- 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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