Information and Incentives

♪ [music] ♪ – [Alex] We’re now going
to examine in more depth how the price system solves
the great economic problem. Here is by now our very familiar
diagram of the market for oil. Notice that all of the uses of oil
above the market price are the higher valued uses
and the satisfied demands. The uses of oil
below the market price are the lower valued uses
and the unsatisfied demands. Take a look at the use
which is just equal or very, very close
to the market price right here. We can think about this use
in two different ways. We can think about this
as being the value of the highest valued
unsatisfied demand, or pretty much
exactly the same thing, this is the least valuable
satisfied demand. The price is thus equal
to the marginal value. The marginal value is the lowest
valued satisfied demand, or the highest valued
unsatisfied demand. We can also say
that the price is equal to the social opportunity cost. What do I mean?
Take a look. Take one of these users up here. They’re going to be comparing
the value of oil in their use to the market price. But that means
that they’re comparing the value of oil in their use to the next
most valuable use of oil. If these guys were not to use
this barrel of oil, the next most valuable use of oil,
that would be here. In comparing their value
to the market price and saying, “Well, my value is higher,
therefore I’m going to use the oil,” the oil flows
to the highest valued users. It doesn’t go
to the unsatisfied users because their value of oil
is too low. It goes to the highest valued users. It’s the same thing
with the guys down here. They have a low valued use. They’re comparing the value
of oil in their use to the market price. They’re saying, “Well, I’m not
going to use this barrel of oil.” And that too is good, because if they were to use
that barrel of oil, then it would no longer
be available to satisfy the lowest value
currently satisfied demand. In comparing the value
of oil in their use to the market price, once again
what they’re really doing, unbeknownst to them,
is comparing their use of oil with the social opportunity
cost of oil — and that’s exactly what we want
the market system to do. That’s exactly how we solve
the great economic problem. To really bring us home,
let’s look at what happens when there’s an increase
in the cost of supplying oil. How does the market respond? With an increase in the cost
of producing oil the supply curve shifts up. Notice that the price goes up and the quantity
of oil used goes down. Now notice that the satisfied
demands now become these — the most, the highest value demands,
which we can still satisfy given the reduced quantity
of oil available. The unsatisfied demands
become these demands. We’ve got more of them now, but notice which demands
become unsatisfied. It’s the least valuable demands
given the quantity that become unsatisfied. Moreover, we’re letting
millions of people make their own choices. We’ve let them look around and say, “Well, with this higher price
of oil, how can I respond? What do I know
about the substitutes for oil? What do I know about
the alternatives for oil in my use? What do I know
about the value of oil in my use?” These people, whoever they are — we don’t need
to know who they are — decide on their own
using their own information that, “Yes, now that the value of oil
in alternative uses is higher, I should give up my use of oil.” What kind of uses are given up? It’s the use of oil
in the least valuable uses — just for paving
your driveway with asphalt. The key is we let people decide
using their own information, about all of the substitutes for oil
in their many, many uses, whether it’s producing candy bars
or asphalt for driveways, or bricks or whatever. These users of oil will decide
to give up their oil in response to the higher price — and that is exactly
what we want them to do. The higher price signals
what the users of oil should do and it gives them an incentive
to do exactly that. Remember, to solve
the great economic problem we need to solve
information problems and incentive problems. Let’s take a closer look
at how the market, how the price system is doing this. How does the price system
solve the information problem? The market collapses
all of the relevant information into a single number —
the market price. Instead of collecting
all the required information in a central spot, the market transmits
just a little bit of information to everyone
in a decentralized fashion. Here’s what Friedrich Hayek, Nobel Prize winner
in Economics said. “The most significant fact
about this system [price system] is the economy of knowledge
with which it operates… by a kind of symbol [the price], only the most essential information
is passed on and passed on
only to those concerned… The marvel is that
in a case like that of a scarcity of one raw material
without an order being issued, without more than perhaps
a handful of people knowing the cause of the scarcity, tens of thousands of people whose identity
could not be identified by months of investigation — they are made to use
the material or its products more sparingly, i.e. they move
in the right direction.” The price system economizes
on information. It’s able to allocate resources
in a decentralized fashion using all of the information
available, but without collecting
all of that information, without having to transmit
all of that information, because it makes use
of the information in a decentralized fashion. It uses the information
which is in people’s heads. The way that Tyler and I
like to summarize this is that a price is a signal
wrapped up in an incentive. An increase in the price of oil signals users that oil has become
more valuable in alternative uses. But that alone is not enough. We also want people
to move in the right direction, to take the signal seriously, to adjust in the right way
to the signal. And the higher price
does exactly this. It gives users of oil an incentive
to respond to the signal. They respond by using less, by substituting
a lower cost alternative. And suppliers are also
incentivized by the signal to invest more in exploration,
to look for alternative sources, to build more, and so forth. One final point before we wrap up. Politicians and consumers
sometimes fail to understand the signaling role of prices. After a hurricane for example, it’s quite common for the prices
of ice and generators and chainsaws to skyrocket. Consumers complain
of price gouging. Politicians call
for price controls. But really this is
a bad rap on the market because it’s just doing its job. It’s signaling
that we need resources. The higher prices
in a hurricane-devastated region, that says,
“Bring the resources here!” The high price is a signal
saying that the value of ice, the value of generators,
the value of chainsaws — it’s really high in this location,
in this time. And that higher price
is acting as an incentive. It’s telling entrepreneurs, “You can profit
by bringing resources from where they have low value
to where they have high value.” The price system is doing
exactly its right job. It’s signaling
and incentivizing people to respond to these shortages. Okay. Let’s summarize a little bit
what we’ve learned. Markets are linked. They are linked geographically
across the world. They are linked
across different goods. They’re also linked,
by the way, through time. We haven’t actually
discussed that one yet. We’ll discuss that
in the next few lectures when we talk
about speculation. And the market, it kind of acts
like a giant computer that arranges our limited resources
over space, time, and across different goods
so that we can satisfy as many of our wants as possible. Prices are the signals that coordinate
all of this economic activity. Thanks. – [Narrator] If you want
to test yourself, click “Practice Questions.” Or, if you’re ready to move on,
just click “Next Video.” ♪ [music] ♪

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