Price as Signal and Incentive

… a core concept in Economic Analysis and Atlas102

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Concept description

In three videos Alex Tabarrok (references below), elaborates on the contention that “a price is a signal wrapped up in an incentive.”

In “Information and Incentives” (video link on right), he notes that an increase in the price of oil is a signal on how to respond and gives users of oil an incentive to respond – by using less oil or substituting lower-cost alternatives for oil. He emphasizes that markets let people decide how to most effectively allocate the use of goods and resources. His summary:

MarketsTakeaway

In “I, Rose” (reference below and video on right), Tabarrok explores “the mystery and marvel of prices”:

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“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.”

Tabarrok quotes Nobel prize winner, Vernon Smith:

“The pricing system is a scientific mystery, as deep, fundamental, and inspiring as that of the expanding universe or the forces that bind matter.”

The great economic problem

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In “The Great Economic Problem” (reference below and video on right) Tabarrok notes how the way markets are linked to one another helps solve the great economic problem of how to most effectively arrange our limited resources (scarcity of resources) to satisfy our needs and wants.

“How does the price of oil affect the price of candy bars? When the price of oil increases, it is of course more expensive to transport goods, like candy bars. But there are other, more subtle ways these two markets are connected. For instance, an increase in the price of oil leads to an increase in demand for oil substitutes, like ethanol. And when the supply of oil falls, oil should shift to higher-valued uses. But, which uses? How do we decide where to use less oil? This brings us to the great economic problem: how to most effectively arrange our limited resources (scarcity of resources) to satisfy our needs and wants.”

Weaknesses of central planning

Tabarrok answers his question, “Which approach – central planning or the price system – is better at solving the great economic problem?” by examining two principal weaknesses of central planning (where a single official or bureaucracy is responsible for allocating limited resources):

  1. Too much information to process
  2. Too few incentives

He uses the example of misallocation of resources during the last major experience with extensive price controls: President Nixon’s response to the oil shock of 1973.

The market solves the information and incentive problems

Tabarrok argues that the Invisible Hand or the market effectively solves both the signaling and the incentive problems, and summarizes with a quote from Friedrich Hayek:

MarketAndHayek

Practice questions

From http://www.mruniversity.com/node/190032http://www.mruniversity.com/node/192285 and http://www.mruniversity.com/node/192286, accessed 1 May 2016.

  1. Circa 1200 BCE, a decreasing supply of tin due to wars and the breakdown of trade led to a drastic increase in the price of bronze in the Middle East and Greece (tin being necessary for its production). It is around this time that blacksmiths developed iron- and steel-making techniques (as substitutes for bronze). What does the increasing price of bronze signal?
  2. Let’s see if the forces of the market can be as efficient as a benevolent dictator. Since laptop computers are increasingly easy to build and since they allow people to use their computers wherever they like, an all-wise benevolent dictator would probably decree that most people buy laptops rather than desktop computers. This is especially true now that laptops are about as powerful as most desktops. Since it’s become much easier to build better laptop computers in recent years, laptop supply has increased. What does this do to the price of laptops?
  3. If a nation’s government made it impossible for inefficient firms to fail by giving them loans, cash grants, and other bailouts to stay in business, is that nation likely to be poorer or richer as a result of this strategy? (Hint: Steven Davis and John Haltiwanger. 1999. “Gross Job Flows.” In Handbook of Labor Economics (Amsterdam: North–Holland) found than in the United States, 60% of the increase in U.S. manufacturing efficiency was caused by people moving from weak firms to strong firms.)

Atlas topic, subject, and course

The Price System and Price Regulation (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, I Rose (3-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-system-definition-invisible-hand, accessed 1 May 2016.

Alex Tabarrok, Information and Incentives (10-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/information-problem-economics-hayek, accessed 1 May 2016.

Alex Tabarrok, A Price Is a Signal Wrapped up in an Incentive (5-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-system-spontaneous-order, accessed 1 May 2016.

Alex Tabarrok, The Great Economic Problem (8-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/economic-problem-central-planning-70s-oil-crisis, accessed 1 May 2016.

Page created by: Ian Clark, last modified 1 May 2016.

Images: Alex Tabarrok, minute 0:14 of Information and Incentives (10-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/information-problem-economics-hayek, accessed 1 May 2016.

Alex Tabarrok, minute 0.00 of A Price Is a Signal Wrapped up in an Incentive (5-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/price-system-spontaneous-order, accessed 1 May 2016.

Alex Tabarrok, minute 0:14 of The Great Economic Problem (8-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/economic-problem-central-planning-70s-oil-crisis, accessed 1 May 2016.