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So, long story short: The amount of money a person can earn for their labor in a market economy is constrained by the amount of value they can produce. Those who are able to generate a lot of revenue for employers will be hot commodities that employers will want to have, and those employers’ competition with each other to win those productive workers’ services will bid up their wages. But those who aren’t able to generate as much revenue, on the other hand, won’t be in such high demand; employers won’t be as willing to bid up their wages, and so those wages will stay low as a result. As Sowell writes:

The tendency to regard low-paid workers as exploited is understandable as a desire to seek a remedy in moral or political crusades to right a wrong.  But, as noted economist Henry Hazlitt said, years ago:

The real problem of poverty is not a problem of “distribution” but of production. The poor are poor not because something is being withheld from them but because, for whatever reason, they are not producing enough.

This, frankly, sucks for low-productivity workers. Sure, it might be true that all legitimate transactions in a market economy (including employment agreements) are voluntary and mutually beneficial – but “beneficial” in this context doesn’t mean “perfectly ideal;” it just means “better than the alternatives.” And for these workers, that’s not saying much. They must often accept low pay, lousy working conditions, inconvenient work schedules, and other such difficulties for the simple reason that they don’t have any other real alternatives. They’re like the drowning person in that analogy I keep coming back to, who has to accept a grossly lopsided deal from the lone rescue ship because they just can’t find any better options. It’s not a good situation; and we ought to want better for these workers. So what can be done? Well, once again, the most obvious solution is to make it so they do have better options to choose from – to buoy them up, so to speak, so they don’t have to just immediately accept whatever terms are offered by the first rescue ship to come by. In other words, if their low productivity is keeping them from prospering, one thing we can do to help is increase their productivity. As Taylor writes:

The issue in labor markets is not only the number of jobs, but also how to have good jobs that pay decent wages. Over time the labor market will tend to push wages toward underlying levels of productivity. After all, if a worker is receiving more than that worker produces, then the business will have an incentive either to fire that worker or at least not adjust wages upward until productivity rises. If a worker is producing more than that worker’s wage, then a competitive alternative employer should be willing to bid for that worker, and one way or another, the worker will end up with a bigger paycheck. Thus, in the long run, the basis for strong wage growth over time is to increase average worker productivity. That means investing in better education, encouraging investment in better physical capital equipment, and discovering and adopting new technology. When an economy can bring those factors together, the ideal of good jobs at good wages becomes achievable.

He breaks down what exactly this means in a bit more detail:

The underlying cause of long-term economic growth is a rise in productivity growth—that is, higher output per hour worked or higher output per worker. The three big drivers of productivity growth are an increase in physical capital, that is, more capital equipment for workers to use on the job; more human capital, meaning workers who have more experience or better education; and better technology, that is, more efficient ways of producing things. In practice, these work together in the context of the incentives in a market-oriented economy. However, a standard approach is to calculate how much education and experience per worker have increased and how much physical capital equipment per worker has increased. Then, any remaining growth that cannot be explained by these factors is commonly attributed to improved technology—where “technology” is a broad term referring to all the large and small innovations that change what is produced.

When economists break down the determinants of economic growth for an economy such as the United States, a common finding is that about one-fourth of long-term economic growth can be explained by growth in human capital, such as more education and more experience. Another one-fourth of economic growth can be explained by physical capital: more machinery to work with, more places producing goods. But about one-half of all growth is new technology. If you do a similar breakdown of the reasons for growth in low-income countries, where education levels and physical capital are being updated more rapidly, more of their productivity growth tends to come from gains in physical and human capital and less from new technology.

The role of technology here might seem surprising at first; after all, isn’t automation one of the biggest killers of jobs? Well, not necessarily. He continues:

For the past several centuries, workers have feared that new technologies would diminish the demand for their labor and drive down wages. The historical data show that while new technologies have made certain industries and jobs obsolete, they have also helped to create new industries and jobs. Moreover, the use of that new technology has made labor more productive, which results in higher wages.

In other words, if (let’s say) a typist is able to use a typewriter to do their work – or better yet, a computer – they’ll be able to produce a lot more for their employer than if they had to write everything out by hand. This increased output will make their labor worth paying more for; so as a result, their wage will be higher. Likewise, if someone is working in garment construction, they’ll be able to produce a lot more garments using a sewing machine than they would if they had to painstakingly stitch together every piece by hand – so they’ll be able to command a higher wage for their work with the sewing machine. Of course, there are also cases where technology can displace workers by taking over their jobs completely – things like factory assembly lines come to mind – but in those cases, the technology is still increasing worker productivity; it’s just that the workers whose productivity it’s increasing are the ones responsible for installing, operating, and maintaining the technology itself. This naturally has both negative effects (for the workers whose jobs are made obsolete) and positive effects (for everyone else). But we’ll get into that whole discussion momentarily. For now, the point is just to note that technology shouldn’t immediately be dismissed as necessarily bad for workers; in a lot of cases, it can help them in a major way by increasing their productivity (and therefore their wages).

Let’s also examine another factor mentioned above: human capital. Wheelan provides a whole long discussion of this topic – as well as the related topics of technology and productivity in general – which I want to just include in its entirety here (there are also a couple of points about foreign trade that might need a bit of clarification, but we’ll get to those later as well):

Like many people, Bill Gates found his house a little cramped once he had children. The software mogul moved into his $100 million dollar mansion in 1997; not long after, it needed some tweaking. The 37,000-square-foot home has a twenty-seat theater, a reception hall, parking for twenty-eight cars, an indoor trampoline pit, and all kinds of computer gadgetry, such as phones that ring only when the person being called is nearby. But the house was not quite big enough. According to documents filed with the zoning board in suburban Medina, Washington, Mr. Gates and his wife added another bedroom and some additional play and study areas for their children.

There are a lot of things one might infer from Mr. Gates’s home addition, but one of them is fairly obvious: It is good to be Bill Gates. The world is a fascinating playground when you have $50 billion or so. One might also ponder some larger questions: Why do some people have indoor trampolines and private jets while others sleep in bus station bathrooms? How is it that roughly 13 percent of Americans are poor, which is an improvement from a recent peak of 15 percent in 1993 but not significantly better than it was during any year in the 1970s? Meanwhile, one in five American children—and a staggering 35 percent of black children—live in poverty. Of course, America is the rich guy on the block. At the dawn of the third millennium, vast swathes of the world’s population—some three billion people—are desperately poor.

Economists study poverty and income inequality. They seek to understand who is poor, why they are poor, and what can be done about it. Any discussion of why Bill Gates is so much richer than the men and women sleeping in steam tunnels must begin with a concept economists refer to as human capital. Human capital is the sum total of skills embodied within an individual: education, intelligence, charisma, creativity, work experience, entrepreneurial vigor, even the ability to throw a baseball fast. It is what you would be left with if someone stripped away all of your assets—your job, your money, your home, your possessions—and left you on a street corner with only the clothes on your back. How would Bill Gates fare in such a situation? Very well. Even if his wealth were confiscated, other companies would snap him up as a consultant, a board member, a CEO, a motivational speaker. (When Steve Jobs was fired from Apple, the company that he founded, he turned around and founded Pixar; only later did Apple invite him back.) How would Tiger Woods do? Just fine. If someone lent him golf clubs, he could be winning a tournament by the weekend.

How would Bubba, who dropped out of school in tenth grade and has a methamphetamine addiction, fare? Not so well. The difference is human capital; Bubba doesn’t have much. (Ironically, some very rich individuals, such as the sultan of Brunei, might not do particularly well in this exercise either; the sultan is rich because his kingdom sits atop an enormous oil reserve.) The labor market is no different from the market for anything else; some kinds of talent are in greater demand than others. The more nearly unique a set of skills, the better compensated their owner will be. Alex Rodriguez will earn $275 million over ten years playing baseball for the New York Yankees because he can hit a round ball traveling ninety-plus miles an hour harder and more often than other people can. “A-Rod” will help the Yankees win games, which will fill stadiums, sell merchandise, and earn television revenues. Virtually no one else on the planet can do that as well as he can.

As with other aspects of the market economy, the price of a certain skill bears no inherent relation to its social value, only its scarcity. I once interviewed Robert Solow, winner of the 1987 Nobel Prize in Economics and a noted baseball enthusiast. I asked if it bothered him that he received less money for winning the Nobel Prize than Roger Clemens, who was pitching for the Red Sox at the time, earned in a single season. “No,” Solow said. “There are a lot of good economists, but there is only one Roger Clemens.” That is how economists think.

Who is wealthy in America, or at least comfortable? Software programmers, hand surgeons, nuclear engineers, writers, accountants, bankers, teachers. Sometimes these individuals have natural talent; more often they have acquired their skills through specialized training and education. In other words, they have made significant investments in human capital. Like any other kind of investment—from building a manufacturing plant to buying a bond—money invested today in human capital will yield a return in the future. A very good return. A college education is reckoned to yield about a 10 percent return on investment, meaning that if you put down money today for college tuition, you can expect to earn that money back plus about 10 percent a year in higher earnings. Few people on Wall Street make better investments than that on a regular basis.

Human capital is an economic passport—literally, in some cases. When I was an undergraduate in the late 1980s, I met a young Palestinian man named Gamal Abouali. Gamal’s family, who lived in Kuwait, were insistent that their son finish his degree in three years instead of four. This required taking extra classes each quarter and attending school every summer, all of which seemed rather extreme to me at the time. What about internships and foreign study, or even a winter in Colorado as a ski bum? I had lunch with Gamal’s father once, and he explained that the Palestinian existence was itinerant and precarious. Mr. Abouali was an accountant, a profession that he could practice nearly anywhere in the world—because, he explained, that is where he might end up. The family had lived in Canada before moving to Kuwait; they could easily be somewhere else in five years, he said.

Gamal was studying engineering, a similarly universal skill. The sooner he had his degree, his father insisted, the more secure he would be. Not only would the degree allow him to earn a living, but it might also enable him to find a home. In some developed countries, the right to immigrate is based on skills and education—human capital.

Mr. Abouali’s thoughts were strikingly prescient. After Saddam Hussein’s retreat from Kuwait in 1990, most of the Palestinian population, including Gamal’s family, was expelled because the Kuwaiti government felt that the Palestinians had been sympathetic to the Iraqi aggressors. Mr. Abouali’s daughter gave him a copy of the first edition of this book. When he read the above section, he exclaimed, “See, I was right!”

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The opposite is true at the other end of the labor pool. The skills necessary to ask “Would you like fries with that?” are not scarce. There are probably 150 million people in America capable of selling value meals at McDonald’s. Fast-food restaurants need only pay a wage high enough to put warm bodies behind all of their cash registers. That may be $7.25 an hour when the economy is slow or $11 an hour when the labor market is especially tight; it will never be $500 an hour, which is the kind of fee that a top trial lawyer can command. Excellent trial lawyers are scarce; burger flippers are not. The most insightful way to think about poverty, in this country or anywhere else in the world, is as a dearth of human capital. True, people are poor in America because they cannot find good jobs. But that is the symptom, not the illness. The underlying problem is a lack of skills, or human capital. The poverty rate for high school dropouts in America is 12 times the poverty rate for college graduates. Why is India one of the poorest countries in the world? Primarily because 35 percent of the population is illiterate (down from almost 50 percent in the early 1990s). Or individuals may suffer from conditions that render their human capital less useful. A high proportion of America’s homeless population suffers from substance abuse, disability, or mental illness.

A healthy economy matters, too. It was easier to find a job in 2001 than it was in 1975 or 1932. A rising tide does indeed lift all boats; economic growth is a very good thing for poor people. Period. But even at high tide, low-skilled workers are clinging to driftwood while their better-skilled peers are having cocktails on their yachts. A robust economy does not transform valet parking attendants into college professors. Investments in human capital do that. Macroeconomic factors control the tides; human capital determines the quality of the boat. Conversely, a bad economy is usually most devastating for workers at the shallow end of the labor pool.

Consider this thought experiment. Imagine that on some Monday morning we dropped off 100,000 high school dropouts on the corner of State Street and Madison Street in Chicago. It would be a social calamity. Government services would be stretched to capacity or beyond; crime would go up. Businesses would be deterred from locating in downtown Chicago. Politicians would plead for help from the state or the federal government: Either give us enough money to support these people or help us get rid of them. When business leaders in Sacramento, California, decided to crack down on the homeless, one strategy was to offer them one-way bus tickets out of town. (Atlanta reportedly did the same before the 1996 Olympics.)

Now imagine the same corner and let’s drop off 100,000 graduates from America’s top universities. The buses arrive at the corner of State and Madison and begin unloading lawyers, doctors, artists, geneticists, software engineers, and a lot of smart, motivated people with general skills. Many of these individuals would find jobs immediately. (Remember, human capital embodies not only classroom training but also perseverance, honesty, creativity—virtues that lend themselves to finding work.) Some of these highly skilled graduates would start their own businesses; entrepreneurial flair is certainly an important component of human capital. Some of them would leave for other places; highly skilled workers are more mobile than their low-skilled peers. In some cases, firms would relocate to Chicago or open up offices and plants in Chicago to take advantage of this temporary glut of talent. Economic pundits would later describe this freak unloading of buses as a boon for Chicago’s economic development, much as waves of immigration helped America to develop.

If this example sounds contrived, consider the case of the Naval Air Warfare Center (NAWC) in Indianapolis, a facility that produced advanced electronics for the navy until the late 1990s. NAWC, which employed roughly 2,600 workers, was slated to be closed as part of the military’s downsizing. We’re all familiar with these plant-closing stories. Hundreds or thousands of workers lose their jobs; businesses in the surrounding community begin to wither because so much purchasing power has been lost. Someone comes on camera and says, “When the plant closed back in [some year], this town just began to die.” But NAWC was a very different story. One of its most valuable assets was its workforce, some 40 percent of whom were scientists or engineers. Astute local leaders, led by Mayor Stephen Goldsmith, believed that the plant could be sold to a private buyer. Seven companies filed bids; Hughes Electronics was the winner.

On a Friday in January 1997, the NAWC employees went home as government employees; the following Monday, 98 percent of them came to work as Hughes employees. (And NAWC became HAWC.) The Hughes executives I interviewed said that the value of the acquisition lay in the people, not just the bricks and mortar. Hughes was buying a massive amount of human capital that it could not easily find anywhere else. This story contrasts sharply with the plant closings that Bruce Springsteen sings about, where workers with limited education find that their narrow sets of skills have no value once the mill/mine/factory/plant is gone. The difference is human capital. Indeed, economists can even provide empirical support for those Springsteen songs. Labor economist Robert Topel has estimated that experienced workers lose 25 percent of their earnings capacity in the long run when they are forced to change jobs by a plant closing.

Now is an appropriate time to dispatch one of the most pernicious notions in public policy: the lump of labor fallacy. This is the mistaken belief that there is a fixed amount of work to be done in the economy, and therefore every new job must come at the expense of a job lost somewhere else. If I am unemployed, the mistaken argument goes, then I will find work only if someone else works less, or not at all. This is how the French government used to believe the world worked, and it is wrong. Jobs are created anytime an individual provides a new good or service, or finds a better (or cheaper) way of providing an old one.

The numbers prove the point. The U.S. economy produced tens of millions of new jobs over the past three decades, including virtually the entire Internet sector. (Yes, the recession that began in 2007 destroyed lots of jobs, too.) Millions of women entered the labor force in the second half of the twentieth century, yet our unemployment rate was still extremely low by historical standards until the beginning of the recent downturn. Similarly, huge waves of immigrants have come to work in America throughout our history without any long-run increase in unemployment. Are there short-term displacements? Absolutely; some workers lose jobs or see their wages depressed when they are forced to compete with new entrants to the labor force. But more jobs are created than lost. Remember, new workers must spend their earnings elsewhere in the economy, creating new demand for other products. The economic pie gets bigger, not merely resliced.

Here is the intuition: Imagine a farming community in which numerous families own and farm their own land. Each family produces just enough to feed itself; there is no surplus harvest or unfarmed land. Everyone in this town has enough to eat; on the other hand, no one lives particularly well. Every family spends large amounts of time doing domestic chores. They make their own clothes, teach their own children, make and repair their own farm implements, etc. Suppose a guy wanders into town looking for work. In scenario one, this guy has no skills. There is no extra land to farm, so the community tells him to get back on the train. Maybe they even buy him a one-way ticket out of town. This town has “no jobs.”

Now consider scenario two: The guy who ambles into town has a Ph.D. in agronomy. He has designed a new kind of plow that improves corn yields. He trades his plow to farmers in exchange for a small share of their harvests. Everybody is better off. The agronomist can support himself; the farmers have more to eat, even after paying for their new plows (or else they wouldn’t buy the plows). And this community has just created one new job: plow salesman. Soon thereafter, a carpenter arrives at the train station. He offers to do all the odd jobs that limit the amount of time farmers can spend tending to their crops. Yields go up again because farmers are able to spend more time doing what they do best: farming. And another new job is created.

At this point, farmers are growing more than they can possibly eat themselves, so they “spend” their surplus to recruit a teacher to town. That’s another new job. She teaches the children in the town, making the next generation of farmers better educated and more productive than their parents. Over time, our contrived farming town, which had “no jobs” at the beginning of this exercise, has romance novelists, firefighters, professional baseball players, and even engineers who design iPhones and Margarita Space Paks. This is the one-page economic history of the United States. Rising levels of human capital enabled an agrarian nation to evolve into places as rich and complex as Manhattan and Silicon Valley.

Not all is rosy along the way, of course. Suppose one of our newly educated farmers designs a plow that produces even better yields, putting the first plow salesman out of business—creative destruction. True, this technological breakthrough eliminates one job in the short run. In the long run, though, the town is still better off. Remember, all the farmers are now richer (as measured by higher corn yields), enabling them to hire the unemployed agronomist to do something else, such as develop new hybrid seeds (which will make the town richer yet). Technology displaces workers in the short run but does not lead to mass unemployment in the long run. Rather, we become richer, which creates demand for new jobs elsewhere in the economy. Of course, educated workers fare much better than uneducated workers in this process. They are more versatile in a fast-changing economy, making them more likely to be left standing after a bout of creative destruction.

Human capital is about much more than earning more money. It makes us better parents, more informed voters, more appreciative of art and culture, more able to enjoy the fruits of life. It can make us healthier because we eat better and exercise more. (Meanwhile, good health is an important component of human capital.) Educated parents are more likely to put their children in car seats and teach them about colors and letters before they begin school. In the developing world, the impact of human capital can be even more profound. Economists have found that a year of additional schooling for a woman in a low-income country is associated with a 5 to 10 percent reduction in her child’s likelihood of dying in the first five years of life.

Similarly, our total stock of human capital—everything we know as a people—defines how well off we are as a society. We benefit from the fact that we know how to prevent polio or make stainless steel—even if virtually no one reading this book would be able to do either of those things if left stranded on a deserted island. Economist Gary Becker, who was awarded the Nobel Prize for his work in the field of human capital, reckons that the stock of education, training, skills, and even the health of people constitutes about 75 percent of the wealth of a modern economy. Not diamonds, buildings, oil, or fancy purses—but things that we carry around in our heads. “We should really call our economy a ‘human capitalist economy,’ for that is what it mainly is,” Mr. Becker said in a speech. “While all forms of capital—physical capital, such as machinery and plants, financial capital, and human capital—are important, human capital is the most important. Indeed, in a modern economy, human capital is by far the most important form of capital in creating wealth and growth.”

There is a striking correlation between a country’s level of human capital and its economic well-being. At the same time, there is a striking lack of correlation between natural resources and standard of living. Countries like Japan and Switzerland are among the richest in the world despite having relatively poor endowments of natural resources. Countries like Nigeria are just the opposite; enormous oil wealth has done relatively little for the nation’s standard of living. In some cases, the mineral wealth of Africa has financed bloody civil wars that would have otherwise died out. In the Middle East, Saudi Arabia has most of the oil while Israel, with no natural resources to speak of, has a higher per capita income.

High levels of human capital create a virtuous cycle; well-educated parents invest heavily in the human capital of their children. Low levels of human capital have just the opposite effect. Disadvantaged parents beget disadvantaged children, as any public school teacher will tell you. Mr. Becker points out, “Even small differences among children in the preparation provided by their families are frequently multiplied over time into large differences when they are teenagers. This is why the labor market cannot do much for school dropouts who can hardly read and never developed good work habits, and why it is so difficult to devise policies to help these groups.”

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Why does human capital matter so much? To begin with, human capital is inextricably linked to one of the most important ideas in economics: productivity. Productivity is the efficiency with which we convert inputs into outputs. In other words, how good are we at making things? Does it take 2,000 hours for a Detroit autoworker to make a car or 210 hours? Can an Iowa corn farmer grow thirty bushels of corn on an acre of land or 210 bushels? The more productive we are, the richer we are. The reason is simple: The day will always be twenty-four hours long; the more we produce in those twenty-four hours the more we consume, either directly or by trading it away for other stuff. Productivity is determined in part by natural resources—it is easier to grow wheat in Kansas than it is in Vermont—but in a modern economy, productivity is more affected by technology, specialization, and skills, all of which are a function of human capital.

America is rich because Americans are productive. We are better off today than at any other point in the history of civilization because we are better at producing goods and services than we have ever been, including things like health care and entertainment. The bottom line is that we work less and produce more. In 1870, the typical household required 1,800 hours of labor just to acquire its annual food supply; today, it takes about 260 hours of work. Over the course of the twentieth century, the average work year has fallen from 3,100 hours to about 1,730 hours. All the while, real gross domestic product (GDP) per capita—an inflation-adjusted measure of how much each of us produces, on average—has increased from $4,800 to more than $40,000. Even the poor are living extremely well by historical standards. The poverty line is now at a level of real income that was attained only by those in the top 10 percent of the income distribution a century ago. As John Maynard Keynes once noted, “In the long run, productivity is everything.”

Productivity is the concept that takes the suck out of Ross Perot’s “giant sucking sound.” When Ross Perot ran for president in 1992 as an independent, one of his defining positions was opposition to the North American Free Tree Agreement (NAFTA). Perot reasoned that if we opened our borders to free trade with Mexico, then millions of jobs would flee south of the border. Why wouldn’t a firm relocate to Mexico when the average Mexican factory worker earns a fraction of the wages paid to American workers? The answer is productivity. Can American workers compete against foreign workers who earn half as much or less? Yes, most of us can. We produce more than Mexican workers—much more in many cases—because we are better-educated, because we are healthier, because we have better access to capital and technology, and because we have more efficient government institutions and better public infrastructure. Can a Vietnamese peasant with two years of education do your job? Probably not.

Of course, there are industries in which American workers are not productive enough to justify their relatively high wages, such as manufacturing textiles and shoes. These are industries that require relatively unskilled labor, which is more expensive in this country than in the developing world. Can a Vietnamese peasant sew basketball shoes together? Yes—and for a lot less than the American minimum wage. American firms will look to “outsource” jobs to other countries only if the wages in those countries are cheap relative to what those workers can produce. A worker who costs a tenth as much and produces a tenth as much is no great bargain. A worker who costs a tenth as much and produces half as much probably is.

While Ross Perot was warning that most of the U.S. economy would migrate to Guadalajara, mainstream economists predicted that NAFTA would have a modest but positive effect on American employment. Some jobs would be lost to Mexican competition; more jobs would be created as exports to Mexico increased. We are now more than a decade into NAFTA, and that is exactly what happened. Economists reckon that the effect on overall employment was positive, albeit very small relative to the size of the U.S. economy.

Will our children be better off than we are? Yes, if they are more productive than we are, which has been the pattern throughout American history. Productivity growth is what improves our standard of living. If productivity grows at 2 percent a year, then we will become 2 percent richer every year. Why? Because we can take the same inputs and make 2 percent more stuff. (Or we could make the same amount of stuff with 2 percent fewer inputs.) One of the most interesting debates in economics is whether or not the American economy has undergone a sharp increase in the rate of productivity growth. Some economists, including Alan Greenspan during his tenure as Fed chairman, have argued that investments in information technology have led to permanently higher rates of productivity growth. Others, such as Robert Gordon at Northwestern University, believe that productivity growth has not changed significantly when one interprets the data properly.

The answer to that debate matters enormously. From 1947 to 1975, productivity grew at an annual rate of 2.7 percent a year. From 1975 until the mid-1990s, for reasons that are still not fully understood, productivity growth slowed to 1.4 percent a year. Then it got better again; from 2000 to 2008, productivity growth returned to a much healthier 2.5 percent annually. That may seem like a trivial difference; in fact, it has a profound effect on our standard of living. One handy trick in finance and economics is the rule of 72; divide 72 by a rate of growth (or a rate of interest) and the answer will tell you roughly how long it will take for a growing quantity to double (e.g., the principal in a bank account paying 4 percent interest will double in roughly 18 years). When productivity grows at 2.7 percent a year, our standard of living doubles every twenty-seven years. At 1.4 percent, it doubles every fifty-one years.

Productivity growth makes us richer, regardless of what is going on in the rest of the world. If productivity grows at 4 percent in Japan and 2 percent in the United States, then both countries are getting richer. To understand why, go back to our simple farm economy. If one farmer is raising 2 percent more corn and hogs every year and his neighbor is raising 4 percent more, then they are eating more every year (or trading more away). If this disparity goes on for a long time, one of them will become significantly richer than the other, which may become a source of envy or political friction, but they are both growing steadily better off. The important point is that productivity growth, like so much else in economics, is not a zero-sum game.

What would be the effect on America if 500 million people in India became more productive and gradually moved from poverty to the middle class? We would become richer, too. Poor villagers currently subsisting on $1 a day cannot afford to buy our software, our cars, our music, our books, our agricultural exports. If they were wealthier, they could. Meanwhile, some of those 500 million people, whose potential is currently wasted for lack of education, would produce goods and services that are superior to what we have now, making us better off. One of those newly educated peasants might be the person who discovers an AIDS vaccine or a process for reversing global warming. To paraphrase the United Negro College Fund, 500 million minds are a terrible thing to waste.

Productivity growth depends on investment—in physical capital, in human capital, in research and development, and even in things like more effective government institutions. These investments require that we give up consumption in the present in order to be able to consume more in the future. If you skip buying a BMW and invest in a college education instead, your future income will be higher. Similarly, a software company may forgo paying its shareholders a dividend and plow its profits back into the development of a new, better product. The government may collect taxes (depriving us of some current consumption) to fund research in genetics that improves our health in the future. In each case, we spend resources now so that we will become more productive later. When we turn to the macroeconomy—our study of the economy as a whole—one important concern will be whether or not we are investing enough as a nation to continue growing our standard of living.

Our legal, regulatory, and tax structures also affect productivity growth. High taxes, bad government, poorly defined property rights, or excessive regulation can diminish or eliminate the incentive to make productive investments. Collective farms, for example, are a very bad way to organize agriculture. Social factors, such as discrimination, can profoundly affect productivity. A society that does not educate its women or that denies opportunities to members of a particular race or caste or tribe is leaving a vast resource fallow. Productivity growth also depends a great deal on innovation and technological progress, neither of which is understood perfectly. Why did the Internet explode onto the scene in the mid-1990s rather than the late 1970s? How is it that we have cracked the human genome yet we still do not have a cheap source of clean energy? In short, fostering productivity growth is like raising children: We know what kinds of things are important even if there is no blueprint for raising an Olympic athlete or a Harvard scholar.

The study of human capital has profound implications for public policy. Most important, it can tell us why we haven’t all starved to death. The earth’s population has grown to six billion; how have we been able to feed so many mouths? In the eighteenth century, Thomas Malthus famously predicted a dim future for humankind because he believed that as society grew richer, it would continuously squander those gains through population growth—having more children. These additional mouths would gobble up the surplus. In his view, humankind was destined to live on the brink of subsistence, recklessly procreating during the good times and then starving during the bad. As Paul Krugman has pointed out, for fifty-five of the last fifty-seven centuries, Malthus was right. The world population grew, but the human condition did not change significantly.

Only with the advent of the Industrial Revolution did people begin to grow steadily richer. Even then, Malthus was not far off the mark. As Gary Becker points out, “Parents did spend more on children when their incomes rose—as Malthus predicted—but they spent a lot more on each child and had fewer children, as human capital theory predicts.” The economic transformations of the Industrial Revolution, namely the large productivity gains, made parents’ time more expensive. As the advantages of having more children declined, people began investing their rising incomes in the quality of their children, not merely the quantity.

One of the fallacies of poverty is that developing countries are poor because they have rapid population growth. In fact, the causal relationship is best understood going the other direction: Poor people have many children because the cost of bearing and raising children is low. Birth control, no matter how dependable, works only to the extent that families prefer fewer children. As a result, one of the most potent weapons for fighting population growth is creating better economic opportunities for women, which starts by educating girls. Taiwan doubled the number of girls graduating from high school between 1966 and 1975. Meanwhile, the fertility rate dropped by half. In the developed world, where women have enjoyed an extraordinary range of new economic opportunities for more than a half century, fertility rates have fallen near or below replacement level, which is 2.1 births per woman.

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The subject of human capital begs some final questions. Will the poor always be with us, as Jesus once admonished? Does our free market system make poverty inevitable? Must there be losers if there are huge economic winners? No, no, and no. Economic development is not a zero-sum game; the world does not need poor countries in order to have rich countries, nor must some people be poor in order for others to be rich. Families who live in public housing on the South Side of Chicago are not poor because Bill Gates lives in a big house. They are poor despite the fact that Bill Gates lives in a big house. For a complex array of reasons, America’s poor have not shared in the productivity gains spawned by Microsoft Windows. Bill Gates did not take their pie away; he did not stand in the way of their success or benefit from their misfortunes. Rather, his vision and talent created an enormous amount of wealth that not everybody got to share. There is a crucial distinction between a world in which Bill Gates gets rich by stealing other people’s crops and a world in which he gets rich by growing his own enormous food supply that he shares with some people and not others. The latter is a better representation of how a modern economy works.

In theory, a world in which every individual was educated, healthy, and productive would be a world in which every person lived comfortably. Perhaps we will never cure the world of the assorted physical and mental illnesses that prevent some individuals from reaching their full potential. But that is biology, not economics. Economics tells us that there is no theoretical limit to how well we can live or how widely our wealth can be spread.

Can that really be true? If we all had Ph.D.s, who would pass out the towels at the Four Seasons? Probably no one. As a population becomes more productive, we begin to substitute technology for labor. We use voice mail instead of secretaries, washing machines instead of maids, ATMs instead of bank tellers, databases instead of file clerks, vending machines instead of shopkeepers, backhoes instead of ditch diggers. The motivation for this development [comes from the concept of] opportunity cost. Highly skilled individuals can do all kinds of productive things with their time. Thus, it is fabulously expensive to hire an engineer to bag groceries. (How much would you have to be paid to pass out towels at the Four Seasons?) There are far fewer domestic servants in the United States than in India, even though the United States is a richer country. India is awash with low-skilled workers who have few other employment options; America is not, making domestic labor relatively expensive (as anyone with a nanny can attest). Who can afford a butler who would otherwise earn $50 an hour writing computer code?

When we cannot automate menial tasks, we may relegate them to students and young people as a means for them to acquire human capital. I caddied for more than a decade (most famously for George W. Bush, long before he ascended to the presidency); my wife waited tables. These jobs provide work experience, which is an important component of human capital. But suppose there was some unpleasant task that could not be automated away, nor could it be done safely by young people at the beginning of their careers. Imagine, for example, a highly educated community that produces all kinds of valuable goods and services but generates a disgusting sludge as a by-product. Further imagine that collecting the sludge is horrible, mind-numbing work. Yet if the sludge is not collected, then the whole economy will grind to a halt. If everyone has a Harvard degree, who hauls away the sludge?

The sludge hauler does. And he or she, incidentally, would be one of the best-paid workers in town. If the economy depends on hauling this stuff away, and no machine can do the task, then the community would have to induce someone to do the work. The way to induce people to do anything is to pay them a lot. The wage for hauling sludge would get bid up to the point that some individual—a doctor, or an engineer, or a writer—would be willing to leave a more pleasant job to haul sludge. Thus, a world rich in human capital may still have unpleasant tasks—proctologist springs to mind—but no one has to be poor. Conversely, many people may accept less money to do particularly enjoyable work—teaching college students comes to mind (especially with the summer off).

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Human capital creates opportunities. It makes us richer and healthier; it makes us more complete human beings; it enables us to live better while working less. Most important from a public policy perspective, human capital separates the haves from the have-nots. Marvin Zonis, a professor at the University of Chicago Graduate School of Business and a consultant to businesses and governments around the world, made this point wonderfully in a speech to the Chicago business community. “Complexity will be the hallmark of our age,” he noted. “The demand everywhere will be for ever higher levels of human capital. The countries that get that right, the companies that understand how to mobilize and apply that human capital, and the schools that produce it . . . will be the big winners of our age. For the rest, more backwardness and more misery for their own citizens and more problems for the rest of us.”

Wheelan makes an important point in his final few paragraphs there. It can be tempting, when contrasting the wealth of the ultra-wealthy with the poverty of the lowest-income workers, to simply blame the entire existence of poverty on the rich. (And to be fair, they can certainly be blamed for (if nothing else) not donating more of their wealth to alleviate it, as I argued in my last post.) But really, the biggest reason why poverty exists isn’t the fact that some people are able to command high salaries, but rather that more people aren’t able to, due to low productivity. Heath continues this line of thought:

Whenever we talk about wages, it is important to keep in mind a few basic economic facts. First of all, the baseline human condition is one of abject poverty. Most of humanity, throughout most of human history, has lived at or near the subsistence level, with an average life expectancy somewhere around age 30, and constant exposure to the perils of famine, disease, and war. Poverty does not require any sort of special explanation—it’s simply what you have in the absence of anything else. Go to any museum of archeology and consider how much effort it used to require to fashion a blade, or a vessel capable of carrying water, or a roof to keep the rain off your head. When contemplating what life must have been like, one is reminded of Friedrich Nietzsche’s suggestion (offered as a “consolation for the delicate”) that perhaps “at that time pain didn’t hurt as much as it does nowadays.”

The second important fact is that inequality is not as big a part of the story as it is sometimes made out to be. Social inequality has always afforded some individuals within every society something of a buffer against the uncertainty and hardships that afflict the majority. And when people are extremely poor, the difference between social classes stands out in stark relief. Members of the upper class in England used to be easy to identify, for example, because they were often a good head taller than the average person. This wasn’t genetic; it was due to the fact that they were the only ones who had been properly fed since childhood. At the beginning of the nineteenth century, the average 14-year-old upper-class boy entering the Royal Military Academy stood a full 10 inches taller than naval recruits of the same age drawn from the working classes. Thus officers would quite literally “look down upon” enlisted men or “stare down their noses” at them (hence the origin of these expressions).

As it was then in England, so it is today in many underdeveloped countries. Yet despite the enormous differences in standard of living that prevail, not to mention a class system that often seems like little more than organized theft, the fact is that in most poor societies, inequality does not contribute all that much to the deprivations of the ordinary person. Even if you seized all of the wealth being hoarded by the upper class and redistributed it to the people, you wouldn’t actually see much of an improvement in the average person’s standard of living. Why? Because in a typical underdeveloped country there is just not that much wealth to go around. It may seem like a lot, but usually that’s just because it is highly concentrated in the hands of a very few individuals. Once you start dividing it up among thousands, it turns out not to go very far. (You can see this by looking at GDP per capita statistics, which basically tell you how much each person would get if all the wealth in a country were divided up equally.) The fundamental problem in underdeveloped countries is not that the wealth is badly divided, but that there is not enough of it. And so what is needed, first and foremost, is growth. (Indeed, the major harms inflicted upon poor countries by social inequality tend not to be a direct consequence of the pattern of distribution, but rather a product of indirect consequences—such as corruption—that undermine the institutional preconditions needed for broad-based economic growth.)

It is also worth keeping in mind that the relative share of national income going to workers tends to be fairly stable over time. The “income share of employees” in the G7 economies has been between 55% and 58% of GDP since 1970 (in the United States, it has remained between 55% and 60% since the 1950s). Furthermore, the long-term trends that emerge tend not to be the result of “political” factors, such as the success of unions in securing wage increases for their members. While the United States has seen a decline in the labor share of national income since the 1980s, that decline has been even more dramatic in Europe and Japan. The rollback of unionization in the United States over the past three decades is not really a central part of the story (far more important have been long-term changes in the types of work people are doing). Also, most industrialized nations have not seen any significant increases in economic inequality in the past decade or two. The United States is quite exceptional in this regard, and is not representative of the dominant trends in capitalist economies.

What really determines the income of the average person in any given country is not how well or how badly “labor” is treated by that country’s social and political institutions. It may make a big difference to the quality of life of the average worker, but it is not the most important factor in determining his or her wealth. Distributive shares are important; they just aren’t that important. What really matters is the average level of labor productivity. This is what, ultimately and in the long run, determines wages. Beijing factory workers are paid badly because the entire country is poor. You can fiddle with wages all you want, but the only way to give them a permanent, stable, sustainable increase in income is to make the entire country more productive. To take just one example, in 1999 the average worker in a Chinese steel mill produced 45 tons of output. Meanwhile, the average worker at South Korea’s largest steel manufacturer produced 1,501 tons per year. This statistic says a lot about why workers in China are poor and workers in South Korea are rich—not just in the steel industry, but across the entire economy.

Because of this, if one’s goal is to enhance the welfare of the average worker, getting too absorbed by questions of distribution is not really that great a strategy. It would take Herculean effort to increase the labor share of national income by even a percentage point or two. Meanwhile, whatever impact this was having on the wage-distribution front would be completely overshadowed by the effects of economic growth. (Recall that even a mature capitalist economy can grow at a steady annual rate of 2% or 3%: A single year’s growth is typically as great as the total magnitude of variation in distributive shares over the course of a decade.) This means that gains on the distribution front can easily be vitiated if the struggle to obtain them depresses the rate of growth too much.

This is all worth emphasizing, because there is a tendency to think of “social justice” with respect to wages in terms of a distributional conflict between workers and factory owners. Factory owners, according to this view, try to lowball workers, and the average wage rate is determined by the extent to which they succeed. There is an element of truth in this, but it personalizes the issue in an unhelpful way. The crucial variable is “the extent to which they succeed.” Whether or not factory owners succeed in hiring someone at a low wage rate depends crucially upon what other options that person has. If the alternative to factory work is dirt farming, then that person is likely to settle for a low wage. If the alternative is another factory down the street, then that changes things. This is why the wages of factory workers in China have been rising by about 10% per year for the past decade. The entire Chinese economy has been growing at approximately this rate.

Again, this concept of workers having more than one good alternative to choose from is the key when it comes to ensuring that their incomes are livable. As Heath explains, it’s why Wheelan’s hypothetical ultra-productive world in which even the sludge haulers are well-paid actually makes economic sense – because productivity gains in one sector of the economy, even if they’re not matched by productivity gains in other sectors, can still drive wages higher for workers in those other sectors simply by virtue of giving them more attractive alternative employment opportunities to choose from (so that their employers will have to pay them more if they still want to retain them):

One of the reasons that inequality in poor countries often seems so extreme has to do with the number of personal servants people have. Even fairly middle-class people will often have households that are teeming with hired hands. It goes without saying that everyone has a maid, nanny, and cook (social class is reflected in whether they have one, two, or three people to do these jobs). Many people have drivers, tutors of various sorts, and, of course, security guards. When I was much younger, I spent a couple of weeks working in Mexico City. Invited over to my manager’s house one Sunday afternoon, I was appalled to discover that they had a guy whose job seemed to be to hang around waiting for me to finish my Corona so that he could run get me a new one. I appeared to be the only person who found it difficult to relax by the pool under these conditions.

I sometimes think about this when I’m assembling a particularly recalcitrant piece of Ikea furniture, or trying to rewire a light socket. “Here I am, living in one of the richest countries in the world,” I say to myself. “Why do I have to build my own furniture and do my own electrical work?” The answer, of course, is that it’s precisely because I live in one of the richest countries in the world that I have to do my own electrical work. Because labor is so productive, most people have better things to do with their time than hook up other people’s light fixtures. As a result, it is punitively expensive to lure them away from these other, more productive occupations. Getting an electrician to come wire your light fixture would typically cost more than the light fixture itself.

This is also why we tend to throw things away rather than get them repaired. It’s not because of some general ailment called “consumerism”—it’s because getting something repaired is incredibly expensive. One day my stove beeped loudly and the nifty digital display started blinking “Error 5.” I looked it up in the manual, which told me to call for immediate servicing. Since it’s a gas stove, I figured I wouldn’t take chances. I called the company. Two days later, a guy in coveralls showed up at my door during breakfast time. He opened up the oven, yanked something out, tore open a bag, stuck something new in, mumbled something about a “broken sensor,” then handed me a bill for $169. He was in my house less than 10 minutes. The sensor cost $70; the rest of the bill was labor and taxes. Imagine how much it would have cost if the stove itself had been broken (as opposed to just the system designed to tell me when the stove is broken).

It is a general feature of advanced economies that, as the country as a whole becomes richer, services become more expensive relative to manufactured goods. The basic reason is that productivity growth in the service sectors lags behind that of the manufacturing sector. In a sense, it’s not that services get expensive, it’s that everything else get incredibly cheap. What’s amazing is not that it costs me $169 to get my stove repaired; it’s that it costs me only $599 to buy a brand-new one. When you think about it, the amount of value produced by the guy who goes around repairing gas stoves has not increased all that significantly over the course of the last 50 or 60 years. He wastes a huge amount of time traveling from one house to another. And despite the bells and whistles, the basic technology has not changed all that much—pressurized gas in a pipe, something to light it and control the burn, and so on. The technology for checking it all to see if it is in working order also has not changed much. The factory that manufactures stoves, on the other hand, has been completely revolutionized over the past 50 years. It would not be surprising to discover that workers there were producing three or four times as many stoves per capita, thanks to improvements in manufacturing technology.

This improvement in manufacturing, combined with relative stagnation in the service sector, produces what the economist William Baumol called the “cost disease” in services. When productivity increases in the manufacturing wing of the firm, the gains will typically be divided up—by hook or by crook—among all the firm’s constituency groups. As a result, that productivity increase will tend to generate (among other things) wage increases. Yet suppose that there is considerable labor mobility between those who repair and those who manufacture stoves—that anyone qualified to do the former can also do the latter. If the wages of factory workers go up, some people who work in service will want to switch jobs. This will have the effect of putting downward pressure on the wages in manufacturing and upward pressure on the wages in repair. The firm will have to pay more to keep people working in repair even though there have been no productivity gains in this sector. This increases the “unit cost” of providing the service.

Thus the benefits to workers that come from increased productivity in one sector will tend to be shared by other workers, regardless of whether or not they themselves are working any more productively. In the short term, some set of workers may be able to capture the benefits of a particular set of productivity gains, particularly if they have some special skill or have undergone costly or time-consuming training that makes it harder for others to enter their corner of the market. But in the long run labor is quite mobile between occupations. This is why, if you look at productivity growth in various sectors of the economy over the course of a few decades and compare it to changes in wages, you see very little correlation (unlike, say, changes in output price, which track changes in productivity fairly closely). Yet there is a strong correlation between average productivity growth (across the entire economy) and wage increases. This is why wages in underdeveloped countries are very low, even in highly automated factories where the level of productivity of the individual worker is comparable to that in wealthier parts of the world. What they are paid bears only a slight relationship to what they produce. It is the average level of productivity in the economy, or in the broader sector in which they are employed, that determines wages.

This is why personal services become more expensive as the country as a whole becomes wealthier. Everyone’s wages get pushed up, even if there is no change in the way particular services are provided. While posing as a maid ([Barbara] Ehrenreich-style), the Globe and Mail journalist Jan Wong contemplated the absurdity of a client having asked her to do some ironing:

The client has left written instructions on little yellow sticky papers stuck to three small mountains of ironing. 1. “Iron for sure this pile. Must do.” 2. “Iron if time allows.” 3. “Fold and iron IF TIME ALLOWS.” I snort at the things she wants ironed: jeans, T-shirts, cotton turtlenecks … We’re booked for four hours, at $171. After two hours, I’m only midway through the second pile of ironing. After three hours, I have seven items left. There are 51 items in all, including sheets and pillowcases, which means it costs the client $1.25 per item.

The observation is perfectly sensible, yet Wong fails to draw the obvious implication: Even when working somewhat below the minimum wage, she is essentially being overpaid relative to the value of the service that she is providing. This is why maids don’t make very much money and are subject to such constant pressure to work harder and faster. It’s because—save perhaps for the invention of the vacuum cleaner—the basic level of productivity among housecleaners has not increased much since the nineteenth century. Housecleaning is time-consuming manual labor with no economies of scale. As a result, it is only the existence of nasty working conditions that makes it possible for people outside the upper classes to hire maids. (Wong was working for an agency and points out, astutely, that only middle-class clients hire maids through agencies.) The alternative to having maids who do grueling work at minimum wage working for agencies is not well-paid maids, but rather the absence of maids (in the same way that our economy currently features an absence of butlers).

If people were paid for the value of what they create, the cost of hiring a maid would have changed very little since the late nineteenth century. Yet if the wages paid to maids were stuck at nineteenth-century levels, no one would be willing to work as a maid. Wages have therefore risen, enough to keep a certain number of people willing to do the job. But as they have risen, the advantages of hiring someone to clean your house, as opposed to doing it yourself, have declined. And so various forms of domestic service have essentially been squeezed out of the economy. The problem is not that employers are mean; it’s that the amount of value produced through that sort of labor is intrinsically very low. People used to pay their butlers to iron the newspaper in the morning, so that the ink would not rub off on their fingers. This was cost-effective at the time, because the overall productivity level of human labor was so appallingly low that a butler, released from this sort of service, couldn’t actually produce that much more value in another occupation. In the present day, however, hiring a butler to do this means outbidding all of the other people who might be able to make use of this person’s skills in a highly automated assembly plant or any of a multitude of other employments where significant value is produced. The scarcity price of labor means that if you want to divert someone from a useful occupation in order to have him sit around ironing your morning newspaper, then you have to compensate everyone else who might have made use of his time in some other way. As labor in general becomes more productive, the amount of compensation you have to offer for it increases, until at some point hiring servants becomes simply not worth the trouble, even for those who are quite wealthy.

There are many examples of occupations getting squeezed out of the economy by the “cost disease,” but one data set I particularly like compares the cost of having a shirt washed and ironed to the prevalence of commercial dry cleaners in several different countries. (One can see here the effects of the immigration system in the United States, which floods the country with low-skilled labor. I use the word “system” here loosely, to include the wink-wink, nudge-nudge features of the American system that make it possible for employers to hire illegal immigrants.)

	Cost per shirt ($US)	Ratio of population to laundry workers
Denmark	$5.20	3,500
Sweden	$4.25	727
Spain	$3.90	905
West Germany	$3.70	667
United Kingdom	$2.20	750
United States	$1.50	391

The alternative to having a particular service squeezed out is that it becomes an object of luxury consumption. Baumol initially developed his argument using the example of symphony orchestras—pointing out that it takes exactly the same number of musicians to play a Beethoven symphony now as it did a century ago. By rights, they should be paid pennies, not dollars, per hour for live performances. Yet of course they aren’t. Their wages have, by and large, kept up with those of factory workers. Some of this has been recouped through a shift to studio work and recorded music. But the more obvious result has been the transformation of live performances of classical music into a luxury good, and even then, one available only with massive public subsidy.

An exception to this rule occurs when it is the employee’s time itself that is valued by the consumer. The problem with maids is that they are valued primarily for the output they produce. Some of Ehrenreich’s clients seemed to have derived enjoyment from watching her scrub the floor, but most didn’t. In fact, they weren’t even home. All they wanted was to have the house clean when they got back from work. This is what imposes the upper bound on how much they are willing to pay. With other sorts of employment, on the other hand—anything that is advertised as “pampering”—the waste of someone else’s time constitutes a significant element of that which is being consumed. This is why there are fewer maids than there once were but more massage therapists. The more expensive the other person’s time is, the greater the sense of luxury produced through the act of wasting it.

He concludes:

Most of us are quite lucky that wages aren’t determined by the intrinsic value of what we create; if they were, we’d be very poor. One of the ways of thinking about this is to take your job, consider your daily routine, and ask yourself whether you’re producing 10 times more than someone doing the same job a century ago. Farmers, construction workers, miners, accountants, engineers, filing clerks, and factory workers can easily answer yes to this question. The rest of us cannot. Yet for those of us who answer no, it means that we are basically hitching a ride on the coattails of workers in sectors that have undergone more significant productivity gains. We are taking advantage of the fact that markets have something of an equalizing tendency with respect to wages.

In a sense, you get paid not so much for what you do, but rather for what you could do. If you weren’t being paid at least that much, then you would stop doing what you’re doing and start doing that other thing. This is why, despite the fact that we all do approximately the same job, law professors make about twice as much money as philosophy professors. The difference is that the law professors have better outside options. In fact, most of them could earn even more money than they do now if they quit the university and went to work as lawyers. Philosophy professors, on the other hand, can’t really use their skills to do anything but teach philosophy. If the salaries of philosophy professors around the world were one day cut in half, across the board, I doubt that a single department of philosophy would close down. The same would not be true of law schools.

This also explains, incidentally, why McDonald’s employees in Denmark earn $22 an hour plus six weeks’ paid vacation. Even though these workers are still making the same burgers that other (less well-compensated) McDonald’s workers across the world are making, the fact that Denmark is so rich in human capital, with well-educated, well-qualified workers in every sector of the economy, means that McDonald’s has to pay them that much in order to keep them from switching to one of the many equally appealing alternative sources of employment available to them. (Denmark’s strong unions, naturally, also play a big part in this.) In a very real sense, then, a rising tide of productivity really does lift all boats.

But of course, this isn’t quite the end of the story. Because every different component of the economy is so interconnected, increasing national productivity isn’t generally as simple as just making one sector – or one subset of workers – more productive in isolation, and then letting them pull everyone else up with them. Different sectors of the economy, after all, don’t really exist in isolation, and neither do the individual workers that make them up. For workers to become more productive, it’s often necessary to improve the whole network of factors surrounding them (which can include everything from transportation infrastructure to broader cultural norms), not just their own characteristics as discrete individuals. Sowell illustrates:

While the term “productivity” may be used to describe an employee’s contribution to a company’s earnings, this word is often also defined inconsistently in other ways. Sometimes the implication is left that each worker has a certain productivity that is inherent in that particular worker, rather than being dependent on surrounding circumstances as well.

A worker using the latest modern equipment can obviously produce more output per hour than the very same worker employed in another firm whose equipment is not quite as up-to-date or whose management does not have production organized as efficiently. For example, Japanese-owned cotton mills in China during the 1930s paid higher wages than Chinese-owned cotton mills there, but the Japanese-run mills had lower labor costs per unit of output because they had higher output per worker. This was not due to different equipment—they both used the same machinery—but to more efficient management brought over from Japan.

Similarly, in the early twenty-first century, an international consulting firm found that American-owned manufacturing enterprises in Britain had far higher productivity than British-owned manufacturing enterprises. According to the British magazine The Economist, “British industrial companies have underperformed their American counterparts startlingly badly,” so that when it comes to “economy in the use of time and materials,” fewer than 40 percent of British manufacturers “have paid any attention to this.” Moreover, “Britain’s top engineering graduates prefer to work for foreign-owned companies.” In short, lower productivity in British-owned companies reflected differences in management practices, even when productivity was measured in terms of output per unit of labor.

In general, the productivity of any input in the production process depends on the quantity and quality of other inputs, as well as its own. Thus workers in South Africa have higher productivity than workers in Brazil, Poland, Malaysia, or China because, as The Economist magazine pointed out, South African firms “rely more on capital than labour.” In other words, South African workers are not necessarily working any harder or any more skillfully than workers in these other countries. They just have more or better equipment to work with.

The same principle applies outside what we normally think of as economic activities, and it applies to what we normally think of as a purely individual feat, such as a baseball player hitting a home run. A slugger gets more chances to hit home runs if he is batting ahead of another slugger. But, if the batter hitting after him is not much of a home run threat, pitchers are more likely to walk the slugger, whether by pitching to him extra carefully or by deliberately walking him in a tight situation, so that he may get significantly fewer opportunities to hit home runs over the course of a season.

During Ted Williams’ career, for example, he had one of the highest percentages of home runs—in proportion to his times at bat—in the history of baseball. Yet he had only one season in which he hit as many as 40 homers, because he was walked as often as 162 times a season, averaging more than one walk per game during the era of the 154-game season.

By contrast, Hank Aaron had eight seasons in which he hit 40 or more home runs, even though his home-run percentage was not quite as high as that of Ted Williams. Although Aaron hit 755 home runs during his career, he was never walked as often as 100 times in any of his 23 seasons in the major leagues. Batting behind Aaron during much of his career was Eddie Mathews, whose home-run percentage was nearly identical with that of Aaron, so that there was not much point in walking Aaron to pitch to Mathews with one more man on base. In short, Hank Aaron’s productivity as a home-run hitter was greater because he batted with Eddie Mathews in the on-deck circle.

More generally, in almost any occupation, your productivity depends not only on your own work but also on cooperating factors, such as the quality of the equipment, management and other workers around you. Movie stars like to have good supporting actors, good make-up artists and good directors, all of whom enhance the star’s performance. Scholars depend heavily on their research assistants, and generals rely on their staffs, as well as their troops, to win battles.

Whatever the source of a given individual’s productivity, that productivity determines the upper limit of how far an employer will go in bidding for that person’s services. Just as any worker’s value can be enhanced by complementary factors—whether fellow workers, machinery, or more efficient management—so the worker’s value can also be reduced by other factors over which the individual worker has no control.

Even workers whose output per hour is the same can be of very different value if the transportation costs in one place are higher than in another, so that the employer’s net revenue from sales is lower where these higher transportation costs must be deducted from the revenue received. Where the same product is produced by businesses with different transportation costs and sold in a competitive market, those firms with higher transportation costs cannot pass all those costs along to their customers because competing firms whose costs are not as high would be able to charge a lower price and take their customers away. Businesses in Third World countries without modern highways, or efficient trains and airlines, may have to absorb higher transportation costs. Even when they sell the same product for the same price as businesses in more advanced economies, the net revenue from that product will be less, and therefore the value of the labor that went into producing that product will also be worth correspondingly less.

In countries with high levels of corruption, the bribes necessary to get bureaucrats to permit the business to operate likewise have to be deducted from sales revenues and likewise reduce the value of the product and of the workers who produce it, even if these workers have the same output per hour as workers in more modern and less corrupt economies. In reality, Third World workers more typically have lower output per hour, and the higher costs of transportation and corruption which must be deducted from sales revenues can leave such workers earning a fraction of what workers earn for doing similar work in other countries.

In short, productivity is not just a result solely of what the individual worker does but is a result of numerous other factors as well. To say that the demand for labor is based on the value of the worker’s productivity is not to say that pay is based on merit. Merit and productivity are two very different things, just as morality and causation are two different things.

And Wheelan adds:

Human capital is what makes individuals productive, and productivity is what determines our standard of living. As University of Chicago economist and Nobel laureate Gary Becker has pointed out, all countries that have had persistent growth in income have also had large increases in the education and training of their labor forces. (We have strong reasons to believe that the education causes the growth, not the other way around.) He has written, “These so-called Asian tigers grew rapidly by relying on a well-trained, educated, hard-working, and conscientious labor force.”

In poor countries, human capital does all the good things we would expect, and then some. Education can improve public health (which is, in turn, a form of human capital). Some of the most pernicious public health problems in the developing world have relatively simple fixes (boiling water, digging latrines, using condoms, etc.). Higher rates of education for women in developing countries are associated with lower rates of infant mortality. Meanwhile, human capital facilitates the adoption of superior technologies from developed countries. One cause for optimism in the development field has always been that poor countries should, in theory, be able to narrow the gap with richer nations by borrowing their innovations. Once a technology is invented, it can be shared with poor countries at virtually no cost. The people of Ghana need not invent the personal computer in order to benefit from its existence; they do need to know how to use it.

Now for [some] bad news. [Earlier], I described an economy in which skilled workers generate economic growth by creating new jobs or doing old jobs better. Skills are what matter—for individuals and for the economy as a whole. That is still true, but there is a glitch when we get to the developing world: Skilled workers usually need other skilled workers in order to succeed. Someone who is trained as a heart surgeon can succeed only if there are well-equipped hospitals, trained nurses, firms that sell drugs and medical supplies, and a population with sufficient resources to pay for heart surgery. Poor countries can become caught in a human capital trap; if there are few skilled workers, then there is less incentive for others to invest in acquiring skills. Those who do become skilled find that their talents are more valuable in a region or country with a higher proportion of skilled workers, creating the familiar “brain drain.” As World Bank economist William Easterly has written, the result can be a vicious cycle: “If a nation starts out skilled, it gets more skilled. If it starts out unskilled, it stays unskilled.”

As a side note, this phenomenon is relevant in rural America, too. Not long ago, I wrote a story for The Economist that we referred to internally as “The Incredible Shrinking Iowa.” As the working title would suggest, parts of Iowa, and other large swathes of the rural Midwest, are losing population relative to the rest of the country. Remarkably, forty-four of Iowa’s ninety-nine counties had fewer people in 2000 than they had in 1900. Part of that depopulation stems from rising farm productivity; Iowa’s farmers have literally grown themselves out of jobs. But something else is going on, too. Economists have found that individuals with similar skills and experience can earn significantly higher wages in urban areas than they can elsewhere. Why? One plausible explanation is that specialized skills are more valuable in metropolitan areas where there is a density of other workers with complementary skills. (Think Silicon Valley or a cardiac surgery center in Manhattan.) Rural America has a mild case of something that deeply afflicts the developing world. Unlike technology or infrastructure or pharmaceuticals, we cannot export huge quantities of human capital to poor countries. We cannot airlift ten thousand university degrees to a small African nation. Yet as long as individuals in poor countries face limited opportunities, they will have a diminished incentive to invest in human capital.

As Sowell points out, this lack of human capital is also a big part of the reason why it’s so much more difficult to take an unproductive country and turn it into a productive one than it is to restore productivity to a country that was already rich in human capital but has temporarily suffered a loss of productivity for some other reason (e.g. having its physical assets destroyed by a war or natural disaster):

Physical wealth may be highly visible, but human capital, invisible inside people’s heads, is often more crucial to the long-run prosperity of a nation or a people. John Stuart Mill used this fact to explain why nations often recover, with surprising speed, from the physical devastations of war: “What the enemy have destroyed, would have been destroyed in a little time by the inhabitants themselves” in the normal course of their consumption, and would require replenishing. Given the wear and tear on capital equipment, constant reproduction of new equipment would likewise be required. What the war does not destroy is the human capital that created the physical capital in the first place.

Even the massive physical devastations of World War II, from bombings and widely destructive ground battles, were followed by a rapid economic recovery in postwar Western Europe. Aid from the United States under the Marshall Plan has often been credited with this recovery, but the later sending of foreign aid to many Third World countries produced no such dramatic economic growth.

The difference is that industrialized Western Europe had already developed the human capital which had produced modern industrial societies there before the war began, but Third World countries had yet to develop that human capital, without which the physical capital was often of little or no use when it was donated as foreign aid. The Marshall Plan eased the transition to peacetime economic recovery in Western Europe, but foreign aid could not create the necessary scale of human capital where that human capital did not already exist.

Confiscations of physical capital have likewise seldom produced any major or lasting enrichment of those who do the confiscating—whether these are Third World governments confiscating (“nationalizing”) foreign investments or urban rioters looting stores in their neighborhoods. What they cannot confiscate is the human capital that created the physical things that are taken. However serious the losses suffered by those who have been robbed, whether by governments or by mobs, the physical things have a limited duration. Without the human capital required to create their replacements, the robbers are unlikely to prosper in future years as well as those who were robbed.

The bottom line, then, is that there are no shortcuts when it comes to making a population economically successful. For better or worse, it has to be done the old-fashioned way – by putting in the necessary investments, making the most of productive technology, and building human capital from the ground up (while also, I should stress, providing a strong enough social safety net that the lowest-productivity workers have some basic means of keeping their heads above water as they work to improve their stations). It’s a major challenge, no doubt, but as examples like Denmark (with its $22/hr McDonald’s workers) prove, it’s not an impossible one. In fact, it’s the only path to prosperity our species has found that actually has worked. And the fact that these prosperous countries have pulled it off means that other countries can pull it off too; they just have to resist the urge to try and skip the necessary steps by resorting to “quick fix” interventions that ultimately prove counterproductive.

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