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.

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
an 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 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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