upon whether we want to look at the immediate causes or the ultimate causes. And these processes are also interacting in a dynamic and changing environment. We do know some of the things that matter, however. And the example of growth miracles, like China, Korea and Japan - that's encouraging. It is possible for very poor countries to grow very quickly and to reach their true potential once better incentives and institutions are put into place.


In the next section, we're gonna dive deeper into the factors of production in order to create a simple, but useful model of economic growth. Thanks!

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Show 2 Answers (Answer provided by Ion Sterpan)
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Kenya is probably not the best example of agricultural productivity because half of its farming is mere subsistence farming (the product is just enough to feed the farmer's family).
In the US, output per working hour has grown 12 times from 1950 to 2000. Corn productivity for example is 153 bushels of corn per acre every year. At a price of 3.40 dollars per bushel, that gives 520 dollars productivity per acre. It's pretty good. Have subsidies produced this change? It cannot be subsidies that made this happen because the government has been constantly (not increasingly) subsidizing farming. Labor has remained the same, or to be precise, it has decreased by 2 percent. So what explains the growth in productivity? To answer this question growth theory speaks in terms of (a) factors of production or inputs such as pieces of capital and pieces of labor; (b) the knowledge to combine the inputs in such a way that the value of output is greater than the sum of inputs' values; and in terms of (c) the incentives that people face to combine them in that way.
One key to understanding how the whole system works, is to recognize that the economically relevant knowledge to combine inputs only exists in dispersed, local and tacit form in many people's minds. F.A. Hayek's Use of Knowledge in Society explains this in more detail. The article is available on econlib.org. The other key is to recognize that the institutions which provide those people with the right incentives are those which support economic competition. These institutions are free exchange and free enterprise, and private property (which means that those entrepreneurs who combine inputs profitably keep the profit, and those who combine them badly suffer the losses).
You are right that the US is also wasting money. In fact, the level of subsidies is 20 dollars per acre, and this is a lot of waste. This is not just a waste at the economy level. It might even retard agricultural productivity rather than explain its productivity, since subsidies protect existing farmers from competition, the institution which fosters innovation in combining inputs. But the U.S. can afford some waste because it is also getting rich. And the U.S. becomes rich when people play upon rules which encourage entrepreneurs to use their knowledge and combine inputs in the least wasteful ways.

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I'm involved in the dairy industry in Kenya. I do not see them as being more productive. What do you mean?

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Show 1 Answer (Answer provided by Ion Sterpan)
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I totally agree. Entrepreneurial skills have to be combined with something else to produce value. For an economist, the value of an entrepreneurial idea simply means how much people are willing to pay for it. This means that the generation of value entails a whole system or network, in which the entrepreneur is just one node. Value requires a market, so people can bid for acquiring an idea; that those people have enough assets to buy it; have enough knowledge to understand it; expect they will enjoy the security to use it without fear of confiscation, accusation etc; that they will have the expectation that once they acquire it they will be able to make and keep their profit, if any. Moreover (just like you suggest when you mention a university system) an entrepreneurial skill, like the skill needed to create Visicalc is itself generated within a special kind of network which rewards, step by step a certain kind of intellectual progress. It is too complex to simply pop up in someone's mind out of nothing. These two observations lead us to conclude that if you extract one node -- say, Wozniacki -- and transport it in another network, not only might he die anonymous, but would never come up with that idea. (All this in no way suggest that entrepreneurs should share their profits with the so called "community" in the form of taxes to the government. The larger network is already enriched by innovators' ideas.) But perhaps we talk too much about the heroic innovators. Hayek (the author I mentioned in my earlier comment) talks about the small entrepreneur, the shipper who earns his living from using otherwise half-filled journeys, or the small arbitrageur who speculates local differences in prices. These business ideas qualify as "new" ideas, since no one had them before. They too are innovations, literally, they are new ways of combining concrete inputs. Growth is produced by a large number of small innovations like these. These people who provide small services, who only has ideas of circumstantial and transitory value, who combine unique concrete pieces of capital, don;t have any general or theoretical ideas. This view of the entrepreneur belongs to Ludwig von Mises, and is developed by Israel Kirzner.

I think you mean Steve Wozniak, not Wozniacki. :)

An "entrepreneur" is a misnomer because it describes at least 2 core functions: building and selling. In the Apple example, Steve Wozniak designed and created the Apple I, but it was Steve Jobs who sold their first order of 50 to the Byte Shop. Similarly, Bill and Paul shared the building and selling duties. One of the reasons Bill ended up with 70% of Microsoft was that when their initial customer, Altair, went out of business, he continued in Micro-soft while Paul took a job. Bill was able to rustle up new customers and when Paul returned, their 50/50 partnership was changed. The entrepreneur is therefore usually an entrepreneurial team. I describe these in my book.

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Show 1 Answer (Answer provided by Ion Sterpan)
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Such industries and activities belong to the 'third sector' - the nonprofit and nongovernmental sector. This is a sector which is neither commercial nor mandated by some public authority and coercively funded from taxes. It refers to cooperatives, voluntary nonprofit organizations, social enterprises and charities. There is such a thing as an economics of the third sector. These fall under the purview of economics because there is a demand and supply for these services and because the scope and limits of these activities arise from economizing choices - choices made by individuals who who are trying to achieve goals using as few resources as possible. The market for resources used in these activities generates prices and these prices makes the calculation of which nonprofit activity is more economic than which. These activities seem to be underprovided but people still engage in them for their own sake and also from concerns with their reputation. An entrepreneur's reputation generated by such activities may increase the demand for her product and thus increase monetary revenue.

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Show 1 Answer (Answer provided by Ion Sterpan)
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Good question. A resource can be in either one of four property regimes: open access (anyone can use it), private property, common property (the community excludes outsiders and also regulates individual insiders' access), and government property. There is also a fifth regime, a regime of uncertainty, where it is not yet clear who has the right to exclude whom from doing what, regarding a resource. This is probably the 'worst', because it leaves resources underutilized.
Eminent domain does vitiate the concept of private property rights because the "just compensation" is based not on the price aksed by the owner of that unique resource, but on the price of other resources judged by government experts to be similar to it. The concept of eminent domain moves resources from a private property regime or a common property regime towards a regime of uncertainty or government property.
I don't think there is a Marginal Revolution University video but here is a post by Alex Tabarrok:
http://marginalrevolution.com/marginalrevolution/2009/10/elinor-ostrom-a.... And there are other scholars at George Mason University who dedicate time to study the Ostroms such as Paul Dragos Aligica and Pete Boettke.
Elinor Ostrom does demonstrate that a common property regime is more efficient than private property when the resource cannot be divided into individual shares (for example a fishery), when resource use is too complicated to understand by a third party enforcer (a government policeman), and when users have a lower cost of reciprocally monitoring and enforcing compliance to rules than a third party.

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