A Price Is a Signal Wrapped up in an Incentive

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. Such as 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? That one way of adjusting to a reduced supply of oil was greater consumption of chocolate? And another way, was 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 this 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. As Nobel Prize winning economist, Vernon Smith, has put it, "The pricing system is a scientific mystery as deep, fundamental, and inspiring as that 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.