| (Q1) Spring 2013 Homework Questions |
Humble yourself before the modern economy
Take any product you consume and ask yourself: do you understand hardly anything about how it is made? Chances are, you know almost nothing. Remember, much of our wealth stems from how we specialize in producing only a few things, becoming really good at it and trading those few goods for others for things we wish to consume but do not—often, cannot—make for ourselves. In a modern economy, you are not supposed to know how the stuff you consume is made.
Most of the information needed for an economy to function properly is decentralized, meaning pieces of information are scattered throughout an economy, and is unable to be completely gathered or understood by any one person.(H1) Plumbers understand plumbing and the manager at Fuzzy Tacos understands the restaurant business, but the manager of Fuzzy Tacos does not know plumbing and the plumber has no experience running a restaurant.
Consider the case of water in Texas. In recent years, the availability of water has been declining. Both suburban households in central Texas and rice farmers south of them use water, and both must decrease their water consumption,(P1) but which entity should forgo the most water? The question requires us to know the value people in central Texas place on having a green lawn, the various ways they can adjust to less water, and other water sources available to households. The question also requires us to know the profits rice farmers can make producing rice and the substitutes to rice production available to them. It is almost impossible for governments to estimate these things accurately, especially if we are considering large decreases in water uses. One could implement surveys, but people do not reveal their true values on surveys.(M1) Only rice farmers know the profits they make from rice production. Only suburban households know how strongly they want green lawns. These are not things a government official can look-up in a handbook, nor are they things a consultant to discover for them.
Do we want politicians to make these water decisions? Why would they have the proper information, and why do we expect politicians to want a good outcome for everyone, as opposed to benefitting their campaign supporters? What about experts, like agricultural economists? They too cannot synthesize the decentralized information to make good decisions. I have tried to make decisions like this and I have a Ph.D in economics. Only if I was extremely arrogant could I claim to know the answer.
What this means is that it would be arrogant for you to presume to have the knowledge and intellect to tell industries and consumers how they should behave. Who are you to say what the wage rate should be? Who are you to say whether a business is charging too high or too low of a price? Who are you to tell a business what preservatives it should add to foods? Who are you to say people should eat less sugar?
There are indeed some instances when a democracy should constrain businesses and consumers, but good policy first requires you to be realistic about what you can understand about a modern economy. However humble you may claim to be, videos 1 and 2 will make you humbler.
Video 1—I, Pencil: The Movie
Video 2—I, Smartphone: The Movie
Prices coordinate the economy
Are you now humble? Perhaps too the point that your ignorance bothers you? Good, because now I can tell you that this ignorance is no weakness. There is very little a business or consumers needs to understand about the rest of the economy, because most of the information they need to know about the economy is revealed through market prices.
The solution to the water problem in Texas is actually quite simple, at least in theory. If we allow water to be sold to the highest bidder, only then will we know whether rice provides more social value as an input into rice production or as irrigation to suburban lawns. Whoever will pay the highest price for water values water the most. Indeed, in 2013 such a process was being pursued, as a group of central Texans sought to pay rice farmers downstream to not farm rice. If they are able to offer rice farmers a high enough price to convince them not to flood patties for rice production, then the water is valued higher by suburban communities in central Texas than it is for rice production further south.(P1)
It must be stressed that this refers only to market prices, where buyers and sellers voluntarily interact and are not constrained in the prices they negotiate. As soon as government places restrictions on these prices, the information they contain begins to vanish.
Video 3—The Information in Market Prices
Only by allowing them to interact and trade with each other in markets can the decentralized information people possess be combined in an effective way to ensure a wise use of resources.
Video 4—What Prices "Know" That You Don't
Market Prices and Tunnel-Vision
Modern democracies rely on market prices as guides for most choices. This makes everyday decisions by corporations and consumers much simpler, allowing them to concentrate on what they do best. A rice farmer doesn't need to spend two hours everyday studying production and consumption of rice in different regions throughout the world to determine how much rice they should grow. Instead, they can just observe the market price of rice. This includes the current market price and futures prices, which tell them the price of wheat one month, two months, and even a year from now. Relying on the rice price for information, the farmer can then concentrate on her area of specialization: growing quality rice efficiently.
The farmer can then develop tunnel-vision,(S1) where she doesn't worry about how much rice India is producing, or whether Mexicans are consuming less rice. She just observes rice prices and concentrates on earning a higher profit, which means she is creating greater value for the rest of us.
Market prices allow individuals to focus their time on becoming even more specialized in the production of a few goods or services. This allows them to become even better at what they do, and when everyone throughout an economy becomes more efficient producers, that economy produces greater wealth.
Tunnel-Vision Vision Versus Panoramic Blurryness
In a subsequent article we will see how this tunnel-vision can create problems. If businesses focus only on what impacts them without society at large, they might not see that the small amounts of pollution by each firm totals to a massive amount of pollution by all firms. Tunnel-vision in this case makes us ignorant, and we pay for it.
Before we move to situations where tunnel-vision is bad and some sort of collective action is needed, we must first point out that because it is so hard for anyone to understand the economy, and government that tries to regulate firms by looking at the big-picture will only see a very blurry picture, and it is for this reason that central planning by governments have performed so poorly in socialist countries. I refer to this as panoramic-blurryness, and before we attempt to use government action to improve the big picture, we must humble ourselves and recognize that big portrait of the world we see is a very, very blurry picture, and no one person will ever see what the picture really looks like.
References
(H1) Hayek, F. A. 1988. The Fatal Conceit. Chicago University Press: Chicago, IL.
(M1) Murphy, J. J., P. G. Allen, T. H. Stevens, and D. Weatherhead. 2004. “A Meta-Analysis of Hypothetical Bias in Stated Preference Valuation.” Environmental and Resource Economics. 30(3):313-15.
(P1) Price, Asher. March 3, 2013. “Central Texas coalition urges buyout of rice farmers.” Statesman.com. Accessed March 18, 2013 at http://www.statesman.com/news/news/state-regional-govt-politics/central-texas-coalition-urges-buyout-of-rice-farme/nWf6J/.
(S1) Seabright, Paul. 2004. In the Company of Strangers. Princeton University Press: Princeton, NJ.
