The Great Economic Problem

In this video, we discuss how different markets are linked to one another. How does the price of oil affect the price of candy bars? When the price of oil increases, it is of course more expensive to transport goods, like candy bars. But there are other, more subtle ways these two markets are connected. For instance, an increase in the price of oil leads to an increase in demand for oil substitutes, like ethanol. And when the supply of oil falls, oil should shift to higher-valued uses. But, which uses? How do we decide where to use less oil?

This brings us to the great economic problem: how to most effectively arrange our limited resources to satisfy our needs and wants. Which approach — central planning or the price system — is better at solving this problem? Join us as we explore this question further.

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- [Alex] 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.

- [Narrator] 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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