A (6:02)

And just to be clear, just to reinforce it, all capitalist societies or all capitalist economies have markets and voluntary exchange.

B (6:12)

And they require the institutions that were grown up organically during those stages. You can't do without a sense of propriety in exchange. You can't do without a currency in a set of institutions for reducing the transactions cost. And that's what markets are. So capitalism assumes that both of the larger circles are still operating and then something more which makes them capitalist.

A (6:38)

And we're going to get to that. So let's start with the simplest and most basic one, which is in all these systems, which is voluntary exchange, or we sometimes call it in economics, mutually beneficial exchange. What do we mean by that and.

B (6:58)

Why is it important in an exchange both, in a voluntary exchange, both parties to the exchange are better off. And I've gone off on a whole separate set of research initiatives about what makes an exchange voluntary. So I wrote about you. Voluntary or truly voluntary exchange, the set of conditions that are required for an exchange to be voluntary. And you could put up in the show notes some of the links to that work, if people are interested, and.

A (7:27)

We did an episode on it. If you're lazy and don't want to read the real work, you can hear us talking about that.

B (7:35)

If you are a connoisseur of previous episodes.

A (7:38)

That's what I meant.

B (7:40)

And I think we lose sight, and I know students lose sight of the power of having many, many small improvements. And economists often talk about things at the margin. Tyler Cowen's blog with Alex Tabarak is about marginal revolution. The aggregate consequences of many, many small improvements is, in the aggregate, probably more important than looking just at really big improvements. So if you and I engage in an exchange and both of us are better off, how would we measure that? Economists say that they have a way of knowing how much better off people are, and that's the concept of consumer surplus. So if I pay you for something, that must mean that I value the thing more than what I'm paying you, and you must value it less. The question is how much more? And so economists, because we believe that we know utility functions and we can monetize preferences, say that consumer surplus is the amount of benefit that I get above and beyond what I have to pay. So let's suppose that I would pay as much as $10, but I can get it for $4. That means that I have a benefit of $6. That's consumer surplus. Now, if you and I are just exchanging, then in effect, both of us have consumer surplus. Because I'm not giving you money. We're talking about apples and bananas. So I have an apple, you have a banana. Each of us like better what the other person has, so each of us is better off if we exchange. Now, the world doesn't look any different because the amount of apples and bananas in the world is the same. There's still one. But the world is a better place because each of us is better off. That's why voluntary exchange is important. It's actually very difficult because we don't know utility functions. And people actually decide how much better they are off they are. In contemplating the exchange, I see something and I think, huh, I'd actually like to have that. And I would like to have it more than this thing that I have that the other person will accept. And so the power of voluntary exchange is that all these people are collecting some small, some large consumer surplus from every one of these exchanges. And no matter how advanced the society, even in a capitalist society, where the rubber hits the road is the fact that all of us are made better off by all of these myriad little transactions where we're better off with the thing than what we have to get up to obtain the thing. So we should never lose sight of the fact that at the ground level, all of this is individual voluntary exchanges.

A (10:30)

Just a footnote or two on that. Of course, there's some uncertainty in the real world. A slightly refined definition of what you said is that I make an exchange expecting that I will be better off. I may be disappointed. I may turn out. Turns out I don't like bananas. I like the look of it. So we understand that in any single exchange, people can make a mistake. They can also be defrauded. And we'll talk about that more later. But in general, if I swap something and you swap it with something else with me, we both do so in the expectation we're going to prefer the thing we're receiving to the thing we gave up. Sometimes that's money, when it's a monetary, when it's a purchase. But we might want to. We're starting here talking about, literally, exchange or barter. And you may now use your second favorite Adam Smith quote.

B (11:27)

My second favorite Adam Smith quote is that I assume this is what you mean, that people have an innate propensity to truck barter and exchange. That means that it is something like, I have a desire for hunger or what? For food because I'm hungry. Or what Adam Smith called the mutual attraction of the sexes or thirst. People like exchanging for the sake of exchanging. Now, in addition, the product of that is that we both get things that make us better off. The problem with exchange is that it doesn't change the total amount of stuff. It just makes better use of the stuff that we already have. That's really important. And given the amount of stuff that we have, exchange always moves it in the right direction. Not only with no central plan, but with no individual plan. I just say, well, I'd like to have that. What will you take for it? And you say, well, okay, what do you. What have you got? And we exchange.

A (12:40)

I just want to go deeper into that because, you know, in a conversation we had before we recorded this, I realized I didn't really fully understand the implication of Smith. And I think it's half of what you said, and the other half is something you've, I think, said implicitly. So we have a natural propensity, according to Smith, to truck, barter and exchange. But what does that mean exactly? And I, you know, I think we probably talked about this. I probably talked about him. The episode with Dwayne Betts, when we talked about Primo Levy as well as Ralph Ellison, and in his book the Truce, where Primo Levi talks about coming back from Auschwitz and we're trying to get back to Italy, which is a long, meandering, painful and challenging journey, was an immense amount of barter. An unbelievable amount of barter. It's an incredibly large part of the book. And he's got a buddy he falls in with. And if I remember this correctly, there's a scene where they just negotiate over things they don't own or have. They're just practicing. They're just enjoying the give and take. The theatrical aspect of negotiation or truck and barter and exchange. So I think we like the idea of getting a deal. And that's part of what Adam Smith is saying. But the deeper part, which I didn't appreciate until we talked about it, is it's a desire to improve oneself. So I might like apples. They're fine. But if I feel like I'd like a banana more than an apple, and you feel the same way about an apple versus a banana, we make that exchange not because we just, oh, it's so fun to trade, but because we have a thirst and hunger to do better. And I think that's do you agree with that?

B (14:27)

Not only do I agree with it, it actually brings me back to one of my other favorite Adam Smith quotes, which is that his claim is that we actually care what other people think about us. And so what's hidden in Smith's truck, barter and exchange is in the earlier book, he's developed what he calls propriety. And propriety is the way that we judge the actions of others. And the way that we do that is that we engage in an imaginative speculation about an impartial spectator. And that is, would this impartial spectator approve of this action? So what you said, which is very deep, is not only do I desire to improve myself, I desire to improve you. I want the exchange to be fair. And so each of these exchanges, now, sometimes I might cheat people. Maybe it's someone that I don't know, that I won't see again. But by and large, at the level of we're just talking about voluntary exchange now, these are mostly local. These are mostly with people that I will see again. And we start to develop an institution where not only I'm trying to improve myself, but I want you to allow. I want to allow you to improve yourself also in the exchange because we have a long term reciprocal relation. And what Smith develops, that I think is such a deep insight, is that at first, it's actually literally my desire to improve myself. And you, I see you, I look in your eyes, I see you smile. You look at the banana, you're happy. Over time, though, I become committed to the principle of making the person I'm trading with better off. It's not just you personally, but it's me imagining how I would feel if I were the person that I was exchanging with. That's what the impartial spectator does. It internalizes my how I would feel if I were the person being exchanged worth. And I wouldn't like being defrauded. And so I don't defraud people.

A (16:32)

So when you mentioned his earlier book, that's the Theory of Moral Sentiments, where he says, man naturally desires not only to be loved, but to be lovely. And by using that language, he means honored, respected, praised, worth, and lovely, meaning worthy of honor, worthy of respect, worthy of praise. So I want you to respect me, and I want to earn that respect honestly. And of course, as you say, Smith understands we can fool ourselves, we can be imperfect, but it is some restraint on our self interest, which is the focus of the wealth of nations, and the sense in which there's this empathetic, impartial Spectator idea in the wealth of Nations. It's not explicit. He almost never says anything remotely like it. But he does, if I remember correctly, say that I'll be a better player in the marketplace. I'll exchange more effectively with you if I can imagine what you need, if I can put myself in your shoes. And so what. The way I hear what you're saying is the following. If I'm going to be interacting with you as a neighbor or as a person at the local marketplace that meets on the weekends, where we exchange produce or other things we maybe made in that setting, the more I understand what you're going to want, the more I can help myself and you, of course, but. But it's a simultaneous system. So what exchange is about is these two things, as you've taught me in our conversation before we recorded and in some of your writing that we'll link to, is that this seemingly self interested drive of self improvement, and that's not the best word because that sometimes means moral. But.

B (18:30)

Improving my lot, they're of a piece I don't think you should. That's well put.

A (18:35)

Okay, so I want to improve my lot, meaning I want to have more stuff. At the same time I'd like to be a better person. Because if by doing that I can be more empathetic to your needs and what would make your lot better, what would improve your well being, then I will be able to exchange with you more effectively.

B (18:55)

And it is the separation of that by modern economists that makes Adam Smith hard to understand. Adam Smith would be mystified about why you would want to separate those two things. I think improving myself is exactly right. I want to improve my household situation. I want to improve the set of the opulence of my living. And I want to improve at the same time my character and my commitment to propriety and justice.

A (19:20)

Okay, so in general, let me try to summarize what we said about voluntary exchange. Then we'll move on to markets in general with voluntary, with what is simply. I'll just call it exchange. If you and I make a deal, we both expect to be better off. We've rearranged the stuff in the world in a more attractive allocation, a more attractive distribution. But it's been done voluntarily and it works best with people that have repeat interactions so that I can use this desire to be loved and lovely to constrain bad behavior and opportunistic behavior. On the other hand, in a small society, if you are a rapacious traitor and not considerate and lie about what I'M getting. And when we make the trade, you might get pushed out into the wilderness. People just won't deal with you anymore, you'll get blacklisted. But that's trade exchange. Excuse me, that's exchange and exchange. It's good, but it barely touches the opportunity for our commercial interactions to transform our standard of living and material well being. So let's, let's move on.

B (21:00)

Well, let me say two things about the transition, because they're important. Yes, Voluntary exchange doesn't. It seems like it's local and it doesn't improve much, although it takes the stuff that we have and makes, gives it to a better use. What Pareto would say was, some people are better off, no one's worse off. As a result of these exchanges. That continues though that is still the foundation of even the most advanced society, because it's still true that I'm trying to obtain things. The thing that the true genius of Smith was that he recognized, darn it, we need scale. And without scale we can't really do much better. We can't achieve opulence because we need some way to start to increase the amount of stuff. Not just to make better use of what we have already, but to increase the amount of stuff. That's the nature of opulence. And so the transition comes when my commitment is not to I see you, another person, I want to make you better off also because that increases my sense of, of propriety about myself. I become committed to what Smith thinks is the core principle of a prosperous society. And that's what he calls justice. This justice is abstaining from what is another's. And it has three parts, person, property and promise. I become committed to not taking someone else's stuff. I become committed to not interfering with another person's life. And I become committed to carrying out my promises for their own sake. And the impartial spectator approves of this. So you have to go through the exchange period, the stage of exchange, to develop justice. Now, once you have this underlying justice, you can start to develop the institutions for what I want to claim is the second stage. So in terms of concentric circles, this is all the exchanges still going on. But for some societies, they start to develop markets. And markets are a set of institutions for reducing the transactions cost of impersonal exchange. And notice what a big change that is. This is impersonal exchange. It requires that the people have reached that the people participating have reached a certain stage of commitment to justice for its own sake. Because it's no longer, I know I will be trading with you again. This enables one off transactions where I buy something from someone that I won't see again, but I can still be relied on to act justly in according with justice, there's all sorts of problems. So that when I say reduce, it's not eliminate, but reduce the transactions cost of impersonal exchange. And I have to admit, in graduate school, I took a couple of classes from Douglas north, and the definition of markets that I just gave is his. I had no idea why he emphasized impersonal exchange so much. It's taken me decades to understand this and another decade to understand that that's actually what Adam Smith was talking about. Markets are a way of reducing the transactions cost of impersonal exchange. Why? Why do we need to do that? I said we needed scale. Why do we need that? And the answer is, and this is again, Smith's genius. I actually get goosebumps just this is before the Industrial Revolution, the early parts of the Industrial Revolution, Smith recognized that this source of opulence is in a context where exchange is allowed. And it works well with not much friction because we've developed these other institutions. It's division of labor. And I don't think anyone, not one person in 100, understands division of labor. They can give you the definition, but they don't understand it. And my evidence is Duke students are smart and well educated and they have no idea what division of labor is.

A (25:09)

Well, I probably don't understand it either, but I've thought about it a lot because it's such an extraordinary and beautiful engine of prosperity. I did a solo episode of Econ Talk on this that we'll link to with connecting the ideas of Smith on this with David Ricardo and exchange and trade generally. Let's walk through what the division of labor unleashes. So I want to go back to our. I want to set it up for you. It turns out you like bananas and I like apples, but my land's really good for growing bananas and yours is good for apples. So when I say prefer, I like them both, but I might want more than I might just be able to grow of one or the other. So one of the opportunities we have, once you enter my life once Friday is part of Robinson Crusoe's existence, is there's another person who brings their productivity into the. Into the exchange. So if instead of growing both apples and really, excuse me, instead of growing bananas really well and apples not so well, because I like them both, I might grow just bananas and you might grow just Apples, and I'll get my apples by exchanging bananas with you. And that's a very primitive division of labor. I'm going to specialize. I'm going to do one thing. And one of Smith's great insights is that when you do one thing, you can get better at it. But he's got an idea about division of labor that's much more subtle and nuanced than that. So give us the flavor of that. It's of kind. The pin factory he writes about as one example. You can read about that in the wealth of Nations. And there are other places.

B (27:05)

What's interesting about this is that there's two things. One of the reasons that I think no one understands division of labor is that they tend to go straight to. And you've referred to it, and quite rightly, that division of labor might be based just on comparative advantage, that some people are good at one thing and some people are good at another thing. Smith takes an additional step and recognizes that even if we were all clones, we were all exactly the same. If we were the philosopher and the street porter when we were very young and basically indistinguishable as we spend time specializing in a particular thing, we might become better. And that's the thing that society needs to organize. A context where people are free to learn particular skills, become inculcated with ways of doing things, with knowledge, with the accumulation of knowledge. Because you start to accumulate knowledge when you start to specialize, and then you can hand it on to the next generation. So the way I like to think about this, and I hate to belabor it, but I want to make sure that people understand. I start with four people in class, and let's suppose that these four people each want to have clothes, shoes, fish and vegetables. And we start up. We all are in this little area, and each of us are making our own clothes, our own shoes, catching our own fish and growing our own vegetables. We are deeply, desperately poor. And so we notice that some of us may be a little bit better. Adam Smith gives the example of a bowman. So there is a person who is a very good artisan at making bows. And so to begin with, we're all hunters. And so I make my own bow, and then I spend a little bit of time making a bow for you. Before long, I'm making a bow for the whole village. And he says that that's the beginning of specialization. So we notice, because we have this propensity to truck, barter and exchange. If all of us are making all of our own stuff there's no point exchanging because we all have just tiny amounts of all four things. So none of us plans it. None of us say, you know, it would be cool if we specialized. We just start doing it. So I start at the margin because I'm a little bit better at fishing. I start spending more time at fishing and then exchanging for the other three things. You start making clothes, and you start exchanging for the other three things. So before long, we end up. The four people have engaged in what's called artisanal specialization. That is, I've become an artisan. One of us makes only clothing, and before long, I know a lot about making clothing. One of us does only fishing, one of us does only vegetables, and one of us makes only shoes. So Smith claims that because we are able to first engage in this activity only, I improve my dexterity. I practice, I become better at it. Even if all four of us were clones to begin with, within a year, there are dramatic differences in how productive we are because of changes in dexterity.

A (30:29)

Learning by doing is the modern jargon for that. I get. I get better at it. Practice makes perfect. You know, I start to do something over and over again, as long as I don't get bored, which is a separate issue.

B (30:40)

Even if you get bored, because you're probably bored making all four things before this is, you had to spend all of your time. That's an important point. Let's focus on that for a second. Before you had to make all four, you spent 23 hours a day doing it. You could hardly ever sleep otherwise. You're gonna be starved, you're gonna be starving, have no shoes. You can barely provide. So, yes, you're bored now for the 13 hours a day you work, but now you get a little bit of time off because you're so much more productive. So it was always boring if you had to work all the time. Now you have some leisure time. So the other thing that you start to engage in because of improvements in dexterity, you have tool use. As you specialize, you start to think about technological improvements in the production process. And so as a result, this little group of four people is much wealthier. But that's artisanal. That's not division of labor.

A (31:39)

Before you go on, I always want to emphasize the transition that we've been talking about. In our first example, you just had some stuff. Maybe you grew it, maybe you didn't. Sometimes you're endowed with stuff. There's apple trees on your property. You're not a farmer, you just have apple trees. And you have banana trees on your property and we swap. Once we have the possibility of specialization, the amount of stuff to be exchanged isn't fixed anymore. And it's a glorious thing. The total pile of stuff gets bigger. Through the two processes we mentioned. There's a natural improvement because some people are better at some of these things than others. We're not all equal. The second improvement is we get dexterity and practice learning by doing. The third is we start to imagine and implementing sometimes tools that make us even more productive than we were originally. So there's a lot more bananas, a lot more apples, a lot more shoes, et cetera, et cetera. So it basically puts the production specialization puts the production process on steroids. And of course, Ricardo's great insight was that you might be the best fisherman, Mike, of the four of us, but that doesn't mean you will be the fisherman. It may turn out that because you're so good at growing vegetables that to be a fisherman means you're going to sacrifice the opportunity cost. What you give up to be a fisherman is so large that you're actually going to not. We're not going to assign the best person in fishing to fishing. That's a profound insight. And the other piece of this is that in a modern economy, wages are playing a role of assigning people to different tasks and jobs. And that's an amazing thing. You could spend an enormous portion of an economics class giving people the intuition of how that happens and how it doesn't necessarily mean that the most skilled person at a task is the person who you'd want to assign to it because they'd give up even more. It's much more effective to let you grow the vegetables, Mike and Al Fisher. I'm not as good a fisherman as you are, but you're so much better at vegetable growing than I am that our exchange will be more productive for both of us. If you choose the thing that you give up, the thing that you're the best at.

B (34:12)

Not only is that right, I think we need to invert it. Because the power of Ricardo's insight is not that the person who as best will be necessarily doing that one thing because they're even better at something else. Suppose we have someone who is desperately poor and they are worse at everything. The poorest person, they will still now be employed and be significantly better off because they will do the thing that other people are relatively worst off, not that they're worst at. He doesn't have to be the best at anything. He can be the worst at everything. But if the person who is the best at fishing is the fisher person, the person, the person best in relative terms, that I can produce more fish than I can anything else, someone else makes clothes, someone else makes shoes, I'm going to be out there growing vegetables, and the result is I will be better off than I would otherwise have been. So it's not so much. It's not just that Ricardo's insight says that the person who is best will specialize. It's that even the person who is worst off will benefit from specializing because of the power of division of labor, the increase in the amount of stuff that we then suboptimize by exchanging.

A (35:34)

And now we get to Adam Smith's. My third favorite quote of Adam Smith. We've mentioned the first two. The third quote is underappreciated and gets dwarfed by Ricardo's insight because I think it's better for exam questions, which is a tragedy. But Smith's great insight is the division of labor is limited by the extent of the market.

B (35:57)

So if this George Stigler actually published a paper with that as the title to make sure that it was impossible to miss, because that is a theorem, that's actually a theorem that the division of labor is limited by the extent of the market. And it's the title of just the third chapter of book one of wealth of Nations. So if we don't appreciate it, it's because we're not paying attention.

A (36:19)

So why is it important?

B (36:25)

Remember that the market is a set of institutions for reducing the transactions cost of impersonal exchange. And we haven't said what those institutions might be. One of the things that they might include is institutions that improve and reduce the cost of administration of justice. So a sense of property rights, a judicial system for adjudicating disputes over property rights, breach of contract. You know, you said you do this, you didn't do this. If we can enforce that, then people are more likely just always to obey because in equilibrium, any breach of contract will be punished. And so I can more reliably, I can rely on you keeping your promises in addition to your desire to keep promises. Because of your sense of propriety, you will keep the promise because otherwise the legal system will subject you to cost. And so they act together. Now, if we had to contract for everything, that would be no good. You've said a number of times in in the United States, if you buy a house, a bunch of stuff that's in the house goes along. And it's not because it was in the contract. So if I say you're going to buy my house, and I mentioned there's this one expensive chandelier that does not convey, which means it doesn't go in the, in the sale and you show up at the house after you bought it. And I also took the gas range. No, no, no, you don't do that. It is understood that the stuff that's in the house goes along. And it's just because it's understood I'm not doing it because the legal system would threaten me. And I have a sense of justice and that's what I do. So we've developed a bunch of institutions that reduce the transactions cost of impersonal exchange. And a big one of those is money, some sort of currency, a reliable system for being able to exchange a numeraire. Good. Which is what economists mean by this is something everybody wants because it allows me to buy other things. Barter exchange requires the double coincidence of wants. If I have something you want, you also have to have something I want. Or we have to find a third person and make a three way exchange. Money means that all of us can engage in bilateral exchanges. So we've started to develop those institutions. Now the extent of the market is the size of the people who cooperate within that system of what in effect provides the public good of reduced transactions cost. Reduced transactions cost is platform to reduce the friction of voluntary exchange, the frictions that prevent voluntary exchanges. Because someone else far away may have something that I want, but me acquiring it is so expensive that it dwarfs the consumer surplus that I would obtain. So if we can reduce transportation costs, we have systems of accounting that allow me to have big infrastructure, ships, railroads. Accounting systems are another one of the things that allow us to start to achieve scale. And that's what extent of the market means. So.

A (39:25)

Well, let me just say that. Let me just expand that because that was a long sentence. The larger the pool I can trade with now, pool's not the right word. The larger the number of people I can trade with. And in this sense the word market, I'm going to use it now in the everyday sense. The larger the market for what I make meaning the larger the number of people who might want to buy it, the more I can have divisional labor. And that sounds like okay, yeah, yeah, yeah, yeah, but it's unbelievably important and deep because.

B (39:59)

And it brings us.

A (40:00)

Because when I trade. No, you go ahead.

B (40:03)

It brings us back to our four people.

A (40:05)

That's what I was going to do too.

B (40:07)

Sorry. Well, then you get the assistance, you get the assist. It's okay in hockey. We both get a point. Let's go back to our four people, because we left them, and they were all artisans, and things are going along pretty well. We are a lot richer. But we notice that there are other villages not very far away. And we don't know much about those people. They're sort of creepy. Maybe they worship different gods. They have all sorts of different language and different habits. But still, we are an inland village. And it's a little bit difficult for us to engage in fishing because we have a river. But it's far to go to the coast. This other village is right on the coast. They have a lot more fish. The person who engages in fishing there is really good at that. And so we say, you know what we could do? We seem to have really fertile land. Why don't all four of us engage in farming vegetables? And we will then be able to exchange the huge amount of vegetables we're able to produce with this other village that now has started to produce only fish. And now the four of us take the job of farming, which the artisan farmer before was pretty good at. He was really producing a lot of cantaloupes and zucchini. So we were doing okay. But now we divide the act of farming into four steps. So one of us specializes in domesticating plants, in seeds, in planting. One of us learns about plowing and developing tools that make plowing and harvesting more effective. So sharp metal edges. We start to develop metallurgy. One of us learns about harvesting and storing, maybe using salt or something else to preserve. And one of us specializes in carting all of the vegetables that we have developed to other villages. So now we have so many vegetables, but that's not opulence.

A (42:15)

Yeah. Just to emphasize if the very best vegetable grower was the one who was the grower of vegetables in our little community of four people, you'd think that if we all became farmers, we'd have four times that, but not quite, because he was the best one. The idea here is that you're going to get eight or 16 times or more of output of vegetables because of this power of specialization of the division of labor.

B (42:46)

And at that point, you're adding a third factor. Remember, the two factors before were dexterity and the development of tools. Both of those are dramatically increased by dividing into the four tasks. The other thing that Smith mentions, though, is that I'm not so often changing between tasks. I'm just engaging in the same task over and over. Again, so the scope of how much I'm working on is reduced, which means that I don't have to do 10 or 12 different things. I'm doing three or four different things. And so dexterity improves quite a bit. And tool use means that I've really thought deeply about each of the small steps in the process that I'm working on, and I'm not switching back and forth between tasks. So what you said is, perfect. We've got four people. If all four of us engaged in farming or one of the other things, at best it would be four times what we had before. This is 20, 30 times as much. What economists call this is increasing returns to scale. As we add more labor to this process, we're actually getting proportionately more output up to a certain point. And that's what's important about the extent of the market. Let's suppose that the village starts to grow and we have more and more people. How many people would be engaged in this activity? And the answer is not obvious. The number of people engaged in the activity is limited by. Wait. It is obvious. The extent of the market. How much can we sell? How much can we sell?

A (44:22)

And this is the most important point we haven't mentioned yet. I'm sorry to cut it, because it does gives me goosebumps too, is that if you're going to grow 40 zucchinis and harvest 40 zucchinis and drive 40 zucchinis to the market, you might have a little patch of land and a hoe, and you're going to have a cart or a bicycle to take them to the market. If you're growing 40,000 zucchinis, you can have a truck and you can have a harvester and a mechanized plow and so on. And you'd say, well, you could have those anyway. Doesn't make sense when you're growing 40. In fact, it's more expensive to grow 40 with a big truck and a harvester and a mechanized plow.

B (45:05)

But he's the thing to develop them. The process of developing those, because those are tools, you would only think to develop those if you are climbing up the amount of production. So all of what we think of as the industrial revolution is driven by this tendency to truck, barter and exchange unleashed by market institutions that increase the extent of the market. No one says, you know, we need to have an industrial revolution. It just happened. It was an emergent phenomenon that results from the fact that the division of labor is limited by the extent of the market. And the extent of the market wants to Be bigger. We want to find more and more people to exchange with, not because it makes them wealthier, but because it makes us wealthier. It just also makes them wealthier.

A (45:53)

And that brings us to a punchline that both you and I have come to, that I love, and I know you love, which is that if you have 100 people who are incredibly skilled, unbelievably talented, I'll let you pick them. You pick the 99 most skilled people in the world to live with you on the most resource rich island in the world. You can put any kind of resources on that island that you want. You're going to be desperately poor. It doesn't matter how skilled you are, because those hundred people, there's not that much room for the division of labor. But when you trade with 7 billion people, which is to some extent, sorry, the punishment, the world that we live in now, you could have unimaginable specialization and the standard of living for people of limited skill, not the 100 most skilled people in the world. People have, okay, skill can be fabulously well off in the material sense from the opportunities to trade with this enormous group of people, because as you point out, we've reduced the transaction costs and we've allowed for that impersonal exchange with not just the other village, not just the people across the country, people in different countries, faraway countries. And that's the miracle of the modern prosperity that so many people enjoy in 2025.

B (47:17)

And so that's what Deirdre Merclosky has called the great enrichment. There's this sort of puzzle that for most of human history, there wasn't much improvement. There were some inventions in science. You know, there's some improvement, there's changes in fashions. But then at some point there was this giant takeoff. And as a result, we have seen the decline of poverty at the same time that there was an enormous increase in the amount of population. And when you put those two things together, it actually does seem miraculous. It's not just that a fixed number of people got relatively more wealthy. We doubled, tripled, quadrupled the number of people at the same time that the absolute level of poverty was also falling. And the reason is division of labor. Division of labor is increasing returns. And so Malthus was worried about exponential population growth. What we have seen is there has been population growth, that's true. But the increasing returns to scale that come from division of labor has more than kept pace with the population increase to the point that it is much better to be poor today than it was to be a king in 1600.

A (48:34)

And I think the other important point to add is that most people see the world, many people see the world as a zero sum game. If I get better off, you must be, somebody must be worse off. This is a world and this is the world of human history. And it's, it's not a small point and it is, I think, incredibly profound. The gradual increase in material well being of the world's population during a time of population growth, dramatic, enormous population growth allowed people to be better off at no one's expense, at no one getting worse without anyone getting worse off. Who did they take it from? How did they acquire that well being? Who did they extract it? Who did they from? Who did they exploit? And the answer is no one. Now that's not to say there weren't people who exploited people. There are people who are thieves. There are people who are crony capitalists who use the system to use the legal system to exploit people. For sure, there are dishonest people who defraud customers who provide things that aren't what they promise 100%. But the fundamental underlying story of the last 150 or so years of human history is an enormous expansion of well being without anyone suffering because of it. And that Smith understood before it happened.

B (49:57)

He predicted it and it now we probably shouldn't go too far in that direction. His understanding of corporations and of division of labor, some of what he was talking about though was not just within a country. He talked about it being along rivers, but he did foresee the importance of exchanging with other nations. And that's why his book is addressed to the philosophy of mercantilism, where wealth and opulence is a result of keeping precious metals and money at home. He said no, opulence comes from exchange and, and we should exchange more with other nations. And that was the. That prediction is what has borne fruit. It's the expanse to make markets operate in the entire world that has improved the wealth not just of the wealthy countries. The big increases in wealth have been in the poor countries. And that's the miracle of markets.

A (51:01)

And now let's turn to capitalism, which until we had our prep conversation for this episode, turns out I didn't really understand. Kind of awkward. But I learned something deep from you. So tell us what capitalism is.

B (51:15)

Nobody. No, I did. I said nobody knows what division of labor is. 1 in 100, 0 out of 100 know what capitalism is.

A (51:23)

Don't say that because a lot of listeners will just turn off their players and turn on other podcasts.

B (51:29)

Yeah, they might just write an angry letter and listen in order to say, if they've listened this far, far, then I'm hoping that they will continue. And of course, when I say what capitalism is, it means it's how I want to define it. And people might want to quarrel with that. That's not even. You're wrong about that. So my definition of capitalism is an elaboration of markets. And so again, in terms of the concentric circles, we've still got all of that voluntary exchange operating, and we've still got all of those markets operating. Capitalism is something in addition, that assumes all of the exchanges and all of the division of labor is also operating.

A (52:09)

Capitalism and the institutions and the institutions.

B (52:12)

That make those work, the institutions, the attitudes, the ideas, culture. So if, and we saw this, if you say, well, all you need to do to have capitalism is to have a set of rules in a stock exchange, then the former Soviet Union says, oh, well, that's what we'll have too. We'll have capitalism. It doesn't work. It falls apart. So capitalism can't be grafted on to a society that doesn't have these attitudes and institutions already. And so I hate to keep praising Douglas north, but I am a student of Douglas North. Right after he won the Nobel Prize in 1993, he did one of those world tour things. And you know, people have this very effusive fanboy sort of reaction. Oh, professor north, it is so great to have you here. Can you tell us how our nation can have economic and political development? And he would say, well, first thing you'll need is a different history. Thanks, that's very helpful. But it's true. You can't just have capitalism.

A (53:24)

Well, tell us what it is first.

B (53:27)

Okay, I'm sorry for that. Capitalism is a set of market specialized market institutions that allow time travel. And it's time travel that breaks a chicken and egg problem that thwarts the development of many nations. And the single word that gives the argument for capitalism is one that I think most people don't expect. That single word is liquidity. Liquidity is a way of transitioning from money or resources that have value and can be transferred into fixed capital, which is resources that have value because it increases the productivity of labor, but that cannot be easily transferred into something else. So usually capital is a big bank account or line of credit where I have money and I can devote it to buying things and create a factory, buy land, hire a bunch of consultants, create an organizational structure. So this is money that can be moved around a physical factory, a place where I can build automobiles. Once I have devoted my liquid capital to making that factory, I can no longer convert it to making chips. It is very difficult to convert that to making chips. So suppose I have a new idea about making cars, and I say I'm going to build a factory to make new automobiles. And I live in a country that has well developed markets. So I say, well, first thing I'm going to need is a whole lot of liquidity, because I'm going to use that to build the factory. Where would I get it? I'm not. There's no way for me to solve this chicken and egg problem. I need a factory to make the cars that'll produce the profits, to produce the liquidity that would allow me to buy the factory in the first place. And so I'm stuck. What capitalism does is solve that problem by time travel. We're going to travel forward into the future in expectation to a time when this factory is operating and is producing substantial profits. I'm going to take some of those profits and get in my time machine and go back in time and invest it in the resources that create the fixed capital that now allow me to start earning the profits. But time machines don't exist. So what actually is it? And it's a particular form of institution that allows me to sell shares in the profits that don't yet actually exist. And so the question is, can I find someone? Can I persuade someone and notice that I'm persuading them voluntarily? Maybe fraud happens. It could be that I'm defrauding them. But people who do this for a living are pretty sharp. They ask questions. Think Shark Tank. We're talking about Shark Tank, the TV show. So I come and I have an idea, and I sometimes watch Shark Tank when I'm exercising at the gym. And so I'm there on my elliptical machine. Somebody comes in. They're all excited, and they're immediately deflated by these really aggressive questions from these potential investors. You're not going to make any money from that. What price are you going to charge? What are your costs? So I have a bunch of questions for you. But if you say, well, here's what I expect to be the cost of this thing. A lot of people want to buy it. All I need is enough liquidity to create the factory that will allow me to make the thing that will make the profits. They say, okay, yeah, I will give you this. So liquidity, the first step of liquidity is I can go and Persuade some people that we're going to make profits. And when I say we, that's essential. Not I, we are going to make profits because I'm going to sell shares in my corporation. You own a share, you become a part owner, owner. And I generally can't do this without getting enough capital. In order to do so, a founder usually has to find some investors. And what investors could do is they could loan you the money, so they it could be financed just with debt. But there's a big difference between debt and equity shares. So debt has a long history. You can have capitalism, you can have markets for a long time based just on debt, but it is not capitalism. What capitalism requires is a set of financial markets that allow thick trading where you get prices. You are pricing the future value of a corporation that doesn't exist.

A (58:26)

And as a result of having shares as opposed to debt, if I borrow money from you for my factory.

B (58:35)

Your.

A (58:35)

Money'S at risk if I don't make enough money to pay you back. But you've got no upside except the fixed amount that I promised you as the interest on this loan. The beauty of equity is two things. One, you share in the upside, so you're willing potentially to give me a lot more money, which I couldn't otherwise get you to do because you're just stuck with the interest in the case of debt. But with equity, you have promise of the upside. And also once you have markets in those shares, you have a different level of liquidity in the opportunity if you change your mind, or if you want to have a richer and more diverse portfolio and not only rely on one founder to come up with a good idea, you could have multiple founders because you have shares in multiple companies, totally transformed the landscape. But I want to say two things. First of all, the word capital, which sometimes it's hard to remember, that's in the word capitalism, because capitalism kind of runs together. But the word capital has two meanings in what we're saying. Capital is liquidity. It means, oh, yeah, I have some capital I could share with you. I could invest in your company because I have some extra capital I can invest. But it also means the physical resources that, as you point out, make labor more productive. So if I'm making cars in an artisanal way with chisels and pickaxes and I don't know what hammers, and because I can sell, if I'm making one, that's probably how I'm going to do it. But if I can make a million, because the market's Large enough to support a million. I can create a factory and the workers in that factory are going to make really good wages because I'm providing capital, the machines that they work with to make them more productive. And that of course, is another way in which our general acquisition of material well being occurs in the modern world. But the point that is profound here, that you helped me see, that I did not see before, is that when you have exchange and you just barter and you move stuff around, you have a potential to improve through the process of getting more of what you like relative to things you have to start with. When you move to a market, you can have production and divisional labor and you can make more of what you want and more of what other people want. And there's still that Smithian empathy of understanding. I wonder if they'd like to this. But the third level, which is the even bigger steroidal leap of productivity, is there's some things that we aren't making yet and they're risky. Most of them aren't going to pan out. People aren't going to like them. They're going to be products that people don't want to pay for. So who should take a chance on whether that's a good idea or not? The answer is the dreamer, the visionary. Alongside the investors who are convinced that that upside could materialize, which allows that time travel to bring that future profit back into the present and launch that enterprise, which often fails. But when it succeeds, you expand enormously the range of things that are available to enjoy the goods and services that we can make our lives more pleasant with. And that is why capitalism, you've taught me, is so powerful. Without those financial institutions, without the ability to invest and do have the liquidity to do that time travel trick, you really are stuck with whatever you got already. You can maybe make it a little more effectively by figuring out some new tool or some new division of labor allocation. But to get stuff you haven't dreamed of that one person imagines and can convince some people to risk their hard earned capital, well, that's capitalism. And you get an explosion of what's possible.

B (62:43)

It's a shocking explosion. So let me emphasize a couple of things that you said that are really important. And one is that if we're talking about debt, the amount of money that I will loan you, I might loan you a very considerable amount, but it has to be paid back. And so just when I get at the point where the business is starting to prosper, I want a second factory. It's time to invest. Oh, but wait, I owe you basically all of that, all that I've saved, plus I have to borrow more. I have no way of getting any of the money that I would need to invest. If you're a stockholder, you're saying this is great because I don't have to get my money back. I have already had a substantial appreciation in the equity shares. But if I want to, there's a secondary market, a thick secondary market that allows me to sell those shares to someone else so I can realize the gain. None of that money comes out of the investment stream of the company. All of it is being plowed back into the company. So the way that you can get growth in a capitalist system is not possible in a debt financed system. And so I wrote an article a while back and it is an interesting question about whether China is a capitalist country. China more and more is finding itself capital constrained because they're not able to raise equity shares. All of of China's production is financed either out of, in effect tax money that comes from the government or it is savings that have come from the business itself. And so it's very difficult for businesses to expand very much. So let's compare two different meanings. One is so in a capitalist system, in a full grown capitalist system, there is such a level of specialization that you have a few hundred people that are specializing in a business called venture capital. And what they do is they get money from people who have capital in the sense of being funds that they can spare to invest and they find the best targets for these things. Now most of those are going to fail. But if you lose $100,000 on 10 businesses and on the 11th you make 100 million, you're good. That's all you have to do is a venture capitalism. You can have a batting average that would immediately kick you out of AA baseball. I'm only batting.080, but those eight out of 100 companies that I have invested in, huge returns, more than enough to offset the amount that. So I have lunch with some venture capitalists. I tell them some stories, I have some data, they look at my spreadsheets, they make a couple of phone calls and they next morning I get an email saying, yes, we are going to give you an equity stake of $25 million and we want 30% of your company. We ink that we have a contract and now I can start my factory meeting. Two, I go and meet with a bunch of government officials and I say look, if we can build this factory, I think we can really Produce some really great products. Now the government officials, if the company succeeds, receive nothing because there's no equity share. The government doesn't have this. The government is just trying to decide whether to loan us some money or if the company goes bankrupt because it's building a bunch of high rise apartments that no one will ever occupy. But they can say we achieved our objective. Because the way we evaluate bureaucracies is did they spend their budget? Well, they've got $100 million. Yes, they spent their budget check mark. The bureaucrat gets to keep their job. There's no upside, there's no downside to that. Second meeting, the first meeting, there's a really big upside and a really big downside. And so they care a lot about whether this business is going to succeed. But you can only have that degree of specialization in a capitalist system where these venture capitalists and there's only a few hundred people who are really first level venture capitalists. That degree of specialization and that amount of capital to be available means that there are very few capitalist countries. And it's hard to become a capitalist country because you have to have a set of institutions. Well, you need a different history. Basically, Doug north was right. For most countries you would need a different history.

A (67:39)

So just to emphasize this point about a new product, if, if our town's growing and I decide I want to open a grocery store, it's already a grocery store. But our town's growing, there's room for a second one. I usually borrow that money. I don't look for investors. I go to the bank and I get a loan. The bank.

B (68:01)

Because we know what a grocery store is. We can, that, that makes sense.

A (68:04)

They can make it growing. They can measure pretty well, not perfectly because sometimes things go wrong, but they can measure pretty. And I might not be good at running a grocery, by the way, which would be the other important thing. But they were pretty good at figuring out what my prices are going to be, what my revenue might likely to be, my cost, my revenue. And as a result they can realize that, oh, he'll probably be able to pay back this loan and if he doesn't, we still have the building. We could sell it for some other use. That's called collateral. But if I'm going to start an online grocery store, or let's say an online bookstore, which was what Amazon started as, there's no way I can't go to the bank.

B (68:39)

There's no way. That's ridiculous.

A (68:40)

Can't go to the bank, can't get a loan. Got to get an equity investment, you got to get someone to take a share of the company. And. And this insight of capitalism as liquidity, and I would just add, because it's implicit, a profit and loss system, a system by which success is measured by profit and failures, losses or failures, is extraordinary. And it's a huge part of what sustains our well being.

B (69:13)

You did a podcast a while back with, I believe it was Paul Graham, the head of Y Combinator, and talked about a company that I was ridiculous. There's no chance of it succeeding. So there's a bunch of nuts think that if there's an empty apartment and the owner has the key, that you could have some sort of online arrangement that would allow people to rent that apartment. Well, that's the stupidest thing that I've ever heard. There's no way that's going to work, so I'm not going to invest in that. But a few people did invest in Airbnb, and as a result, it became extremely profitable. Now, they needed to be able to set up an app and they needed a sort of proof of concept. They had to acquire an inventory of properties that would allow them to show that other people might also rent apartments. As a result, it very quickly took off. And so the time travel part of this was they would never have been able to achieve the scale that's necessary to start making people think, well, this might work well enough that I'm going to participate. And so the Y Combinator is. And other. There's a few companies that specialize, organizations that specialize in providing incubators. What's interesting is that venture capital often is another two or three zeros. And that happens enough in a capitalist society that it creates an atmosphere of entrepreneurship where people actually try to think of these ideas. So there's an additional step. It's not that I have a good idea. It's that people are going around trying to think of things that do not yet exist that might work.

A (71:12)

I just want to add a correction to that Airbnb story because I love it so much. The people who founded Airbnb, their original idea wasn't very exciting to the Y Combinator people. So they said, you know, this is not a great idea, but we like you, so why don't you try this? Try it anyway. Or. Anyway, they started Airbnb and it was a terrible failure. And part of the reason was, is that most of the apartments were in New York City and they were living in California, which is where the Y Combinator required them to live. And they said to, you know, to practice and get reaction and get use the skills of the people in the Y Combinator community. And finally they said, you need to move to New York and you need better photographs. And they gave them that simple tip, which I think was not unimportant. And it took off.

B (72:01)

It took capital. It took a little bit of money in order to build that out, because they had to build out a website that actually had those pictures.

A (72:09)

And it was a picture.

B (72:10)

Never have done that without the capital.

A (72:12)

But the point was, is that that was a very, very embryonic enterprise. And the people who invested in it, the Y Combinator people invested in it because they thought that people were talented. They were skeptical about the idea. And it's fun to hear him talk about it. You can hear Paul Graham and also you can hear. I interviewed Nathan Placarczyk, who was one of the founders. We have an episode with him, we'll put up. But basically they said, we'll take a chance because it was a relatively small amount of money with an enormous upside, which has, of course, they time traveled. They brought a lot of that money to the investment eventually and created an incredible enterprise. But that is a brand new idea. It was a total figment of their imagination that the investors thought, yeah, we'll take a chance. One of the many.

B (73:12)

Well, and not only did they take a chance, but they continued to fund it. It was called Airbnb because they had first tried it in the city of Denver, had hosted the Democratic National Convention, and there weren't nearly enough hotels. And so a few people basically allowed couch surfing. So airbnb was couchsurfing, except they used air mattresses so you could sleep on the floor and have an air mattress. And in the morning it was a B and B, meaning that you would get a power bar and a cup of tea.

A (73:43)

It was air bed. Air bed and breakfast.

B (73:46)

Yeah. So it's an air mattress where you get in the morning a granola bar and a cup of tea. So this was. And their idea was it'll be Couchsurfing for people like us. And what the Y Combinator people said, you need business people, you need to go to New York, you need to get better pictures. So it was a couple of years of this is actually not only it wasn't a good idea and okay, we're going to fund it. This is a not very good idea, but it seems like it's worth a risk. And not many people had to take a risk. If only a few people take a risk. And Most of the time, most of these businesses collapse. A few of them, though, become successful. And you don't have to. Your success rate can be tiny, as long as even just a hundredth or a thousandth of the companies you invest in become gigantically successful on the scale of Airbnb. So that's the secret of capitalism, is that it enables people to. I said their ventual capitalist is specialization. There's a few people who can specialize in taking risks and they can diversify. It's almost if it's the inverse of insurance. So I am not spreading out risk of failure, of disaster. I'm spreading out risk of success across many businesses. And if one of them succeeds, that's going to cover all of the other losses. Losses. So liquidity is. And the reason that they were able to cash out was then eventually you can start raising funds from other sources by selling more shares of stock. So the idea that liquidity is a bridge, where you said there's two different kinds of capital, there's one. Because they are united by the concept of liquidity. Liquidity is the ability reliably and cheaply to go back and forth between. I have some capital to invest and I have an automobile factory. Being able to go back and forth and to travel across time is what is the essence of capitalism.

A (76:03)

And of course, it's always important to point out that material well being beats the alternative. Poverty is. I never want to romanticize poverty. It's a brutal, unpleasant thing. But prosperity is not necessarily enough to sustain people emotionally. I think a great challenge of the 21st century in the richest countries of human history, mostly in the west, but increasingly elsewhere, is to also find meaning, either through one's work or through one's family or through one's religion or through one's hobbies. There are a number of ways to do it, but something isn't quite right, it appears to me. And despite the great prosperity that has been unleashed by Smithian division of labor and by the development of institutions that allow trade among strangers, reducing transaction costs and ultimately allowing, at the highest level that we're talking about, the financing of, of new product ideas with equity, where risk taking is encouraged by the profit and prudence is encouraged by the potential for loss, that's just not enough for the things we call human beings. We need to feel like we belong. We look for sources of meaning. So some of that's in Smith in his first book, the Theory of Moral Sentiments, because I think when we're loved and lovely, we have a decent life. I think Smith was very right about that. But that's a little harder, evidently, to do in certain ways than having a high income in modern times. So I want to close on that. I'd love to hear your reaction.

B (77:50)

I think that's exactly right. And that's why we have tried to emphasize that it's not a transition from exchange to markets and exchange from markets to capitalism. All of these things have to continue operating at the same time. Now, when sometimes I will have a Duke student tell me, well, now money isn't everything, I'll ask them, well, how big is your trust fund? Because almost everyone who tells me that money isn't everything was never poor. If you're poor, money is quite a bit. So not having to worry about where am I going to live, am I going to be able to take care of the basic needs of my family? Those things are pretty important. On the other hand, it is true that Adam Smith wrote two books and all of his point about being embedded in a society. Now it's a commercial society, but it is a society, so you can't substitute commerce for society. These things have to go together. And if we can find a way to bring back the society part of commercial society, I think capitalism is likely to be more sustainable as it stands. You're right. We have some thinking to do.

A (79:09)

My guest today has been Mike Munger. Mike, thanks for being part of Ecom Talk.

B (79:13)

A pleasure, Russ. Thank you.

A (79:21)

This is Econ Talk, part of the Library of Economics and Liberty. For more Econ Talk, go to econtalk.org where you can also comment on today's podcast and find links and readings related to today's conversation. The sound engineer for Econ Talk is Rich Goyet. I'm your host, Russ Roberts. Thanks for listening. Talk to you on Monday.