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- [Alex] In our first talk [br]on the price system,

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we looked at how markets [br]link the world,

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how markets linked[br]over space, geographically.

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Today, we're going to look at how

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different markets are linked [br]to one another,

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and this is going to give us[br]a lot of insight into how markets

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solve the great economic problem.

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Earlier, we looked at how the price [br]of oil affects the market for roses.

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Here's another example:

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How does the price [br]of oil affect candy bars?

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Well, there's one obvious way [br]in which these are connected.

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A higher price of oil leads [br]to higher transportation costs,

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and anything you transport [br]therefore becomes

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a little bit more expensive.

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But what I have in mind is[br]actually a more subtle

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and important connection.

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Can you guess what it might be[br]from the picture?

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Higher oil prices increase [br]the demand for substitutes

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such as ethanol.

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In the United States, [br]ethanol is mostly made from corn.

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But in most of the rest [br]of the world, including Brazil,

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it's made from sugar cane.

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Higher oil prices mean [br]that more of the sugar cane crop is

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going to be diverted [br]into producing ethanol,

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and less of it is going [br]to be used to produce sugar.

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That means a reduced [br]supply of sugar.

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That means an increase [br]in the price of sugar,

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and that increases the cost [br]of producing candy bars.

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Who would have thought [br]that one way of adjusting

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to a higher price of oil is [br]to eat fewer candy bars?

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Yet that is exactly[br]how the price system works.

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A change in the price [br]of one resource ripples out

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throughout the world economy,[br]changing the consumption patterns

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of many, many different goods

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in first, second, [br]and third order effects.

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All in order to try and find [br]the best way of responding

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to this reduced amount [br]of the resource.

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How do we adjust to less?

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We adjust on many,[br]many different margins,

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all working[br]through the price system.

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Here's another example [br]of how a change in the price

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in one market ripples out [br]throughout the world economy,

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changing prices, consumption [br]and production decisions,

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incentives, and choices [br]throughout the entire world.

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We're going to show how [br]the price of oil affects

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how driveways are built.

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A barrel of oil is refined [br]into gasoline but also

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into many other products,

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such as jet fuel, lubricants,[br]and also asphalt.

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Asphalt, in fact, is [br]what's left over

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after the other products[br]have been extracted.

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Within limits, refiners can choose [br]how much of each product to extract.

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A higher price of gasoline will[br]cause refiners to work extra hard

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to extract more gasoline[br]from a given barrel

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than they otherwise would.

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This means as they extract [br]more gasoline, there's less

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production of asphalt, and that [br]means a higher price of asphalt.

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So, when someone is thinking [br]about how to pave their driveway,

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they're going to see [br]the higher price of asphalt.

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So, they're going to use, instead, [br]concrete, cobblestone or brick,

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one of the substitutes.

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Who would have thought that [br]concrete is a substitute for oil?

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Yet, in fact, it is.

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That's what the market system does.

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It causes us to rearrange [br]our choices in order to get

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the most value from our[br]resources, and that may involve

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substituting concrete for oil.

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So, here's the big picture.

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The great economic problem [br]is how to arrange

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our limited resources to satisfy[br]as many of our wants as possible.

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Resources are not equally [br]valuable in all uses,

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so we must choose where to allocate[br]our resources in order

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to get the most value [br]out of those resources.

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If the supply of oil falls, [br]we want oil to be shifted

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to higher valued uses, [br]but which uses?

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How are we going to choose[br]where to use less oil?

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We must use less oil [br]somewhere, but where?

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And how are we going [br]to make these decisions?

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There are a couple [br]of possible methods.

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We could use a central planner,[br]or we could use the price system.

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One way of solving [br]the great economic problem is

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through central planning.

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Make a single official, a czar, [br]or a bureaucracy, responsible

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for allocating our limited resources [br]to all the different uses.

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This was the approach taken [br]in communist countries

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in centrally planned economies.

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Does it work? [br]It's got big, big problems --

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problems of information [br]and problems of incentives.

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Let's look at information first.

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Think about all [br]of the different uses of oil.

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Oil is used for producing steel [br]and is used for growing vegetables.

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If we have less oil, which one [br]do we cut back most on --

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on steel or on vegetables?

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You might think that's easy

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because maybe steel is [br]worth more than vegetables.

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Maybe, but even if that is true,

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perhaps there are [br]really good substitutes

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for oil in its use [br]in producing steel,

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but no good substitutes for oil [br]in its use in producing vegetables.

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In that case, we would want [br]to cut back on steel

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and continue to use oil [br]for vegetables.

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Think about all of the different [br]responses we've seen

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to an increase in the price of oil.

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People use less sugar, they had [br]fewer candy bars, they cut back

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on asphalt and switched to paving [br]their streets and their driveways

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with concrete and brick.

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Could any bureaucracy,[br]even a large bureaucracy

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with massive computing power --[br]could it know all of the many,

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many uses of oil and all [br]of the substitutes for those uses?

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And the substitutes [br]for the substitutes?

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Could it make all [br]of these subtle choices

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that we've seen[br]that the market makes?

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It's highly unlikely.

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The information problem [br]is too difficult,

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even for massive [br]computing power to solve.

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Moreover, even if we could [br]gather all of this information,

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this dispersed information

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for millions and millions [br]of people, and even if we could

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compute the right thing to do [br]with all of that information,

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would anyone have the incentive [br]to do the right thing?

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Would people have [br]the right incentive to respond

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to the bureaucracy with the truth?

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No, everyone's going to say, [br]"My use is really valuable.

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It's the most valuable use.

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There are not good substitutes [br]for oil in my use."

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Even if their use happens to be[br]heating their swimming pool.

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We saw, in fact, what happened [br]in the United States

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when the Department of Energy [br]tried to centrally plan

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the allocation of oil in the 1970s.

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We had oil rigs off the coast [br]of California which could not

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themselves get [br]enough oil to operate.

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In other words, [br]under central planning of oil,

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we had massive inefficiencies [br]and misallocation of resources.

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We saw exactly the same [br]misallocation of resources

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on a larger scale in the command [br]economies, such as the Soviet Union

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under communism, [br]or China under communism.

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Central planning is not [br]a good solution

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to the great economic problem

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because of problems [br]of information and incentives.

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We need a better approach.

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- [Narrator] If you want to test [br]yourself, click "Practice Questions."

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Or, if you're ready to move on,[br]just click "Next Video."

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♪ [music] ♪