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

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we looked at how markets 
link the world,

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how markets linked
over space, geographically.

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Today, we're going to look at how

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different markets are linked 
to one another,

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and this is going to give us
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 
of oil affects the market for roses.

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Here's another example:

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How does the price 
of oil affect candy bars?

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

NOTE Paragraph

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A higher price of oil leads 
to higher transportation costs,

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and anything you transport 
therefore becomes

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a little bit more expensive.

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But what I have in mind is
actually a more subtle

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and important connection.

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Can you guess what it might be
from the picture?

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Higher oil prices increase 
the demand for substitutes

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such as ethanol.

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

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But in most of the rest 
of the world, including Brazil,

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it's made from sugar cane.

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

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going to be diverted 
into producing ethanol,

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

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That means a reduced 
supply of sugar.

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That means an increase 
in the price of sugar,

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and that increases the cost 
of producing candy bars.

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Who would have thought 
that one way of adjusting

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

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Yet that is exactly
how the price system works.

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A change in the price 
of one resource ripples out

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throughout the world economy,
changing the consumption patterns

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of many, many different goods

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in first, second, 
and third order effects.

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

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to this reduced amount 
of the resource.

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How do we adjust to less?

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We adjust on many,
many different margins,

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all working
through the price system.

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

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in one market ripples out 
throughout the world economy,

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changing prices, consumption 
and production decisions,

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incentives, and choices 
throughout the entire world.

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

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how driveways are built.

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A barrel of oil is refined 
into gasoline but also

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into many other products,

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such as jet fuel, lubricants,
and also asphalt.

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Asphalt, in fact, is 
what's left over

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after the other products
have been extracted.

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

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

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to extract more gasoline
from a given barrel

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than they otherwise would.

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

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production of asphalt, and that 
means a higher price of asphalt.

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

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

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

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one of the substitutes.

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Who would have thought that 
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 
our choices in order to get

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the most value from our
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 
is how to arrange

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our limited resources to satisfy
as many of our wants as possible.

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Resources are not equally 
valuable in all uses,

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so we must choose where to allocate
our resources in order

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to get the most value 
out of those resources.

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

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to higher valued uses, 
but which uses?

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How are we going to choose
where to use less oil?

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We must use less oil 
somewhere, but where?

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And how are we going 
to make these decisions?

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There are a couple 
of possible methods.

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

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One way of solving 
the great economic problem is

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through central planning.

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Make a single official, a czar, 
or a bureaucracy, responsible

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for allocating our limited resources 
to all the different uses.

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This was the approach taken 
in communist countries

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in centrally planned economies.

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

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problems of information 
and problems of incentives.

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Let's look at information first.

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Think about all 
of the different uses of oil.

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Oil is used for producing steel 
and is used for growing vegetables.

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If we have less oil, which one 
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 
worth more than vegetables.

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Maybe, but even if that is true,

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perhaps there are 
really good substitutes

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for oil in its use 
in producing steel,

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

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

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and continue to use oil 
for vegetables.

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Think about all of the different 
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 
fewer candy bars, they cut back

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on asphalt and switched to paving 
their streets and their driveways

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with concrete and brick.

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Could any bureaucracy,
even a large bureaucracy

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

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many uses of oil and all 
of the substitutes for those uses?

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And the substitutes 
for the substitutes?

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Could it make all 
of these subtle choices

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that we've seen
that the market makes?

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It's highly unlikely.

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The information problem 
is too difficult,

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even for massive 
computing power to solve.

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Moreover, even if we could 
gather all of this information,

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this dispersed information

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for millions and millions 
of people, and even if we could

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

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would anyone have the incentive 
to do the right thing?

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Would people have 
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, 
"My use is really valuable.

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It's the most valuable use.

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

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Even if their use happens to be
heating their swimming pool.

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We saw, in fact, what happened 
in the United States

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when the Department of Energy 
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 
of California which could not

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themselves get 
enough oil to operate.

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In other words, 
under central planning of oil,

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we had massive inefficiencies 
and misallocation of resources.

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We saw exactly the same 
misallocation of resources

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

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under communism, 
or China under communism.

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Central planning is not 
a good solution

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to the great economic problem

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because of problems 
of information and incentives.

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We need a better approach.

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

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

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♪ [music] ♪