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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- 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 means a higher

transportation cost, and anything you
transport therefore, becomes a little bit

more expensive. But what I have in mind is
actually 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 then
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 the

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 to 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 substitute
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 response
that we've seen to an increase of 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 the substitutes for

those users? And the substitutes for the
substitutes?

Could it make all of these
subtle choices?

The scene that the market makes, it's
highly unlikely. The information problem

is too difficult even from 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.

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