The Great Economic Problem

In our first talk on the price system, we looked at how markets link the world, how markets linked over space, geographically. Today, we're going to look at how different markets are linked to one another, and this is going to give us a lot of insight into how markets solve the great economic problem.

Earlier, we looked at how the price of oil affects the market for roses. Here's another example: How does the price of oil affect candy bars? Well, there's one obvious way in which these are connected. A higher price of oil leads to higher transportation costs, and anything you transport therefore becomes a little bit more expensive. But what I have in mind is actually a more subtle and important connection. Can you guess what it might be from the picture? Higher oil prices increase the demand for substitutes such as ethanol. In the United States, ethanol is mostly made from corn. But in most of the rest of the world, including Brazil, it's made from sugar cane. Higher oil prices mean that more of the sugar cane crop is going to be diverted into producing ethanol, and less of it is going to be used to produce sugar. That means a reduced supply of sugar. That means an increase in the price of sugar, and that increases the cost of producing candy bars. Who would have thought that one way of adjusting to a higher price of oil is to eat fewer candy bars? Yet that is exactly how the price system works.

A change in the price of one resource ripples out throughout the world economy, changing the consumption patterns of many, many different goods in first, second, and third order effects. All in order to try and find the best way of responding to this reduced amount of the resource. How do we adjust to less? We adjust on many, many different margins, all working through the price system.

Here's another example of how a change in the price in one market ripples out throughout the world economy, changing prices, consumption and production decisions, incentives, and choices throughout the entire world. We're going to show how the price of oil affects how driveways are built. A barrel of oil is refined into gasoline but also into many other products, such as jet fuel, lubricants, and also asphalt. Asphalt, in fact, is what's left over after the other products have been extracted. Within limits, refiners can choose how much of each product to extract. A higher price of gasoline will cause refiners to work extra hard to extract more gasoline from a given barrel than they otherwise would. This means as they extract more gasoline, there's less production of asphalt, and that means a higher price of asphalt.

So, when someone is thinking about how to pave their driveway, they're going to see the higher price of asphalt. So, they're going to use, instead, concrete, cobblestone or brick, one of the substitutes. Who would have thought that concrete is a substitute for oil? Yet, in fact, it is. That's what the market system does. It causes us to rearrange our choices in order to get the most value from our resources, and that may involve substituting concrete for oil.

So, here's the big picture. The great economic problem is how to arrange our limited resources to satisfy as many of our wants as possible. Resources are not equally valuable in all uses, so we must choose where to allocate our resources in order to get the most value out of those resources. If the supply of oil falls, we want oil to be shifted to higher valued uses, but which uses? How are we going to choose where to use less oil? We must use less oil somewhere, but where? And how are we going to make these decisions? There are a couple of possible methods. We could use a central planner, or we could use the price system.

One way of solving the great economic problem is through central planning. Make a single official, a czar, or a bureaucracy, responsible for allocating our limited resources to all the different uses. This was the approach taken in communist countries in centrally planned economies. Does it work? It's got big, big problems -- problems of information and problems of incentives.

Let's look at information first. Think about all of the different uses of oil. Oil is used for producing steel and is used for growing vegetables. If we have less oil, which one do we cut back most on -- on steel or on vegetables? You might think that's easy because maybe steel is worth more than vegetables. Maybe, but even if that is true, perhaps there are really good substitutes for oil in its use in producing steel, but no good substitutes for oil in its use in producing vegetables. In that case, we would want to cut back on steel and continue to use oil for vegetables. Think about all of the different responses we've seen to an increase in the price of oil. People use less sugar, they had fewer candy bars, they cut back on asphalt and switched to paving their streets and their driveways with concrete and brick.

Could any bureaucracy, even a large bureaucracy with massive computing power -- could it know all of the many, many uses of oil and all of the substitutes for those uses? And the substitutes for the substitutes? Could it make all of these subtle choices that we've seen that the market makes? It's highly unlikely. The information problem is too difficult, even for massive computing power to solve. Moreover, even if we could gather all of this information, this dispersed information for millions and millions of people, and even if we could compute the right thing to do with all of that information, would anyone have the incentive to do the right thing? Would people have the right incentive to respond to the bureaucracy with the truth? No, everyone's going to say, "My use is really valuable. It's the most valuable use. There are not good substitutes for oil in my use." Even if their use happens to be heating their swimming pool.

We saw, in fact, what happened in the United States when the Department of Energy tried to centrally plan the allocation of oil in the 1970s. We had oil rigs off the coast of California which could not themselves get enough oil to operate. In other words, under central planning of oil, we had massive inefficiencies and misallocation of resources. We saw exactly the same misallocation of resources on a larger scale in the command economies, such as the Soviet Union under communism, or China under communism. Central planning is not a good solution to the great economic problem because of problems of information and incentives. We need a better approach.