Intro. [Recording date: June 17, 2025.]
Russ Roberts: Today is June 17th, 2025, and my guest is economist, author, and podcaster Mike Munger of Duke University. He hosts the podcast The Answer Is Transaction Costs. And this is Mike’s 50th appearance on EconTalk, which makes him, of course, the Babe Ruth or Henry Aaron of EconTalk guests–or the Barry Bonds if Mike uses steroids, which I doubt but could be. He was last here in January of 2025 talking about whether DOGE and Elon Musk will make a difference. So far he looks like he got that one right. Mike, welcome back to EconTalk.
Michael Munger: Russ, it’s a pleasure and it’s hard to believe that it’s 50. This can only mean that you are very old.
Russ Roberts: Exactly. Well, EconTalk is.
Michael Munger: You have not aged at all.
Russ Roberts: No. I’m–Fountain of Youth, baby.
I just want to also mention to listeners that we’re recording this during the Iran-Israel War that started a few days ago, by one count, or a few months, over a year ago by a different count. But, I’m recording this at home and I’m doing that because I need to be near a bomb shelter. So, if some missiles come, I will have to run away. But I will come back.
But, I mention that only because there may be some background noise and a different background of the video version of this, so I hope it’s still acceptable.
Russ Roberts: Our topic for today is the essence of capitalism, which is a sufficiently broad topic to cover almost everything we’ll talk about. But, Mike, you have a very profound, I think, way of thinking about different aspects of economic activity of which capitalism is the third. So, talk about the three; and then I’d like to go through them one by one.
Michael Munger: Well, the reason I came up with this was that I find that the students at Duke–where I teach–and so I teach an introductory class in economics. And I ask them: What is capitalism? And none of them know. It’s not just the ones who don’t like capitalism. It’s the ones who think they like capitalism who have no idea what capitalism is. They’ll cite different parts of it. And so, after a while I realized I actually didn’t know either. So, I tried to think of a way of explaining this.
Russ Roberts: That’s very cool.
Michael Munger: In a way, it’s a stadial theory. So, in the Scottish Enlightenment there was a stadial theory that there were these stages that societies go through. So, you start out with just hunting and fishing, roaming around. Then you domesticate animals. In the third you domesticate plants and you have agriculture. And, the fourth was commercial society.
And so, what I have–and I actually think that this is reminiscent of some of the–it’s consistent with Adam Smith’s theory. I want to have a kind of stadial theory also, but you should think of it in terms of a Venn diagram. That is, all of human societies engage in some sort of the largest of the three, which is voluntary exchange.
Some societies move on to a–and you could call it progress or not progress, but you have to go through the first stage of just exchanging. Exchanging among people. You may move to a smaller part of the Venn diagram that’s completely contained within voluntary exchange, and that’s called markets.
And then, the smallest–the number of countries that have developed the institutions required for this, I would say most advanced, but the smallest set of nations–is capitalism. And the reason why it’s important to go through those stages is that if people engage in voluntary exchange, they start to think in terms of property rights. They start to think in terms of exchange. And they start to think about propriety. That is, the ways that I should act in exchange, where I shouldn’t defraud people. All of that background is necessary in order to move to the next stage, which is markets.
And then, market institutions need to be pretty well-developed to move to the next stage, which is capitalism.
So, that’s the way that I think about this, as a Venn diagram. And if you’re imagining it at home, it’s three concentric circles.
Usually we have Venn diagrams that have intersections and different sets. All the world engages in voluntary exchange. Some of the world has developed markets–and we’ll talk about what that means. And, a relatively small number of nations–and I’m a student of Douglass North, and this actually is very consistent with Douglass North’s theory of the development of what he called ‘open societies,’ as opposed to ‘closed societies’ that didn’t allow advanced exchange. So, you had Barry Weingast on a couple of times who has talked about this. So, this connects with quite a bit of foundational work on the study of markets and political economy. But, it’s easy to draw this diagram of three concentric circles. The largest is voluntary exchange. The next largest is markets, and the smallest is actual capitalism.
Russ Roberts: And, just to be clear, just to reinforce it: All capitalist societies or all capitalist economies have markets and voluntary exchange.
Michael Munger: And they require the institutions that were grown up organically during those stages. You can’t do without a sense of propriety in exchange. You can’t do without a currency and a set of institutions for reducing the transactions cost.
And, that’s what markets are. So, capitalism assumes that both of the larger circles are still operating and then something more, which makes them capitalist.
Russ Roberts: And we’re going to get to that.
Russ Roberts: So let’s start with the simplest and most basic one, which is–in all these systems–which is voluntary exchange; or we sometimes call it, in economics, mutually beneficial exchange. What do we mean by that, and why is it important?
Michael Munger: In a voluntary exchange, both parties to the exchange are better off. And, I’ve gone off on a whole separate set of research initiatives about what makes an exchange voluntary. So, I wrote about euvoluntary–or truly voluntary–exchange, the set of conditions that are required for an exchange to be voluntary and you can put up in the show notes some of the links to that work if people are interested.
Russ Roberts: And we did an episode on it. If you’re lazy and don’t want to read the real work, you can hear us talking about that.
Michael Munger: If you are a connoisseur of previous episodes.
Russ Roberts: That’s what I meant. That’s what I meant.
Michael Munger: I think we lose sight–and I know students lose sight–of the power of having many, many small improvements. And, economists often talk about things at the margin. Tyler Cowen’s blog with Alex Tabarrok is about the ‘marginal revolution’–the aggregate consequences of many, many small improvements is, in the aggregate, probably more important than looking just at really big improvements.
So, if you and I engage in an exchange and both of us are better off, how would we measure that? Economists say that they have a way of knowing how much better off people are, and that’s the concept of consumer surplus. So, if I pay you for something, that must mean that I value the thing more than what I’m paying you and you must value it less. The question is how much more?
And so, economists, because we believe that we know utility functions and we can monetize preferences, say that consumer surplus is the amount of benefit that I get above and beyond what I have to pay. So, let’s suppose that I would pay as much as $10, but I can get it for $4. That means that I have a benefit of $6. That’s consumer surplus.
Now if you and I are just exchanging, then in effect both of us have consumer surplus because I’m not giving you money. We’re talking about apples and bananas. So, I have an apple, you have a banana. Each of us like better what the other person has. So, each of us is better off if we exchange. Now, the world doesn’t look any different because the amount of apples and bananas in the world is the same. There’s still one. But, the world is a better place because each of us is better off. That’s why voluntary exchange is important.
It’s actually very difficult. We don’t know utility functions; and people actually decide how much better off they are in contemplating the exchange. I see something and I think, ‘Huh, I’d actually like to have that; and I would like to have it more than this thing that I have that the other person will accept.’ And so, the power of voluntary exchange is that all these people are collecting–some small, some large–consumer surplus from every one of these exchanges. And, no matter how advanced the society, even in a capitalist society, where the rubber hits the road is the fact that all of us are made better off by all of these myriad little transactions where we’re better off with the thing than what we have to get up to obtain the thing. So, we should never lose sight of the fact that at the ground level, all of this is individual voluntary exchanges.
Russ Roberts: Just a footnote or two on that: Of course, there’s some uncertainty in the real world. A slightly refined definition of what you said is that I make an exchange expecting that I will be better off. I may be disappointed: turns out I don’t like bananas. I like the look of it.
So, we understand that in any single exchange people can make a mistake. They can also be defrauded, and we’ll talk about that more later. But, in general, if I swap something and you swap it with something else with me, we both do so in the expectation we’re going to prefer the thing we’re receiving to the thing we gave up. Sometimes that’s money when it’s a purchase. But, we’re starting here talking about, literally, exchange or barter. And you may now use your second-favorite Adam Smith quote.
Michael Munger: My second-favorite Adam Smith quote is that–I assume this is what you mean–that people have an innate “propensity to truck, barter, and exchange.” That means that it is something like: I have a desire for–hunger–for food because I’m hungry; or what Adam Smith called the mutual attraction of the sexes. Or thirst. People like exchanging for the sake of exchanging. Now in addition, the product of that is that we both get things that make us better off.
The problem with exchange is that it doesn’t change the total amount of stuff. It just makes better use of the stuff that we already have. That’s really important.
And, given the amount of stuff that we have, exchange always moves it in the right direction. Not only with no central plan, but with no individual plan. I just say, ‘Well, I’d like to have that. What will you take for it?’ And, you say, ‘Well, okay. What have you got?’ And, we exchange.
Russ Roberts: I just want to go deeper into that because in a conversation we had before we recorded this, I realized I didn’t really fully understand the implication of Smith. And, I think it’s half of what you said and the other half is something you I think said implicitly. So, we have a natural “propensity,” according to Smith, to “truck, barter, and exchange.” But, what does that mean exactly? I think we probably talked about this–I probably talked about it in the episode with Dwayne Betts when we talked about Primo Levi as well as Ralph Ellison. And, in his book The Truce, where Primo Levi talks about coming back from Auschwitz and we’re trying to get back to Italy, which is a long meandering, painful, and challenging journey, is an immense amount of barter. An unbelievable amount of barter. It’s an incredibly large part of the book. And, he’s got a buddy he falls in with. And, if I remember this correctly, there’s a scene where they just negotiate over things they don’t own or have. They’re just practicing. They’re just enjoying the give and take, the theatrical aspect of negotiation, or truck and barter and exchange.
So, I think we like the idea of getting a deal, and that’s part of what Adam Smith is saying. But the deeper part, which I didn’t appreciate until we talked about it, is: it’s a desire to improve oneself. So, I might like apples, they’re fine; but if I feel like I’d like a banana more than an apple and you feel the same way about an apple versus a banana, we make that exchange not because we just, ‘Oh, it’s so fun to trade,’ but because we have a thirst and hunger to do better. Do you agree with that?
Michael Munger: Not only do I agree with it, it actually brings me back to one of my other favorite Adam Smith quotes, which is that his claim is that we actually care what other people think about us.
And so, what’s hidden in Smith’s truck, barter, and exchange is: in the earlier book he has developed what he calls ‘propriety.’ And propriety is the way that we judge the actions of others. And the way that we do that is that we engage in an imaginative speculation about an ‘impartial spectator.’ And that is: Would this impartial spectator approve of this action?
So, what you said, which is very deep, is: Not only do I desire to improve myself, I desire to improve you. I want the exchange to be fair.
And so, each of these exchanges–now sometimes I might cheat people: maybe it’s someone that I don’t know that I won’t see again. But, by and large at the level of–we’re just talking about voluntary exchange now–these are mostly local. These are mostly with people that I will see again. And we start to develop an institution where not only I’m trying to improve myself, but I want to allow you to improve yourself also in the exchange, because we have a long-term reciprocal relation.
And, what Smith develops that I think is such a deep insight is that at first it’s actually literally my desire to improve myself and you. I see you, I look in your eyes, I see you smile, you look at the banana, you’re happy. Over time though, I become committed to the principle of making the person I’m trading with better off. It’s not just you personally, but it’s me imagining how I would feel if I were the person that I was exchanging with. That’s what the impartial spectator does. It internalizes how I would feel if I were the person being exchanged with. And I wouldn’t like being defrauded. And so, I don’t defraud people.
Russ Roberts: So, when you mentioned this earlier book, that’s The Theory of Moral Sentiments, where he says, “Man naturally desires not only to be loved but to be lovely.” And, by using that language he means honored, respected, praised. And lovely–meaning worthy of honor, worthy of respect, worthy of praise. So, I want you to respect me and I want to earn that respect honestly. And of course, as you say, Smith understands we can fool ourselves, we can be imperfect, but it is some restraint on our self-interest, which is the focus of the Wealth of Nations.
And, the sense in which there’s this empathetic, impartial spectator idea in the Wealth of Nations: It’s not explicit. He almost never says anything remotely like it. But he does, if I remember correctly, say that I’ll be a better player in the marketplace. I’ll exchange more effectively with you if I can imagine what you need. If I can put myself in your shoes.
And so, what the way I hear what you’re saying is the following. If I’m going to be interacting with you as a neighbor or as a person at the local marketplace that meets on the weekends where we exchange produce or other things we’ve maybe made, in that setting, the more I understand what you’re going to want, the more I can help myself. And you, of course. But, it’s a simultaneous system. So, what exchange is about is these two things as you’ve taught me in our conversation before we recorded and in some of your writing that we’ll link to, is that this seemingly self-interested drive of self-improvement–that’s not the best word because that sometimes means moral, but–
Michael Munger: They’re of a piece. They’re of a piece. That’s well put.
Russ Roberts: Okay. So, I want to improve my lot, meaning I want to have more stuff. At the same time, I’d like to be a better person because if by doing that I can be more empathetic to your needs and what would make your lot better, what would improve your well-being, then I will be able to exchange with you more effectively.
Michael Munger: And it is the separation of that by modern economists that makes Adam Smith hard to understand. Adam Smith would be mystified about why you would want to separate those two things. I think improving myself is exactly right. I want to improve my household situation. I want to improve the set of the opulence of my living, and I want to improve at the same time my character and my commitment to propriety and justice.
Russ Roberts: Okay. Let me try to summarize what we’ve said about voluntary exchange and then we’ll move on to markets. In general with voluntary–with what is simply, I’ll just call it exchange–if you and I make a deal, we both expect to be better off. We’ve rearranged the stuff in the world in a more attractive allocation, a more attractive distribution, but it’s been done voluntarily. And, it works best with people that have repeat interactions so that I can use this desire to be loved and lovely to constrain bad behavior and opportunistic behavior. On the other hand, in a small society, if you are a rapacious trader and not considerate and lie about what I’m getting, when we make the trade, you might get pushed out into the wilderness. People just won’t deal with you anymore. You’ll get blacklisted. But, that’s trade. Exchange. Excuse me. That’s exchange. And, exchange it’s good, but it barely touches the opportunity for our commercial interactions to transform our standard of living and material wellbeing. So let’s move on.
Michael Munger: Well, let me say two things about the transition because they’re important.
, volunteer exchange, it seems like it’s local and it doesn’t improve much, although it takes the stuff that we have and gives it to a better use. What Pareto would say was–some people are better off, no one’s worse off as a result of these exchanges.
That continues, though: that is still the foundation of even the most advanced society because it’s still true that I’m trying to obtain things. The true genius of Smith was that he recognized: Darn it, we need scale. And without scale we can’t really do much better. We can’t achieve opulence because we need some way to start to increase the amount of stuff, not just to make better use of what we have already, but to increase the amount of stuff. That’s the nature of opulence.
And so, the transition comes when my commitment is not to: I see you, another person; I want to make you better off also because that increases my sense of propriety about myself. I become committed to what Smith thinks is the core principle of a prosperous society, and that’s what he calls justice.
Justice is abstaining from what is another’s. And it has three parts: person, property, and promise. I become committed to not taking someone else’s stuff; I become committed to not interfering with another person’s life; and I become committed to carrying out my promises for their own sake. And, the impartial spectator approves of this. You have to go through the exchange period–the stage of exchange–to develop justice.
Now, once you have this underlying justice, you can start to develop the institutions for what I want to claim is the second stage. So, in terms of concentric circles, this is all the exchange is still going on, but for some societies they start to develop markets. And markets are a set of institutions for reducing the transactions cost of impersonal exchange.
And, notice what a big change that is. This is impersonal exchange. It requires that the people participating have reached a certain stage of commitment to justice for its own sake because it’s no longer ‘I know I will be trading with you again.’ This enables one-off transactions where I buy something from someone that I won’t see again, but I can still be relied on to act justly in according with justice.
There’s all sorts of problems, so that when I say reduce–it’s not eliminate–but reduce the transactions cost of impersonal exchange. And I have to admit, in graduate school I took a couple of classes from Douglass North; and the definition of markets that I just gave is his; I had no idea why he emphasized impersonal exchange so much. It’s taken me decades to understand this and another decade to understand that that’s actually what Adam Smith was talking about.
Markets are a way of reducing the transactions cost of impersonal exchange. Why? Why do we need to do that? I said we needed scale. Why do we need that?
And the answer is–and this is again Smith’s genius; I actually get goosebumps just–this is before the Industrial Revolution, the early parts of the Industrial Revolution. Smith recognized that the source of opulence is, in a context where exchange is allowed and it works well with not much friction because we’ve developed these other institutions, it’s division of labor. And, I don’t think anyone, not one person in a hundred, understands division of labor. They can give you the definition but they don’t understand it. And my evidence is: Duke students are smart and well-educated, and they have no idea what division of labor is.
Russ Roberts: Well, I probably don’t understand it either, but I’ve thought about it a lot because it’s such an extraordinary and beautiful engine of prosperity. I did a solo episode of EconTalk on this that we’ll link to, connecting the ideas of Smith on this with David Ricardo, and exchange and trade generally.
Let’s walk through what the division of labor unleashes. So, I want to set it up for you. It turns out you like bananas and I like apples, but my land is really good for growing bananas and yours is good for apples. So, when I say prefer: I like them both, but I might want more than I might just be able to grow of one or the other.
So, one of the opportunities we have once you enter my life–once Friday is part of Robinson Crusoe’s existence–is there’s another person who brings their productivity into the exchange. Instead of growing bananas really well and apples not so well–because I like them both–I might grow just bananas. And you might grow just apples. And I’ll get my apples by exchanging bananas with you. And that’s a very primitive division of labor. I’m going to specialize: I’m going to do one thing.
And, one of Smith’s great insights is that when you do one thing, you can get better at it.
But, he’s got an idea about division of labor that’s much more subtle and nuanced than that. So, give us the flavor of that. The pin factory he writes about is one example. You can read about that in the Wealth of Nations and other places.
Michael Munger: What’s interesting about this is that there’s two things–one of the reasons that I think no one understands division of labor is that they tend to go straight to–and you’ve referred to it and quite rightly–that division of labor might be based just on comparative advantage. That, some people are good at one thing and some people are good at another thing.
Smith takes an additional step and recognizes that even if we were all clones–if we were all exactly the same–if we were–the philosopher and the street porter, when we were very young and basically indistinguishable, as we spend time specializing in a particular thing, we might become better. That’s the thing that society needs to organize. A context where people are free to learn particular skills, become inculcated with ways of doing things with knowledge, with the accumulation of knowledge; because you start to accumulate knowledge when you start to specialize and then you can hand it on to the next generation.
So, the way I like to think about this–and I hate to belabor it, but I want to make sure that people understand–I start with four people. In class. And let’s suppose that these four people each want to have clothes, shoes, fish, and vegetables. And we start up: We all are in this little area and each of us are making our own clothes, our own shoes, catching our own fish, and growing our own vegetables. We are deeply, desperately poor.
And so, we notice that some of us may be a little bit better. Adam Smith gives the example of a bowman. So, there is a person who is a very good artisan at making bows. And so, to begin with we are all hunters. And so, I make my own bow; and then I spend a little bit of time making a bow for you. Before long I’m making a bow for the whole village.
And, he says that that’s the beginning of specialization.
So, we notice because we have this propensity to truck, barter, amd exchange, if all of us are making all of our own stuff, there’s no point exchanging because we all have just tiny amounts of all four things. So, none of us plans it. None of us says, ‘You know what would be cool? If we specialized.’ We just start doing it.
So, I start at the margin. Because I’m a little bit better at fishing, I start spending more time at fishing and then exchanging for the other three things. You start making clothes and you start exchanging for the other three things. So, before long we end up, the four people have engaged in what’s called artisanal specialization. That is, I’ve become an artisan. One of us makes only clothing, and before long I know a lot about making clothing. One of us does only fishing; one of us does only vegetables; and one of us makes only shoes. So, Smith claims that because we are able to first engage in this activity only, I improve my dexterity. I practice, I become better at it. Even if all four of us were clones to begin with, within a year there are dramatic differences in how productive we are because of changes in dexterity.
Russ Roberts: ‘Learning by doing’ is the modern jargon for that. I get better at it. Practice makes perfect. I start to do something over and over again. As long as I don’t get bored, which is a separate issue, I get better.
Michael Munger: Even if you get bored–because you’re probably bored making all four things before–you had to spend all of your time–that’s an important point. Let’s focus on that for a second. Before you had to make all four. You spent 23 hours a day doing it. You could hardly ever sleep–otherwise you’re going to be starving, have no shoes. You can barely provide. So, yes, you’re bored now for the 13 hours a day you work, but now you get a little bit of time off because you’re so much more productive. So, it was always boring if you had to work all the time. Now you have some leisure time.
So, the other thing that you start to engage in: because of improvements in dexterity, you have tool use. As you specialize, you start to think about technological improvements in the production process. And so, as a result, this little group of four people is much wealthier.
But that’s artisanal. That’s not division of labor.
Russ Roberts: Before you go on though, I just want to emphasize the transition that we’ve been talking about. In our first example, you just had some stuff. Maybe you grew it, maybe you didn’t. Sometimes you’re endowed with stuff. There’s apple trees on your property. You’re not a farmer, you just have apple trees; and you have banana trees on your property and we swap. Once we have the possibility of specialization, the amount of stuff to be exchanged isn’t fixed anymore. And it’s a glorious thing.
The total pile of stuff gets bigger through the two processes we mentioned. There’s a natural improvement because some people are better at some of these things than others. We’re not all equal.
The second improvement is we get dexterity and practice, learning by doing.
The third is we start to imagine–and implementing sometimes–tools that make us even more productive than we were originally. So, there’s a lot more bananas, a lot more apples, a lot more shoes, etc., etc.
So, specialization puts the production process on steroids. And of course, Ricardo’s great insight was that you might be the best fisherman, Mike, of the four of us; but that doesn’t mean you will be the fisherman. It may turn out that because you’re so good at growing vegetables that to be a fisherman means you’re going to sacrifice the opportunity costs. What you give up to be a fisherman is so large that we’re not going to assign the best person at fishing to fishing. That’s a profound insight.
The other piece of this is that in a modern economy, wages are playing a role of assigning people to different tasks and jobs. And, that’s an amazing thing. You could spend an enormous portion of an economics class giving people the intuition of how that happens and how it doesn’t necessarily mean that the most skilled person at a task is the person who you’d want to assign to it because they give up even more–it’s much more effective to let you grow the vegetables, Mike. And, I’ll fish. I’m not as good a fisherman as you are, but you’re so much better at vegetable growing than I am that our exchange will be more productive for both of us if you give up the thing that you’re the best at.
Michael Munger: Not only is that right: I think we need to invert it because the power of Ricardo’s insight is not that the person who is best will be necessarily doing that one thing because they’re even better at something else. Suppose we have someone who is desperately poor and they are worse at everything–
Russ Roberts: Exactly–that–
Michael Munger: The poorest person–they will still now be employed and be significantly better off because they will do the thing that other people are relatively worse at. Not that they’re worst at: he doesn’t have to be the best at anything. He can be the worst at everything; but, if the person who is the best at fishing is the fisher person–best in relative terms, that I can produce more fish than I can anything else. Someone else makes clothes, someone else makes shoes. I’m going to be out there growing vegetables and the result is I will be better off than I would otherwise have been. So, it’s not just that Ricardo’s insight says that the person who is best will specialize. It’s that even the person who is worst off will benefit from specializing because of the power of division of labor–the increase in the amount of stuff that we then sub-optimize by exchanging.
Russ Roberts: And now we get to Adam Smith’s–my third-favorite quote of Adam Smith. We’ve mentioned the first two. The third quote is underappreciated and gets dwarfed by Ricardo’s insight–because, I think it’s [Ricardo’s is] better for exam questions–which is a tragedy. But, Smith’s great insight is: ‘The division of labor is limited by the extent of the market.’ So if there’s–
Michael Munger: In fairness, George Stigler actually published a paper with that as the title to make sure that it was impossible to miss–because that is a theorem. That’s actually a theorem, that the division of labor is limited by the extent of the market. And, it’s the title of just the third chapter of Book I of Wealth of Nations. So, if we don’t appreciate it, it’s because we’re not paying attention.
Russ Roberts: So, why is it important?
Michael Munger: Remember that the market is a set of institutions for reducing the transactions cost of impersonal exchange. And, we haven’t said what those institutions might be.
One of the things that they might include is institutions that improve and reduce the cost of administration of justice. So, a sense of property rights, a judicial system for adjudicating disputes over property rights, breach of contracts: ‘You said you’d do this; you didn’t do this.’ If we can enforce that, then people are more likely just always to obey because in equilibrium, any breach of contract will be punished. And so, I can more reliably–I can rely on you keeping your promises.
In addition to your desire to keep promises because of your sense of propriety, you will keep the promise because otherwise the legal system will subject you to cost. And so, they act together.
Now, if we had to contract for everything, that would be no good. You’ve said a number of times: In the United States if you buy a house, a bunch of stuff that’s in the house goes along. And, it’s not because it was in the contract. So, if I say you’re going to buy my house and I mention there’s this one expensive chandelier that does not convey–which means it doesn’t go in the sale. And you show up at the house after you bought it; and ‘I also took the gas range.’ No. No, you don’t do that. It is understood that the stuff that’s in the house goes along. And, it’s just because it’s understood. I’m not doing it because the legal system would threaten me. I have a sense of justice and that’s what I do.
So, we’ve developed a bunch of institutions that reduce the transactions cost of impersonal exchange.
And a big one of those is money–some sort of currency. A reliable system for being able to exchange a numeraire good–which is what economists mean by: This is something everybody wants because it allows me to buy other things.
Barter exchange requires the double coincidence of wants. If I have something you want, you also have to have something I want, or we have to find a third person and make a three-way exchange. Money means that all of us can engage in bilateral exchanges.
So, we’ve started to develop those institutions.
Now, the extent of the market is the size of the people who cooperate within that system of what in effect provides the public good of reduced transactions cost. Reduced transactions cost is a platform to reduce the friction of voluntary exchange–the frictions that prevent voluntary exchanges. Because, someone else far away may have something that I want, but me acquiring it is so expensive that it dwarfs the consumer surplus that I would obtain. So, if we can reduce transportation costs, we have systems of accounting that allow me to have big infrastructure, ships, railroads–accounting systems are another one of the things that allow us to start to achieve scale. And that’s what ‘extent of the market’ means.
Russ Roberts: Well, let me just say that–let me just expand that, because that was a long sentence. The larger the pool I can trade with–pool is not the right word. The larger the number of people I can trade with–and in this sense the word ‘market,’ I’m going to use it now in the everyday sense–the larger the market for what I make, meaning the larger the number of people who might want to buy it, the more I can have division of labor. And, that sounds like: Okay, yeah, yeah, yeah, yeah. But, it’s unbelievably important and deep because when I trade–
Michael Munger: It brings back to–
Russ Roberts: No. You go ahead.
Michael Munger: It brings us back to our four people.
Russ Roberts: That’s what I was going to do, too.
Michael Munger: Sorry. Well, you get the assist. You get the assist. It’s okay. In hockey, we both get a point.
Let’s go back to our four people, because we left them and they were all artisans. And things are going along pretty well. We are a lot richer. But, we notice that there are other villages not very far away and we don’t know much about those people. They’re sort of creepy. Maybe they worship different gods. They have all sorts of different language and different habits. But still, we are an inland village; and it’s a little bit difficult for us to engage in fishing because we have a river, but it’s far to go to the coast. This other village is right on the coast. They have a lot more fish. The person who engages in fishing there is really good at that.
And so we say, ‘You know what we could do? We seem to have really fertile land. Why don’t all four of us engage in farming vegetables?’ And, we will then be able to exchange the huge amount of vegetables we’re able to produce with this other village that now has started to produce only fish. And now, the four of us take the job of farming, which the artisan farmer before was pretty good at. He was really producing a lot of cantaloupes and zucchini so we were doing okay.
But, now we divide the act of farming into four steps.
So, one of us specializes in domesticating plants, in seeds, in planting. One of us learns about plowing and developing tools that make plowing and harvesting more effective–so, sharp metal edges. We start to develop metallurgy. One of us learns about harvesting and storing, maybe using salt or something else to preserve. And, one of us specializes in carting all of the vegetables that we have developed to other villages.
So, now we have so many vegetables: but that’s not opulence.
Russ Roberts: Yeah. Just to emphasize: If the very best vegetable grower was the one who was the grower of vegetables in our little community of four people, you’d think that if we all became farmers we’d have four times that, but not quite because he was the best one. The idea here is that you’re going to get eight or 16 times or more of output of vegetables because of this power of specialization, of the division of labor.
Michael Munger: And, at that point you’re adding a third factor.
Remember, the two factors before were dexterity and the development of tools. Both of those are dramatically increased by dividing into the four tasks. The other thing that Smith mentions, though, is that I’m not so often changing between tasks. I’m just engaging in the same task over and over again. So, the scope of how much I’m working on is reduced, which means that I don’t have to do 10 or 12 different things. I’m doing three or four different things and so dexterity improves quite a bit. And, tool use means that I’ve really thought deeply about each of the small steps in the process that I’m working on and I’m not switching back and forth between tasks.
So, what you said is perfect. We’ve got four people. If all four of us engaged in farming or one of the other things at best it would be four times what we had before.
This is 20, 30 times as much.
What economists call this, is increasing returns to scale. As we add more labor to this process, we’re actually getting proportionately more output–up to a certain point.
And, that’s what’s important about the extent of the market. Let’s suppose that the village starts to grow and we have more and more people. How many people would be engaged in this activity? And, the answer is not obvious. The number of people engaged in the activity is limited by–wait, it is obvious–the extent of the market. How much can we sell? How much can we sell?
Russ Roberts: And, this is the most important point we haven’t mentioned yet–which, I’m sorry to cut in because it gives me goosebumps, too–is that: If you’re going to grow 40 zucchinis and harvest 40 zucchinis and drive 40 zucchinis to the market, you might have a little patch of land and a hoe; and you’re going to have a cart or a bicycle to take them to the market. If you’re growing 40,000 zucchinis, you can have a truck. And you can have a harvester, and a mechanized plow, and so on. And you’d say, ‘Well, you can have those anyway.’ Doesn’t make sense when you’re growing 40. In fact, it’s more expensive to grow 40 with a big truck and a harvester and a mechanized plow.
Michael Munger: Nobody would think to develop them.
Russ Roberts: That, too.
Michael Munger: The process of developing those. Because those are tools. You would only think to develop those if you are climbing up the amount of production.
So, all of what we think of as the Industrial Revolution is driven by this tendency to truck, barter, and exchange, unleashed by market institutions that increase the extent of the market. No one says, ‘You know, we need to have an Industrial Revolution.’ It just happened. It was an emergent phenomenon that results from the fact that the division of labor is limited by the extent of the market, and the extent of the market wants to be bigger. We want to find more and more people to exchange with: not because it makes them wealthier, but because it makes us wealthier. It just also makes them wealthier.
Russ Roberts: And that brings us to a punchline that both you and I have come to–that I love and I know you love–which is, that if you have a hundred people who are incredibly skilled, unbelievably talented–I’ll let you pick them; you pick the 99 most skilled people in the world to live with you on the most resource-rich island in the world. You can put any resources on that island that you want. You’re going to be desperately poor.
It doesn’t matter how skilled you are, because those hundred people, there’s not that much room for the division of labor.
But, when you trade with seven billion people–which is to some extent, sorry the pun, the world that we live in now–you could have unimaginable specialization. And the standard of living for people who have limited skill–not the hundred most-skilled people in the world: people who have okay-skill–can be fabulously well-off in the material sense from the opportunities to trade with this enormous group of people. Because, as you point out, we’ve reduced the transaction costs and we’ve allowed for that impersonal exchange with not just the other village, not just the people across the country: people in different countries, far-away countries. And, that’s the miracle of the modern prosperity that so many people enjoy in 2025.
Michael Munger: And so, that’s what Deirdre McCloskey has called the Great Enrichment. There’s this puzzle that for most of human history there wasn’t much improvement. There were some inventions in science; there’s some improvement; there’s changes in fashions. But then, at some point there was this giant takeoff, and as a result we have seen the decline of poverty at the same time that there was an enormous increase in the amount of population.
And, when you put those two things together, it actually does seem miraculous. It’s not just that a fixed number of people got relatively more wealthy. We doubled, tripled, quadrupled the number of people at the same time that the absolute level of poverty was also falling. And, the reason is division of labor. Division of labor is increasing returns.
And so, Malthus was worried about exponential population growth. What we have seen is there has been population growth. That’s true. But the increasing returns to scale that come from division of labor has more than kept pace with the population increase, to the point that it is much better to be poor today than it was to be a king in 1600.
Russ Roberts: And I think the other important point to add is that many people see the world as a zero-sum game. If I get better off, somebody must be worse off. This is a world and this is the world of human history and it’s not a small point. And, it is I think, incredibly profound. The gradual increase in material well-being of the world’s population during a time of population growth allowed–
Michael Munger: Enormous population growth–
Russ Roberts: allowed people to be better off at no one’s expense. Without anyone getting worse off. Who did they take it from? How did they acquire that well-being? Who did they extract it from? Who did they exploit? And, the answer is: No one.
Now, that’s not to say there weren’t people who exploited people. There were people who were thieves. There are people who are crony capitalists who use the legal system to exploit people. For sure, there are dishonest people who defraud customers that provide things that aren’t what they promise. A hundred percent. But, the fundamental underlying story of the last 150 or so years of human history is an enormous expansion of well-being without anyone suffering because of it. And that, Smith understood before it happened.
Michael Munger: He predicted it.
Now, we probably shouldn’t go too far in that direction. His understanding of corporations and of division of labor, some of what he was talking about, though, was not just within a country. He talked about it being along rivers. But he did foresee the importance of exchanging with other nations. And that’s why his book is addressed to the philosophy of mercantilism, where wealth and opulence is a result of keeping precious metals and money at home. He said, No: opulence comes from exchange and we should exchange more with other nations. And, that prediction is what has borne fruit. It’s the expanse to make markets operate in the entire world that has improved the wealth–not just of the wealthy countries. The big increases in wealth have been in the poor countries; and that’s the miracle of markets.
Russ Roberts: And now let’s turn to capitalism. Which, until we had our prep conversation for this episode, it turns out I didn’t really understand. Kind of awkward, but I learned something deep from you. So, tell us what capitalism is.
Michael Munger: Nobody–I said nobody–knows what division of labor is. One in a hundred. Zero out of a hundred know what capitalism is.
Russ Roberts: Don’t say that, because a lot of listeners will just turn off their players and turn on another podcast.
Michael Munger: Yeah. They might just write an angry letter and listen in order to say–if they’ve listened this far, then I’m hoping that they will continue. And of course, when I say what capitalism is, it means it’s how I want to define it. And, people might want to quarrel with that: ‘You’re wrong about that.’
So, my definition of capitalism is an elaboration of markets. And so, again, in terms of the concentric circles, we’ve still got all of that voluntary exchange operating and we’ve still got all of those markets operating. Capitalism is something in addition that assumes all of the exchanges and all of the division of labor is also operating. Capitalism–
Russ Roberts: And, the institutions. And, the institutions that make those work–
Michael Munger: The institutions, the attitudes, the ideas–
Russ Roberts: Culture, justice–
Michael Munger: We saw this. If you say, ‘Well, all you need to do to have capitalism is to have a set of rules in a stock exchange,’ then the former Soviet Union says, ‘Oh, well, that’s what we’ll have, too. We’ll have capitalism.’ It doesn’t work. It falls apart.
So, capitalism can’t be grafted on to a society that doesn’t have these attitudes and institutions already.
And so, I hate to keep praising Douglass North, but I am a student of Douglass North. Right after he won the Nobel Prize in 1993 he did one of those world tour things. And people have this very effusive, fanboy reaction: ‘Oh, Professor North, it is so great to have you here. Can you tell us how our nation can have economic and political development?’ And, he would say, ‘Well, the first thing you’ll need is a different history.’ Thanks. That’s very helpful. But, it’s true. You can’t just have capitalism.
Russ Roberts: Well, tell us what it is first.
Michael Munger: Okay. I’m sorry for that.
Capitalism is a set of specialized market institutions that allow time travel. And it’s time travel that breaks a chicken-and-egg problem towards the development of many nations. And, the single word that gives the argument for capitalism is one that I think most people don’t expect. That single word is ‘liquidity.’ Liquidity is a way of transitioning from money or resources that have value and can be transferred into fixed capital, which is resources that have value because it increases the productivity of labor, but that cannot be easily transferred into something else.
So, usually capital is a big bank account or line of credit where I have money and I can devote it to buying things and create a factory, buy land, hire a bunch of consultants, create an organizational structure. So, this is money that can be moved around. A physical factory–a place where I can build automobiles–once I have devoted my liquid capital to making that factory, I can no longer convert it to making chips. It is very difficult to convert that to making chips.
So, suppose I have a new idea about making cars. And I say, ‘I’m going to build a factory to make new automobiles.’ And I live in a country that has well-developed markets. So, I say, ‘Well, first thing I’m going to need is a whole lot of liquidity because I’m going to use that to build the factory.’ Where would I get it? There’s no way for me to solve this chicken-and-egg problem. I need a factory to make the cars that’ll produce the profits to produce the liquidity that would allow me to buy the factory in the first place. And so, I’m stuck.
What capitalism does is solve that problem by time travel: We’re going to travel forward into the future, in expectation to a time when this factory is operating and is producing substantial profits. I’m going to take some of those profits and get in my time machine and go back in time and invest it in the resources that create the fixed capital that now allow me to start earning the profits.
But, time machines don’t exist. So, what actually is it? And, it’s a particular form of institution that allows me to sell shares in the profits that don’t yet actually exist. [More to come, 56:18]
