A Price Is a Signal Wrapped Up in an Incentive

Join Professor Tabarrok in exploring the mystery and marvel of prices. We take a look at how oil prices signal the scarcity of oil and the value of its alternative uses. Following up on our previous video, “I, Rose,” we show how the price system allows for people with dispersed knowledge and information about rose production to coordinate global economic activity. This global production of roses reveals how the price system is emergent, and not the product of human design.

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- A modern economy depends on the
cooperation of vast numbers of strangers

but how is this cooperation coordinated?
Let's revisit the economics behind roses

but this time let's go back to 1973. In
the 1970s, the price of oil skyrocketed

so it made sense to economize that oil has
many uses. So which uses should we cut

back and which should we maintain? In a
market economy, no one person decides

these questions or perhaps more accurately
everyone does. A price is a signal wrapped

up in an incentive. So when the price of
oil increased it signaled that oil had

become more scarce and it gave everyone an
incentive to listen to that signal. It

said find ways to economize on oil or
develop substitutes and you will profit.

When the price of oil first increased,
most roses bought in the United States

were grown in greenhouses in New Jersey,
in Pennsylvania. The increased price of

oil meant that it cost more to heat those
greenhouses which meant a shift upwards in

the supply curve for flowers and an
increase in the price. The result was that

it encourage people to turn to
substitutes. So just chocolate and Teddy

bears to give to their loved ones at
Valentine's Day but the story doesn't end

there. Seeing the higher price of oil,
entrepreneurs began to think about other

ways to produce flowers. Instead of
heating a greenhouse, why not use the

natural heat of the sun and transport the
roses. Entrepreneurs encourage farmers in

Kenya and Ecuador to start growing roses.
And they began to invest in a new global

infrastructure to deliver roses around the
world. Who could have predict it? Did one

way of adjusting to a reduced supply of
oil was greater consumption of chocolate?

And another way by importing roses. In
fact, no one could have predicted, let

alone plan all the myriad ways in which
people responded to the increased price of

oil. That's because no one knows all the
information that the market uses.

Everything from the cost of growing
greenhouses, to the demand for roses

versus chocolate, to the value that a
particular piece of land in Kenya has for

growing flowers versus coffee. No single
individual knows all of these information.

It's dispersed. So when oil becomes scarce
we want people all over the world to use

this dispersed information, their
information and their ingenuity to figure

out how best to economize on oil. The
price system does this in a remarkably

efficient way. The Kenyan farmer doesn't
have to know anything about oil to have an

incentive to do the right thing. He just
sees that the price paid for roses has

increased and so following his self
interest he starts to produce more roses.

Ultimately, that frees up more oil to be
used in the production of jet fuel where

there are fewer substitutes. Millions of
decisions like this made all over the

world, rearrange and reallocate the
world's production. Taking oil from where

it has low value and moving it to where it
has high value so that we produce the most

value from our limited resources. That is
the invisible hand in action. If it had

been invented the price system would be
one of the most amazing creations of the

human mind. But like language it
wasn't invented and

it worked long before anyone had any
understanding of its principles. There's

Nobel price economist Vernon Smith has put
it, the pricing system is a scientific

mystery as deep, fundamental and inspiring
as out of the expanding universe or the

forces that bind matter. We'll be
exploring more about the mystery and the

marvel of the price system in
the next video.

- If you want to test yourself,
click Practice Questions or if you're

ready to move on, just click Next Video.

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