Information and Incentives

We're now going to examine in more depth how the price system solves the great economic problem.

Here is by now our very familiar diagram of the market for oil. Notice that all of the uses of oil above the market price are the higher valued uses and the satisfied demands. The uses of oil below the market price are the lower valued uses and the unsatisfied demands. Take a look at the use which is just equal or very, very close to the market price right here. We can think about this use in two different ways. We can think about this as being the value of the highest valued unsatisfied demand, or pretty much exactly the same thing, this is the least valuable satisfied demand. The price is thus equal to the marginal value. The marginal value is the lowest valued satisfied demand, or the highest valued unsatisfied demand. We can also say that the price is equal to the social opportunity cost. What do I mean? Take a look.

Take one of these users up here. They're going to be comparing the value of oil in their use to the market price. But that means that they're comparing the value of oil in their use to the next most valuable use of oil. If these guys were not to use this barrel of oil, the next most valuable use of oil, that would be here. In comparing their value to the market price and saying, "Well, my value is higher, therefore I'm going to use the oil," the oil flows to the highest valued users. It doesn't go to the unsatisfied users because their value of oil is too low. It goes to the highest valued users.

It's the same thing with the guys down here. They have a low valued use. They're comparing the value of oil in their use to the market price. They're saying, "Well, I'm not going to use this barrel of oil." And that too is good, because if they were to use that barrel of oil, then it would no longer be available to satisfy the lowest value currently satisfied demand. In comparing the value of oil in their use to the market price, once again what they're really doing, unbeknownst to them, is comparing their use of oil with the social opportunity cost of oil -- and that's exactly what we want the market system to do. That's exactly how we solve the great economic problem.

To really bring us home, let's look at what happens when there's an increase in the cost of supplying oil. How does the market respond? With an increase in the cost of producing oil the supply curve shifts up. Notice that the price goes up and the quantity of oil used goes down. Now notice that the satisfied demands now become these -- the most, the highest value demands, which we can still satisfy given the reduced quantity of oil available. The unsatisfied demands become these demands. We've got more of them now, but notice which demands become unsatisfied. It's the least valuable demands given the quantity that become unsatisfied.

Moreover, we're letting millions of people make their own choices. We've let them look around and say, "Well, with this higher price of oil, how can I respond? What do I know about the substitutes for oil? What do I know about the alternatives for oil in my use? What do I know about the value of oil in my use?" These people, whoever they are -- we don't need to know who they are -- decide on their own using their own information that, "Yes, now that the value of oil in alternative uses is higher, I should give up my use of oil." What kind of uses are given up? It's the use of oil in the least valuable uses -- just for paving your driveway with asphalt. The key is we let people decide using their own information, about all of the substitutes for oil in their many, many uses, whether it's producing candy bars or asphalt for driveways, or bricks or whatever. These users of oil will decide to give up their oil in response to the higher price -- and that is exactly what we want them to do. The higher price signals what the users of oil should do and it gives them an incentive to do exactly that.

Remember, to solve the great economic problem we need to solve information problems and incentive problems. Let's take a closer look at how the market, how the price system is doing this. How does the price system solve the information problem? The market collapses all of the relevant information into a single number -- the market price. Instead of collecting all the required information in a central spot, the market transmits just a little bit of information to everyone in a decentralized fashion.

Here's what Friedrich Hayek, Nobel Prize winner in Economics said. "The most significant fact about this system [price system] is the economy of knowledge with which it operates… by a kind of symbol [the price], only the most essential information is passed on and passed on only to those concerned… The marvel is that in a case like that of a scarcity of one raw material without an order being issued, without more than perhaps a handful of people knowing the cause of the scarcity, tens of thousands of people whose identity could not be identified by months of investigation -- they are made to use the material or its products more sparingly, i.e. they move in the right direction."

The price system economizes on information. It's able to allocate resources in a decentralized fashion using all of the information available, but without collecting all of that information, without having to transmit all of that information, because it makes use of the information in a decentralized fashion. It uses the information which is in people's heads. The way that Tyler and I like to summarize this is that a price is a signal wrapped up in an incentive. An increase in the price of oil signals users that oil has become more valuable in alternative uses. But that alone is not enough. We also want people to move in the right direction, to take the signal seriously, to adjust in the right way to the signal. And the higher price does exactly this. It gives users of oil an incentive to respond to the signal. They respond by using less, by substituting a lower cost alternative. And suppliers are also incentivized by the signal to invest more in exploration, to look for alternative sources, to build more, and so forth.

One final point before we wrap up. Politicians and consumers sometimes fail to understand the signaling role of prices. After a hurricane for example, it's quite common for the prices of ice and generators and chainsaws to skyrocket. Consumers complain of price gouging. Politicians call for price controls. But really this is a bad rap on the market because it's just doing its job. It's signaling that we need resources. The higher prices in a hurricane-devastated region, that says, "Bring the resources here!" The high price is a signal saying that the value of ice, the value of generators, the value of chainsaws -- it's really high in this location, in this time. And that higher price is acting as an incentive. It's telling entrepreneurs, “You can profit by bringing resources from where they have low value to where they have high value." The price system is doing exactly its right job. It's signaling and incentivizing people to respond to these shortages. Okay.

Let's summarize a little bit what we've learned. Markets are linked. They are linked geographically across the world. They are linked across different goods. They’re also linked, by the way, through time. We haven't actually discussed that one yet. We'll discuss that in the next few lectures when we talk about speculation. And the market, it kind of acts like a giant computer that arranges our limited resources over space, time, and across different goods so that we can satisfy as many of our wants as possible. Prices are the signals that coordinate all of this economic activity. Thanks.