How does everyone not become poor over time?

Question

Look at the whole world --the union of all goods and services and workers and customers. Everyone who is a customer is a worker somewhere (they had to get the money to be a customer somehow). But not all revenue goes toward worker wages--some goes to cost of goods--production, not just labor. And considering the whole world--it's a closed system...so if everyone pays Z in as a customer--they lose X to cost of goods and are paid out up to Z-X as workers -- then, when they are next customers, next round of purchasing, Z-X goes back in as rev and Z-2X comes back to everyone... keeps going. You lose cost of goods each round of purchasing. you need X more from customers to sustain this--which means you need to keep injecting X from outside or have more customers than workers. But where do these injections come from if we are accounting for all goods and services? Or where is this larger set of customers who are not also workers? Where does their money come from if not from work? Elderly, children and those who do not work also derive their money from this cycle--they were workers, will be workers or live off a % of workers' wages from taxes or friends and family.

The answer is presumably wealth or value creation but how is this integrated into the cycle of workers and customers so that Z grows instead of shrinks?

Economic novice--thanks!

Answer 1

In short because economy is not a zero-sum game and because economic production does not need to decline but can grow over time.

First of all, forget about money. Money in economics is just extra tool that solves issue of double coincidence of wants, allows you to store value over time and to do accounting. In fact, traditionally money consisted of commodities such as stone, or precious metals or even products, coffee, cigarettes or even alcohol etc at some point in time and place served as money.

As a non-economist this might come as a surprise to you but most microeconomic models do not even have money in them. Money can play an important role in macroeconomic perspective because in the short-run it can affect the real economy, but from micro perspective and even long-term macro perspective money is neutral and not important.

Next, as you pointed out a world's economy, taken as whole, is a closed system but that does not mean people should get poorer over time. This is not an equivalent of thermodynamically closed system where entropy has to dissipate energy overt time. A closed economy can be described as:

$$Y = C + I + G$$

which says that output/income (they are economically equivalent) $Y$ has to be equal to consumption $C$, investment $I$ and government spending $G$. In turn, $Y$ is a result of production. A common specification for production process would be to use Cobb-Douglas production function, so I will do that here as well, although in principle there could be multiple functional forms that production process could have. Moreover, for simplicity I will restrict myself to two factors of production (labor and capital) even though in principle you could put into Cobb-Douglas also human capital (education), land and other factors, but I omit them for sake of brevity. Given these assumptions the production process would be given by:

$$Y = A K^{\alpha} L^{\beta}$$

where $A$ is the available technology (broadly defined - in economics better production strategies count as a technology as opposed to just 'gadgets' such as PC), $K$ is the stock of capital and $L$ is the stock of labor. Alpha and beta are parameters of the production function that determine other characteristics of production such as what sort of economies of scale production exhibits (e.g. increasing, decreasing or constant).

Thus, we can say that the consumption, investment and government spending is equal to this production process:

$$ A K^{\alpha} L^{\beta} = Y = C + I + G$$

So as long as technology $A$ or capital $K$ or labor grows, output $Y$ will grow as well and even completely closed of economy can consume more, invest more or have more government spending.

Furthermore, what we really care about is usually output/income (in economics output and income are equivalent and interchangeable) per head. So if we for simplicity assume constant returns to scale ($\beta = 1-\alpha; 0 < \alpha < 1$) we can divide the last expression by $L$ to get whole expression per capita as:

$$A \left(\frac{K}{L}\right)^{\alpha} = \frac{Y}{L} = \frac{C}{L} + \frac{I}{L} + \frac{G}{L} $$

Here, if we keep the population growth constant then we can see that per capita incomes/output and consequently per capita consumption, investment and government spending will grow when our capital stock and technology stock grows. You get growth in capital stock from investment (investment is part of production that is not consumed but saved for future, possibly for further production), and growth in technology from human ingenuity or also depending on which economic growth theory you buy to also investment.

In addition, all the above is up till now just manipulation of definitional expressions. We could further continue by adding on some growth theory which could yield further insights. For example, the most popular growth model presently is the Solow-Swan growth model where it can be shown that what really matters is growth in $A$ because increase in investment and capital stock can only increase level of output not growth. If you buy into endogenous growth theories investment can even increase the growth rate further beyond that (you can read more on this in Barro & Sala-i-Martin: Economic Growth 2nd ed).

In order for people to get poorer over time (in per capita terms) an economy would have to experience either destruction of technology (for example ancient Romans, Greeks, Carthaginians etc had plumbing but this knowledge was lost in many parts of World - but not all - during dark ages, or another example would be concrete) or by destruction of capital (e.g. war, violence, natural disasters etc. but also just wear and tear i.e. depreciation). Empirically, and let me add thankfully, people historically turned out to be better at producing new technologies and adding new capital through investment, than at destroying either of them.

Consequently, to sum up people do not get poorer over time and in fact get richer because of growth in economic production (which in turn determines people's income), and economic growth occurs primarily thanks to growth in technology and investment. In fact note because the economic growth is to large extent driven by technology, it is possible for economic production to grow indefinitely (assuming technology has no limit - e.g. in real life it is possible you can't get at an end of technology tree like in some strategy game as it might have no end). In addition, more rich models would also include other important factors such as human capital (education) but the explanation above would not conceptually change (education macroeconomically functions in same way as capital - hence why economists call it human capital).

Answer 2

There is a serious flaw in your reasoning. You seem to think that at each production step, some of the money goes to people (labour) and the rest is burnt in a fire.

This is not true. All of the money goes to people. When you pay Z for a product, all of Z goes to workers, owners, investors, rentiers, etc. None is destroyed.

Answer 3

Just adding to the great answer by 1muflon1. There is a fallacy in your argument: some money goes to pay for goods, but in capitalism there are property rights, so those goods (like land or the product of land) are owned by someone that gets an income from the money spent in them. There is no leakage of money.

Answer 4

The simplest possible answer is it's because economy is a system of exchange of labour, where labour is ultimately the source of all wealth.

If you build a log cabin for yourself in the woods, you don't become poorer -- on the contrary, you now have a one cabin's worth of labour in the form of a cabin, where some of that labour went into getting the resources, and some into processing these resources into a cabin. Now, if you have an economy with two people, who both contribute one cabin's worth of labour, they don't become poorer either. In fact, your economy will likely be richer than just 2 cabins, because of division of labour. If one of them focuses on building cabins, and the other on growing food, they can now both have a better cabin and more food than if they each had to build their own cabin and grow their own food. The more people you add to your economy, and the more sophisticated the division of labour, the more productive (ie. richer) your economy as a whole becomes. Note that there's no money here, just labour. Money is a relatively recent invention, and one that makes exchange of labour immensely easier, but it's not actually essential to having an economy.

Now, of course in particular places, in particular economic systems, at particular times, it's possible for economies to contract and lose wealth. That's what economic crises are, in addition to things such as wars, where wealth literally goes up in smoke. But even in crises, where collectively everyone becomes poorer, some people will individually become richer. Those things are however specific to particular circumstances; in general, that is not the case, because economies are essentially ways of answering the question of "what could we achieve if we worked together?". Some are better, some are worse, but they all rest on the value of labour.

Answer 5

And considering the whole world--it's a closed system...

But the world is not a closed system.

The Sun has continually pumped energy into it for billions of years, thus:

• constantly making more plants (including trees and food),
• while leaving abundant amounts of coal, oil and natural gas, and
• powering the weather, which in addition to recycling water, redistributes minerals from mountain rocks to soil.

Also, radioactive decay deep in the Earth powers the recycling of minerals in the crust. (Weathered lava fields are incredibly fertile.)

Efficiently tapping all that energy is what allows us to prosper.