A Price Is a Signal Wrapped Up in an Incentive

Join Professor Tabarrok in exploring the mystery and marvel of prices. We take a look at how oil prices signal the scarcity of oil and the value of its alternative uses. Following up on our previous video, “I, Rose,” we show how the price system allows for people with dispersed knowledge and information about rose production to coordinate global economic activity. This global production of roses reveals how the price system is emergent, and not the product of human design.

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- [Alex] 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,
but 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 encouraged 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 encouraged 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 predicted 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.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

Or if you're ready to move on,
just click "Next Video."

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