- 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.
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